<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-KSB
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended March 31, 1999
Commission File No. 0-28604
ELECTROSCOPE, INC.
------------------
(Exact name of Issuer as specified in its charter)
Colorado 84-1162056
-------- ----------
(State or other jurisdiction of (I.R.S. Identification Number)
incorporation or organization)
4828 Sterling Drive, Boulder, Colorado 80301
- -------------------------------------- -----
(Address of principal executive offices) (Zip Code)
Issuer's telephone number, including area code: (303) 444-2600
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, no par value
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
----- -----
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 $1,568,428 for its fiscal year ended March
31, 1999.
As of June 1, 1999 assuming as a market value the price of $0.47 per share
(the last sales price of the Issuer's Common Stock on the Over the Counter
Bulletin Board) the aggregate market value of shares held by non-affiliates
was $1,406,623.
As of June 1, 1999 the Issuer had outstanding 5,383,507 shares of Common
Stock, no par value.
Documents Incorporated by Reference: Definitive Proxy Statement for the 1999
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 1999 Proxy Statement will be filed within 120 days after the
end of the fiscal year ended March 31, 1999.
This Form 10-K consists of 34 pages.
<PAGE>
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. Monopolar electrosurgery is surgery in which electrical
current flows from an electrosurgical generator to the surgical site via a
single active electrode and is returned to the electrosurgical unit by a
remote return electrode. An active electrode is a device that directs
electrical current from an electrosurgical generator to the surgical site to
achieve the desired surgical effect. The active electrode can be in the form
of scissors, cutting blades, probes or clamps. The market opportunity was
created by the inherent risks of internal electrical burns to a patient
undergoing laparoscopic surgery. The Company's initial approach to the market
was to design, develop, manufacture and market a patented monopolar
electrosurgical shielding system, supplemented by shielded electrosurgical
instruments. The Company's patented Active Electrode Monitoring system
("AEM-Registered Trademark-") protects the surgical patient from stray
electrical energy that can cause injury or even death by actively and
continuously monitoring current flow through the shielding system and
disabling the electrosurgical current when potentially dangerous conditions
exist. The Active Electrode Monitoring system allows surgeons to perform a
broad range of surgical procedures using laparoscopic monopolar
electrosurgery, more safely and more efficaciously than is possible using
unshielded instruments.
Monopolar electrosurgery utilizes radio frequency ("RF") electrical
energy to perform surgical incisions and to control bleeding during surgery.
These 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. 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. These benefits include
reduced trauma to the patient, reduced time in the hospital, shorter recovery
periods for patients and lower costs than conventional open surgery.
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 the nature of the camera system used, the surgeon is
limited to a small field of vision that may be only 1" - 2" in diameter.
Given the surgeon's restricted field of vision, there is the potential for
unintended and unobserved tissue or organ 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.
Capacitive coupling is a physical phenomenon that can occur when a
non-conductor (insulation) separates two conductors. This creates what is
known as a capacitor. In MIS, the conductors are the surgical instrument
shaft and the metal cannula through which the instrument is inserted into the
body and the insulation on the metal shaft of the instrument is the
non-conductor. These tissue and organ burns are particularly dangerous
because they may lead to unrecognized perforation or infection of adjacent
tissues or organs, 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 employees,
independent sales representative organizations, as well as stocking
distributors 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 thus lost its exclusivity. The
Company terminated the agreement in February of 1998.
2
<PAGE>
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
from time to time. The Company will pursue developing new products both
internally and through acquisition of existing product lines from third
parties.
Market Development Overview
In 1995, 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 force 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. However, these measures,
or any others that the Company may adopt, may not result in either increased
revenues or profitable operations. Management does not expect that profitable
operating levels will be reached in fiscal year 2000.
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 in
the insurance industry about patient safety during the use of monopolar MIS
electrosurgical procedures because of the potential for internal injuries.
Such injuries are sometimes caused by burns to non-targeted tissue or organs
at locations that cannot be observed by the surgeon during the surgical
procedure. The burns can result from failure of the insulation on the
surgical instruments or from 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 the surgeon cannot detect this injury at the time of the procedure.
The complication usually presents 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 the edges of a trocar
cannula, or other sharp instruments, during normal use. In addition, the
heating associated with high frequency and high voltage (corona heating) has
been shown 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 current. Accordingly, the
more-difficult-to-detect tiny defects may present more potential for
unrecognized tissue burns than larger insulation defects.
3
<PAGE>
A second risk is capacitive coupling, which can occur when a
non-conductor (insulation) separates two conductors. 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 AEM-Registered Trademark- system, an innovative, safe, and
cost effective solution for use with monopolar electrosurgery, the
predominant method used for minimally invasive surgical applications. The
AEM system protects the patient from the risk of a burn that is out of the
surgeon's view by allowing the free passage of RF electrical energy to the
cutting or coagulating tips of the electrosurgical instruments while
continuously monitoring current flow in the patented instrument shield to
detect dangerous stray energy. The concept of Active Electrode Monitoring
was developed and patented by the Company. AEM 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 AEM system 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.
The Company provides a safe and efficacious solution to the risks
presented by the use of monopolar electrosurgery that is transparent to the
surgeon and is cost effective. The Company's EM2+ Electronic Monitoring
units plug directly into most operating rooms' 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 ACTIVE ELECTRODE MONITORING SYSTEM
The Company's Active Electrode Monitoring 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
patented shielding technology. 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.
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.
4
<PAGE>
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, manufactures and sells an array of the most common
fixed tip and hinged reusable monopolar 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, permitting
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.
The Company also designs and manufactures disposable monopolar
electrosurgical scissors that incorporate AEM-Registered Trademark-
technology.
In the last quarter of Fiscal Year 1999 the Company began to distribute
a line of bipolar electrosurgical instruments.
The Company continues to develop new products that will expand the
product line offered by the Company's sales force. These new products will
take advantage of the Company's expertise and understanding of MIS
procedures, the needs of surgeons performing those procedures and the
advantages of AEM technology.
MARKETING AND SALES
It is the Company's belief that the AEM-Registered Trademark- technology
should be the standard of care in laparoscopic surgery in the world. In
September 1995, the Company decided to replace its initial direct sales
efforts by entering into an exclusive distribution agreement with Valleylab
Inc., then a part of the Hospital Products Group of Pfizer, Inc. The Company
believed that this would enable the Company's products to quickly and
effectively penetrate the market for electrosurgical equipment. Due to
Valleylab's failure to meet the minimum purchase requirements, the agreement
became non-exclusive for calendar year 1997. In February 1998, United States
Surgical Corporation acquired Valleylab, and the Company terminated the
agreement in accordance with its terms.
In certain instances, customers have recognized the problems associated
with monopolar electrosurgery, and have readily accepted the Company's
solution to the problems. However, in other instances the Company has found
that selling the concepts behind the EM2+ product and accessories has been
more difficult, and takes longer, than originally expected. 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 the potential for injury) and the
consequent need to make multiple sales calls on those personnel with the
ability to commit to additional capital expenditures in hospitals. In
addition, a significant number of hospitals have contractual arrangements
with manufacturers of competing surgical instruments that make selling the
Company's products more difficult.
5
<PAGE>
To cost-effectively expand market coverage, the Company has contracted
with and trained a network of independent sales representative organizations
and stocking distributors (each with several sales representatives) across
the U.S. The Company believes that this network, with experience selling into
the hospital operating room environment, offers the Company the best
opportunity to broaden the acceptance of its product line, and to generate
increased revenues. To supplement 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 four full time and two part-time engineers and uses
independent contractors from time to time in its research and product
development efforts. This group is exploring ways to broaden the product
line that the Company can offer to its sales force. This includes developing
and researching products for other than monopolar 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 it 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 to broaden the scope of
products offered by the Company's sales force.
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 2000. 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. Company personnel subject all
finished products to quality assurance and performance testing procedures.
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 ("FDA"). At March 31, 1999, the production staff consisted of
three people and the regulatory affairs and quality assurance staff consisted
of three people.
The Company's leased facility of 11,455 square feet contains
approximately 6,500 square feet of manufacturing, regulatory affairs and
quality assurance space.
6
<PAGE>
The facility is designed to comply with the Quality System Regulation
("QSR") as specified in published FDA regulations. As noted below
(Government Regulation) the Company's facility has recently been inspected by
the FDA and has been found to be "...in substantial compliance with the
Quality System Regulation...".
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 might copy the Company's technology or otherwise
be able to incorporate the technology in their products.
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 monopolar electrosurgical instruments that are not
shielded or 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
products for monitoring for stray energy, the manufacturers of unshielded
instruments will resist any loss of market share resulting from the presence
of the Company's shielded products in the market.
The Company also believes that manufacturers of products based upon
surgical techniques that are alternatives to monopolar electrosurgery are
competitors of the Company, competing for acceptance of the techniques their
products support, and in the case of Everest Medical, competing against the
company for the sale of bipolar instruments. 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
7
<PAGE>
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. 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 FDA regulates the Company and its products under a number of
statutes, including the Federal Food, Drug and Cosmetics Act (the "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-market notification and adherence to
QSR). 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 EM2 Electronic Monitor, monopolar MIS
electrosurgical instruments with Electroshield-Registered Trademark-, and its
Electroshield Monitoring System, 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 FDA regulates the Company's quality control and manufacturing
procedures by requiring the Company and its contract manufacturers to
demonstrate compliance with the QSR as specified in published FDA
regulations. The FDA requires manufacturers to register with the FDA, which
subjects them to periodic unannounced FDA inspections
8
<PAGE>
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 November
1998, the FDA conducted a Quality System Regulation Inspection of the
Company's facilities, with no regulatory follow-up indicated. The Company
believes that it has already corrected any points noted in the inspection.
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 found not to be in compliance with the QSR, 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 that 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.
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 that minimize the potential exposure for
employees. Such materials are disposed of in accordance with specific
procedures. The costs of compliance with these procedures are not
significant.
EMPLOYEES
As of March 31, 1999, the Company employed 24 individuals, 8 of which
are engaged directly in research, development and regulatory activities, 3 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 and sub-leases 11,455 square feet of office and
manufacturing space at 4828 Sterling Drive, Boulder, Colorado 80301. These
leases expire on March 1, 2000 and September 15, 2001.
ITEM 3. LEGAL PROCEEDINGS.
The Company is not involved in any legal proceedings, nor is it aware of
any pending legal proceedings. The Company may become involved in litigation
in the future in the normal course of business.
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, 1999.
9
<PAGE>
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 Bulletin
Board 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, 1998
First Quarter through June 30, 1997 3.50 1.75
Second Quarter through September 30, 1997 3.00 2.00
Third Quarter through December 31, 1997 2.63 1.38
Fourth Quarter through March 31, 1998 1.88 1.38
FISCAL YEAR ENDED MARCH 31, 1999
First Quarter through June 30, 1998 1.81 1.00
Second Quarter through September 30, 1998 1.25 0.50
Third Quarter through December 31, 1998 0.66 0.45
Fourth Quarter through March 31, 1999 0.56 0.22
</TABLE>
As of March 31, 1999, there were approximately 183 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 1, 1999
approximated 550 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.
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 Active Electrode 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 that 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,
Inc., then part of the Hospital Products Group of Pfizer, Inc., under 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. The Company terminated the Agreement in accordance
with its terms in February 1998 after the sale of Valleylab to US Surgical
Corporation. To replace Valleylab as its distributor, the Company has
contracted with a
10
<PAGE>
network of independent sales representative organizations and stocking
distributors 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 its 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 somewhat slow to occur.
The Company has modified its marketing strategies to address the issues of
market acceptance of the technology, and has undertaken efforts to broaden
the product line offerings beyond the original EM2 product and its
accessories.
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 late 1995, when integrated instruments for the
Electroshield Monitoring System were introduced.
The Company believes the installed base has the potential for increasing
as the risks inherent in monopolar laparoscopic electrosurgery become more
widely acknowledged and the sales organization becomes more familiar with the
Active Electrode Monitoring System 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.
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
inherent risks associated with monopolar laparoscopic surgery become more
widely acknowledged and as the network of independent sales representatives
and the Company's international distributors become more familiar with the
AEM-Registered Trademark- system 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 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.
However these measures, or any others that the company may adopt, may not
result in either increased revenues or profitable operations. Management
does not expect that profitable operating levels will be reached in fiscal
year 2000.
PROBABILITY OF CONTINUED OPERATING LOSSES: The Company has incurred losses
from operations since inception and has an accumulated deficit of $12,303,335
as of March 31, 1999. 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
11
<PAGE>
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 its sales network, which may result in higher levels of selling
expenses.
REVENUE GROWTH: The Company expects to introduce additional new products in
fiscal year 2000 which are expected to contribute to increased revenues in
fiscal 2000 and beyond. The Company expects to generate increased revenues
from the U.S. both from sales to stocking distributors with sales forces in
place and as the independent network of representatives becomes more familiar
with the product and expands the installed base of Active Electrode
Monitoring systems with resulting increases in sales of electrosurgical
instruments used by this installed equipment. The Company also expects to
increase the volume of product sold internationally. The Company plans to
attain ISO 9001 certification in FY 2000 and also plans to qualify its
products for CE mark status; (CE is an abbreviation of the phrase Conformite
Europeene. The marking indicates that a manufacturer has conformed to all of
the obligations imposed by European health, safety and environmental
legislation) which will allow the Company to market its products in Europe.
The Company expects to receive ISO 9001 certification, and CE status for at
least some of its products, but such results cannot be guaranteed.
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 on products manufactured or assembled by the
Company 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 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 resulted in the introduction of two new disposable scissors
products in Fiscal Year 1998 and a new bipolar product line in Fiscal Year
1999. Others are anticipated to be introduced in Fiscal Year 2000. Research
and development expenses are expected to increase modestly in FY 2000 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. 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.
RISK FACTORS WHICH MAY AFFECT FUTURE PERFORMANCE:
Among the factors that 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 continue 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
12
<PAGE>
commercially viable quantities. If the Company's products do not achieve
market acceptance in these quantities, the Company's business, financial
condition, operating results and cash flows 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 nature of the
independent 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 and stocking distributors 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.
HISTORY OF OPERATING LOSSES AND CAPITAL AVAILABILITY: The Company was formed
in 1991, and has incurred losses since its inception. The Company has
primarily financed its research and development and operational activities
with sales of common stock. At March 31, 1999, the Company had an
accumulated deficit of $12,303,335. 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. 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, 1999, the Company had $4,361,659 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, 2000.
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 financial position,
results of operations and cash flows.
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
13
<PAGE>
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 financial position, results of operations and cash
flows.
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 in November of
1998. 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 financial
position, results of operations and cash flows.
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 financial position, results of operations and cash flows would be
materially adversely effected.
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-Registered Trademark- Monitoring
System and related accessories and has applied for three additional US
patents. In addition, the Company has three issued foreign patents and one
foreign patent application pending. 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
14
<PAGE>
adversely affect the Company's financial position, results of operations and
cash flows.
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. 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 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 that 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 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. The Company's failure
to manufacture its product in commercial quantities at acceptable costs would
have a material adverse effect on the Company's financial position, results
of operations and cash flows.
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 Active Electrode 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 financial position, results of operations and cash flows.
DEPENDENCE ON KEY PERSONNEL: The Company is highly dependent on a limited
number of key management personnel, particularly its Acting Chief Executive
Officer and Vice President of Research and Development, David W. Newton, its
Vice President of Sales and Marketing, Roger C. Odell and its Vice President
of Finance & Administration, Karl Hawkins. 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 financial
position, results of operations and cash flows.
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
15
<PAGE>
2000. The Company has conducted an assessment of its internal exposure to the
Year 2000 problem. Products manufactured by the Company do not incorporate
any computer programs that rely on two-digit date codes. The cost to replace
hardware and computer software used by the Company does not exceed $10,000.
The Company has formally communicated with its significant vendors of goods
and services with respect to their compliance with Year 2000 programs. Most
of these vendors have responded either with assurances that they are or will
be Year 2000 compliant before the year 2000. However, the Company recognizes
that the nature of its business and those of many of its service providers
and vendors, featuring interconnected systems of businesses, utilities,
government agencies and even individuals, could affect the Company's ability
to provide products to its customers, and by extension, could adversely
affect the Company's financial position, results of operations and cash
flows. The Company continues to make concerted efforts to evaluate the Year
2000 issue as it may affect the Company, but because of the
interrelationships with its vendors, and their relationships with their
vendors, it will not be possible to certify with 100% assurance that the
Company will not be subject to some problems resulting from the Year 2000
issue. The Company does not believe at this time that these potential
problems will materially impact the ability of the Company to continue its
operations, however, no assurance can be given that this will be the case.
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, 1999 ("FY 99")
were $1,568,428, an increase of 19% from the fiscal year ended March 31, 1998
("FY 98"). The increase in FY 99 revenue is attributable to the Company
continuing to develop its own sales and marketing efforts, plus the
introduction of new products mid-way through FY 98, which were available for
all of FY 99. In addition, in FY 99 sales to the first new stocking
distributor were approximately $196,000 compared to $0 in FY 98.
Revenues for FY 98 were $1,315,915, a decrease of 6% from the fiscal
year ended March 31, 1997 ("FY 97"). This decrease was due to a combination
of factors, most importantly the transition from the exclusive Valleylab
sales effort to a network of independent manufacturers representative
organizations.
GROSS PROFIT. Gross profit in FY 99 was $446,730, which resulted in a gross
margin of 28.5% of revenue. This was an improvement of $349,157, over three
times FY 98 gross profit. The increase was primarily the result of increased
revenues, resulting in increased utilization of fixed manufacturing overhead,
reduced headcount and lower charges for inventory reserves.
Gross profit in FY 98 was $97,573, compared to FY 97 when the cost of sales
exceeded revenues by $23,821. The increase in gross profit was primarily
attributable to reduced costs of materials, including lower scrap costs, in
FY 98. The 1997 results were primarily due to 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.
SALES AND MARKETING EXPENSES. Sales and marketing expenses were $1,393,719
in FY 99, a decrease of 24% from FY 98. The decrease was a result of lower
spending on marketing programs, reduced headcount and a change from direct
sales employees, who were paid salaries and commissions, and were reimbursed
for travel and other expenses to a primarily commission only sales force.
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
16
<PAGE>
products. In addition, significant marketing resources were devoted to
increasing public awareness of the hazards inherent in laparoscopic surgery.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses were
$933,642 in FY 99, a decrease of 22% from FY 98. The reduction was a result
of reduced headcount and improved expense controls.
General and administrative expenses were $1,200,572 in FY 98, a decrease of
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 and a
Chief Financial Officer in the 2nd Quarter.
RESEARCH AND DEVELOPMENT. Research and development expenses were $581,659 in
FY 99, a decrease of 11% from FY 98. This reflects reduced headcount and
reduced levels of inventory usage to support development projects.
Offsetting some of the expense reductions was the write-off of approximately
$50,000 in previously capitalized costs relating to patents on technology
that the Company has elected not to pursue, in order to concentrate on the
AEM-Registered Trademark- program.
Research and development expenses were $652,298 in FY 98, an increase of 6%
from FY 97, reflecting increased spending on several product development
programs.
NET LOSS. Net Loss in FY 99 decreased $1,015,374 (32%) compared to FY 98.
Net Loss in FY 98 was $3,194,732, an increase of 10% 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.
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, 1999, and, to a lesser degree, funds provided
by sales of the Company's products. The Company used $1,922,165 of cash in
its operations in FY 99, $3,769,642 in FY 98, and $2,283,765, in FY 97, which
relate primarily to the funding of the Company's annual net losses. The
Company raised $0, $0, and $13,437,102, from issuance's of its Common Stock
in each of Fiscal Years 99, 98 and 97, 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, 1999, the Company had $4,361,659 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 $12,300,000 are
available to reduce taxable income as of March 31, 1999. 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.
17
<PAGE>
ITEM 7. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The following financial statements are included in this Report:
<TABLE>
<CAPTION>
Page
----
<S> <C>
Report of Independent Public Accountants................................... F-1
Consolidated Balance Sheets as of March 31, 1999 and 1998.................. F-2
Consolidated Statements of Operations for the fiscal
years ended March 31, 1999, 1998 and 1997.................................. F-3
Consolidated Statements of Shareholders' Equity for
the fiscal years ended March 31, 1999, 1998 and 1997....................... F-4
Consolidated Statements of Cash Flows for the fiscal years
ended March 31, 1999, 1998 and 1997........................................ F-5
Notes to Consolidated Financial Statements................................. F-6
</TABLE>
18
<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, 1999 and 1998, and the related
statements of operations, shareholders' equity and cash flows for each of the
three fiscal years in the period ended March 31, 1999. 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, 1999 and 1998, and the results of its operations and its cash flows
for each of the three fiscal years in the period ended March 31, 1999, in
conformity with generally accepted accounting principles.
Denver, Colorado, ARTHUR ANDERSEN LLP
May 7, 1999.
F-1
<PAGE>
ELECTROSCOPE, INC.
BALANCE SHEETS
MARCH 31, 1999 AND 1998
<TABLE>
<CAPTION>
ASSETS 1999 1998
------------ ------------
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents $ 1,188,867 $ 2,525,026
Short-term investments, net of discount of $12,258 (1999)
and $34,841 (1998) 3,172,792 3,674,729
Accounts receivable, net of allowance for doubtful
accounts of $7,500 (1999) and $7,500 (1998) 278,533 321,150
Inventory, net of reserve for obsolescence of $125,000 (1999)
and $140,000 (1998) 439,218 543,006
Prepaid expenses 69,112 63,259
------------ ------------
Total current assets 5,148,522 7,127,170
------------ ------------
PROPERTY AND EQUIPMENT, at cost:
Furniture, fixtures and equipment 600,495 621,607
Less- Accumulated depreciation (455,426) (380,659)
------------ ------------
Property and Equipment, net 145,069 240,948
------------ ------------
PATENTS, net of accumulated amortization of $17,204 (1999) 121,676 186,454
and $11,830 (1998)
OTHER ASSETS 13,472 11,450
------------ ------------
Total assets $ 5,428,739 $ 7,566,022
------------ ------------
------------ ------------
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 144,212 $ 99,430
Accrued compensation 135,996 150,635
Accrued liabilities 207,854 191,871
Customer deposits -- 4,376
Other current liabilities 9,960 6,639
------------ ------------
Total current liabilities 498,022 452,951
------------ ------------
LONG-TERM LIABILITIES:
Other long-term liabilities 2,335 5,331
------------ ------------
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 (1999) and 5,383,507 (1998) shares outstanding 16,941,317 16,941,317
Warrants for common stock 290,400 290,400
Accumulated deficit (12,303,335) (10,123,977)
------------ ------------
Total shareholders' equity 4,928,382 7,107,740
------------ ------------
Total liabilities and shareholders' equity $ 5,428,739 $ 7,566,022
------------ ------------
------------ ------------
</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
------------------------------------------------------
1999 1998 1997
------------- ------------- -------------
<S> <C> <C> <C>
REVENUE, net $ 1,568,428 $ 1,315,915 $ 1,398,184
COST OF SALES 1,121,698 1,218,342 1,422,005
------------- ------------- -------------
Gross profit (loss) 446,730 97,573 (23,821)
------------- ------------- -------------
OPERATING EXPENSES:
Sales and marketing 1,393,719 1,834,806 1,511,190
General and administrative 933,642 1,200,572 1,349,371
Research and development 581,659 652,298 616,730
------------- ------------- -------------
Total operating expenses 2,909,020 3,687,676 3,477,291
------------- ------------- -------------
INCOME (LOSS) FROM OPERATIONS (2,462,290) (3,590,103) (3,501,112)
OTHER INCOME (EXPENSE):
Interest income 291,467 413,252 463,854
Other income (expense) (8,535) (17,881) 133,626
------------- ------------- -------------
NET INCOME (LOSS) $ (2,179,358) $ (3,194,732) $ (2,903,632)
------------- ------------- -------------
------------- ------------- -------------
NET INCOME (LOSS) PER SHARE
Basic and diluted net income (loss)
per common share $ (0.40) $ (0.59) $ (0.58)
------------- ------------- -------------
------------- ------------- -------------
Basic and diluted weighted average shares used
in computing net income (loss) per common share 5,383,507 5,377,493 5,045,128
------------- ------------- -------------
------------- ------------- -------------
</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, 1999, 1998 AND 1997
<TABLE>
<CAPTION>
Accumulated
Shares Amount Warrants Deficit Total
--------- ----------- -------- ------------- -----------
<S> <C> <C> <C> <C> <C>
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
Net income (loss) - - - (2,179,358) (2,179,358)
--------- ----------- -------- ------------ -----------
BALANCES, March 31, 1999 5,383,507 $16,941,317 $290,400 $(12,303,335) $ 4,928,382
--------- ----------- -------- ------------ -----------
--------- ----------- -------- ------------ -----------
</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
-----------------------------------------
1999 1998 1997
----------- ----------- -----------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $(2,179,358) $(3,194,732) $(2,903,632)
Adjustments to reconcile net income (loss) to net
cash used in operating activities-
Depreciation and amortization 226,862 187,586 154,673
Amortization of discount, net (150,274) (199,692) (115,864)
Common stock issued in lieu of cash - 100,750 -
Inventory reserve (15,000) 37,404 37,596
Changes in operating assets and liabilities-
Accounts receivable 42,617 (165,704) (44,981)
Inventory 118,788 (58,714) 244,125
Prepaid expenses and other (7,875) 47,518 (41,488)
Accounts payable 44,782 (228,252) 197,314
Accrued compensation and accrued
liabilities 1,344 (267,697) 422,646
Customer deposits (4,376) (15,847) (96,298)
Deferred revenue - - (135,703)
Other liabilities 325 (12,262) (2,153)
----------- ----------- -----------
Net cash used in operating activities (1,922,165) (3,769,642) (2,283,765)
----------- ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of short-term investments, net of discounts (7,852,359) (4,813,473) (20,980,563)
Sale of short-term investments 8,500,084 10,969,999 11,465,000
Capital expenditures (46,501) (181,223) (199,136)
Patent costs (15,218) (50,935) (45,872)
----------- ----------- -----------
Net cash provided by (used in)
investing activities 586,006 5,924,368 (9,760,571)
----------- ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock and warrants - - 13,437,102
Repurchase of Common Stock - (156,715) -
Stock issuance costs - - (1,404,459)
----------- ----------- -----------
Net cash (used in) provided by
financing activities - (156,715) 12,032,643
----------- ----------- -----------
NET INCREASE (DECREASE) IN CASH AND
CASH EQUIVALENTS (1,336,159) 1,998,011 (11,693)
CASH AND CASH EQUIVALENTS,
beginning of period 2,525,026 527,015 538,708
----------- ----------- -----------
CASH AND CASH EQUIVALENTS, end of period $ 1,188,867 $ 2,525,026 $ 527,015
----------- ----------- -----------
----------- ----------- -----------
</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 U.S. It has also
developed and is marketing its own line of integrated, shielded
five-millimeter electrosurgical instruments that 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 U. S. These sales were made primarily
to Valleylab as a distributor in fiscal year 1997. As discussed below, sales
to Valleylab were immaterial in fiscal years 1998 and 1999.
The Company has incurred losses since its inception and has an accumulated
deficit of $12,303,335 at March 31, 1999. In calendar year 1996, Valleylab,
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. In FY 1999 the Company further developed its
distribution channel in the U.S. by contracting with a stocking distributor
and replacing certain independent sales representative organizations with
others believed to be more effective in marketing the Company's products.
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 Year 1999 the Company entered into an exclusive agreement with
a stocking distributor to sell the Company's products in five states. The
Company sells its' products to the distributor at a discount from the
Company's list price, and the distributor is responsible for reselling the
products in its' territory.
During fiscal years 1999, 1998 and 1997, Valleylab accounted for
approximately $2,485, $25,271 and $1,145,900 of the total sales revenue of
approximately $1,568,000, $1,316,000 and $1,398,000, respectively.
F-6
<PAGE>
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
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,"
management determines the appropriate classification of its investments in
debt securities at the time of purchase. At March 31, 1999, the Company's
short-term investments consist primarily of government securities that 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 and corporate securities.
The accounts receivable balance at March 31, 1999 of $278,533 included
$89,076 (32%) from one customer. The Company's accounts receivable balances
are primarily domestic.
F-7
<PAGE>
INVENTORY
Inventories are stated at the lower of cost (first in, first out basis) or
market. At March 31, 1999 and 1998, inventory consisted of the following:
<TABLE>
<CAPTION>
1999 1998
----------- -----------
<S> <C> <C>
Raw Materials $393,606 $448,486
Finished Goods 170,612 234,520
----------- -----------
564,218 683,006
Less - Reserve for Obsolescence (125,000) (140,000)
----------- -----------
$ 439,218 $543,006
----------- -----------
----------- -----------
</TABLE>
PROPERTY AND EQUIPMENT
Property and Equipment are 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. In fiscal year 1999
the Company expensed approximately $50,000 of costs that had been previously
capitalized as patent application costs after it decided not to pursue
development of the related technology in order to focus on the AEM-Registered
Trademark- program.
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).
REVENUE RECOGNITION
Revenue from product sales is recorded when the Company ships the product and
the earnings process is complete. The Company recognizes revenue from sales
to stocking distributors if there is no right of return other than for normal
warranty related matters.
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.
F-8
<PAGE>
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).
COMPREHENSIVE INCOME
The Company adopted the provisions of Statement of Financial Accounting
Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130") as of April
1, 1998. SFAS 130 establishes standards for reporting and display of
comprehensive income and its components in a full set of general-purpose
financial statements. For each period presented there are no differences
between Net Income and Comprehensive Income.
SEGMENT REPORTING
The Company adopted the provisions of Statement of Financial Accounting
Standards No. 131, "Disclosures About Segments of an Enterprise and Related
Information" ("SFAS 131") in the Quarter ended December 31, 1998. SFAS 131
establishes standards for reporting information about the segments of
enterprises' business. The adoption of this statement had no impact on the
Company's financial statements as there are no material differences between
information reported to management and that contained in the financial
statements of the Company.
BASIC AND DILUTED LOSS PER COMMON SHARE
Basic and diluted 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.
(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
F-9
<PAGE>
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 1999 and
1998, using the Black-Scholes option valuation model and the following
weighted average assumptions:
<TABLE>
<CAPTION>
1999 1998
--------- ---------
<S> <C> <C>
Risk-free interest rate 4.9% 6.3 %
Expected lives 4.0 3.8 years
Expected volatility 179% 88 %
Expected dividend yield 0% 0%
</TABLE>
To estimate expected lives of options for this valuation, it was assumed
options would be exercised upon becoming fully vested at the end of four and
3.8 years respectively. 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
$39,771, $1,619,547 and $173,848 for the years ended March 31, 1999, 1998 and
1997, 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 $218,408, $672,271 and $193,564 for 1999, 1998 and
1997, 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,
------------------------------------------------------
1999 1998 1997
----------- ----------- -----------
<S> <C> <C> <C>
Net Loss
As Reported $(2,179,358) $(3,194,732) $(2,903,632)
Pro forma $(2,397,766) $(3,867,003) $(3,097,196)
Pro Forma Net Loss Per Common Share
As Reported $ (0.40) $ (0.59) $ (0.58)
Pro Forma $ (0.45) $ (0.72) $ (0.61)
</TABLE>
F-10
<PAGE>
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 that have no vesting restrictions and are
fully transferable. In addition, option valuation models require the input
of highly subjective assumptions including the expected stock price
volatility. Because the Company's 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.
A summary of the Company's stock option activity, and related information for
each of the three fiscal years ended March 31, 1999 is as follows: (In almost
all cases the exercise price is the Fair Market Value on the date of grant)
<TABLE>
<CAPTION>
Weighted Weighted
Average Average
Exercise Fair
Outstanding Price Value
----------- -------- --------
<S> <C> <C> <C>
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 $2.80
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 $1.38
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
----------- -----
----------- -----
Granted 60,000 $0.71 $0.71
Exercised -
Canceled (827,400) $2.91
-----------
BALANCE, as of March 31, 1999 470,200 $3.13
----------- -----
----------- -----
EXERCISABLE, as of March 31, 1999 254,265 $3.06
----------- -----
----------- -----
</TABLE>
F-11
<PAGE>
The following table summarizes information about employee stock options
outstanding and exercisable at March 31, 1999:
<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 1999 Life in Years Price 1999 Price
- ------------------- ------------ ------------- -------- ------------ --------
<S> <C> <C> <C> <C> <C>
$0.44-$0.50 45,000 4.7 $ 0.47 5,831 $ 0.50
$1.44 10,000 9.1 $ 1.44 -- --
$2.25-$2.50 284,000 6.0 $ 2.42 200,634 $ 2.47
$4.50-$6.60 131,200 5.7 $ 5.90 47,800 $ 5.84
------- -------
470,200 $ 3.13 254,265 $ 3.06
------- -------
------- -------
</TABLE>
Of the 470,200 options for the Company's common stock at March 31, 1999,
45,000 represent nonqualified stock options and 425,200 represent incentive
stock options. The exercise price of all options granted through March 31,
1999, 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,
1999, options for 1,299,238 of the Company's common stock are available for
grant under the plan.
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, 1999, none of the warrants had been exercised.
(4) COMMITMENTS AND CONTINGENCIES
The Company currently leases and subleases its facilities under noncancelable
lease agreements that require payments of $7,623 per month from September 15,
1998 through October 15, 1999, $7,872 per month through February 28, 2000 (at
which time the sub-lease expires), $5,244 per month through October 15, 2000
and $5,504 per month through October 15, 2001 at which time the lease expires
if not renewed by the Company. The Company has an option to renew the lease
for an additional three years.
Rent expense for the fiscal years ended March 31, 1999, 1998 and 1997 was
$99,394, $99,663 and $116,011 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.
The Company was last inspected in November 1998, and has not, at March 31,
1999, 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 that
states in part that, based on the last periodic inspection, the Company was
in substantial compliance with CGMP.
F-12
<PAGE>
(5) INCOME TAXES
From its inception, the Company has generated losses for both financial
reporting and tax purposes. Deferred tax assets (approximately $4.3 million
as of March 31, 1999) 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 $12.3 million of net operating loss carryforwards that 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 PROCEEDINGS
The Company is not engaged in any legal proceedings and is not aware of any
circumstances that would lead to legal proceedings. The Company may become
involved in litigation in the future in the normal course of business.
(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 three 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 and 1999). 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.
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.
F-13
<PAGE>
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:
<TABLE>
<S> <C>
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 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).
10.2 Electroscope, Inc. Stock Option Plan, as amended. (Incorporated by
reference from Registration Statement #333-4118-D dated June 25, 1996).
10.3 Electroscope, Inc. 1997 Stock Option Plan. (Incorporated by reference from
Proxy Statement dated July 15, 1997).
</TABLE>
(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
F-14
<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: June 2, 1999. ELECTROSCOPE, INC.
By: /s/ David W. Newton
-------------------
David W. Newton
Acting 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.
<TABLE>
<S> <C> <C>
/s/ David W. Newton
- --------------------------
David W. Newton Acting Chief Executive Officer (Principal
Executive Officer) and Director June 2, 1999
/s/ Karl Hawkins
- --------------------------
Karl Hawkins Chief Financial Officer (Principal June 2, 1999
Financial and Accounting Officer)
/s/ Vern D. Kornelsen June 2, 1999
- --------------------------
Vern D. Kornelsen Director
/s/ Roger C. Odell
- --------------------------
Roger C. Odell Vice President, Sales and Marketing June 2, 1998
and Director
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
ELECTROSCOPE, INC. BALANCE SHEET AS OF MARCH 31, 1999 AND THE STATEMENTS OF
OPERATIONS AND CASH FLOWS FOR THE FISCAL YEAR ENDED MARCH 31, 1999 AND IS
QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> MAR-31-1999
<PERIOD-START> APR-01-1998
<PERIOD-END> MAR-31-1999
<CASH> 1,188,867
<SECURITIES> 3,172,792
<RECEIVABLES> 286,033
<ALLOWANCES> 7,500
<INVENTORY> 564,218
<CURRENT-ASSETS> 5,148,522
<PP&E> 600,495
<DEPRECIATION> (455,426)
<TOTAL-ASSETS> 5,428,739
<CURRENT-LIABILITIES> 498,022
<BONDS> 0
0
0
<COMMON> 16,941,317
<OTHER-SE> 290,400
<TOTAL-LIABILITY-AND-EQUITY> 5,428,739
<SALES> 1,568,428
<TOTAL-REVENUES> 1,568,428
<CGS> 1,121,698
<TOTAL-COSTS> 2,909,020
<OTHER-EXPENSES> (282,932)
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (2,179,358)
<INCOME-TAX> 0
<INCOME-CONTINUING> (2,179,358)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (2,179,358)
<EPS-BASIC> (0.40)
<EPS-DILUTED> (0.40)
</TABLE>
