As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

 2/07/05  PDL Biopharma, Inc.               8-K:2,8,9   2/07/05    8:2.2M                                   Merrill Corp-MD/FA

Document/Exhibit                   Description                      Pages   Size 

 1: 8-K         Current Report                                      HTML     38K 
 2: EX-23.1     Consent of Experts or Counsel                       HTML      8K 
 3: EX-99.1     Miscellaneous Exhibit                               HTML     14K 
 4: EX-99.2     Miscellaneous Exhibit                               HTML     33K 
 5: EX-99.3     Miscellaneous Exhibit                               HTML    155K 
 6: EX-99.4     Miscellaneous Exhibit                               HTML     88K 
 7: EX-99.5     Miscellaneous Exhibit                               HTML    835K 
 8: EX-99.6     Miscellaneous Exhibit                               HTML    197K 

Exhibit 99.5

 

CONSOLIDATED FINANCIAL STATEMENTS

 

ESP Pharma Holdings and Subsidiary

 

September 30, 2004

 

 

ESP Pharma Holdings and Subsidiary

 

Index to Consolidated Financial Statements

 

Contents

 

Report of Independent Registered Public Accounting Firm	1
Consolidated Balance Sheets as of December 31, 2003 and 2002	2
Consolidated Statements of Operations for the period from April 15, 2002 (inception) to December 31, 2002 and the year ended December 31, 2002	3
Consolidated Statements of Stockholders’ Equity for the period from April 15, 2002 (inception) to December 31, 2002 and the year ended December 31, 2002	4
Consolidated Statements of Cash Flows for the period from April 15, 2002 (inception) to December 31, 2002 and the year ended December 31, 2002	5
Notes to Audited Consolidated Financial Statements	6
Consolidated Balance Sheets as of September 30, 2004 (unaudited) and December 31, 2003	24
Consolidated Unaudited Statements of Income for the nine months ended September 30, 2004 and 2003	25
Consolidated Statements of Stockholders Equity for the year ended December 31, 2003 and the nine months ended September 30, 2004 (unaudited)	26
Consolidated Unaudited Statements of Cash Flows for the nine months ended September 30, 2004 and 2003	27
Notes to Unaudited Consolidated Financial Statements	28

 

 

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders

ESP Pharma Holdings and Subsidiary

 

We have audited the accompanying consolidated balance sheets of ESP Pharma Holdings and Subsidiary as of December 31, 2003 and 2002 and the related consolidated statements of operations, stockholders’ equity and cash flows for the year ended December 31, 2003 and for the period from April 15, 2002 (inception) to December 31, 2002.  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 the standards of the Public Company Accounting Oversight Board (United States). 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, 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.  An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing our opinion on the effectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of ESP Pharma Holdings and Subsidiary at December 31, 2003 and 2002, and the consolidated results of its operations and its cash flows for the year ended December 31, 2003 and for the period from April 15, 2002 (inception) to December 31, 2002, in conformity with U.S. generally accepted accounting principles.

 

		/s/ Ernst & Young LLP

 

March 12, 2004

 

1

 

ESP Pharma Holdings and Subsidiary

 

Consolidated Balance Sheets

 

		December 31
		2003			2002
Assets
Current assets:
Cash and cash equivalents		$	29,507,156		$	5,938,706
Accounts receivable, net		6,140,579			3,426,265
Inventories		3,465,543			702,745
Prepaid expenses and other current assets		2,922,494			129,159
Deferred tax asset		1,034,078			—
Total current assets		43,069,850			10,196,875
Property and equipment, net		1,056,438			515,548
Non-marketable investments		1,600,000			400,000
Product rights, net		70,245,851			27,285,844
Deferred tax assets		2,558,964			310,000
Restricted cash		—			418,739
Deferred financing costs		1,289,838			—
Total assets		$	119,820,941		$	39,127,006
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable		$	2,472,001		$	1,463,820
Accrued expenses		4,493,485			1,239,789
Other current liabilities		4,860,069			1,410,223
Income taxes payable		883,737			38,000
Current portion of long-term debt		10,761,301			—
Total current liabilities		23,470,593			4,151,832
Long-term debt		42,738,699			9,500,000
Stockholders’ equity:
Series A convertible preferred stock; $0.0001 par value; 28,200,000 shares authorized, issued and outstanding as of December 31, 2003 and 2002, respectively (minimum liquidation preference of $28,200,000)		27,404,602			27,404,602
Series B convertible preferred stock; $0.0001 par value; 12,500,000 shares authorized, issued and outstanding as of December 31, 2003 (minimum liquidation preference of $20,000,000)		19,943,210			—
Common stock; $0.0001 par value; 36,300,000 shares authorized, 6,588,708 and 6,775,000 issued and outstanding at December 31, 2003 and 2002, respectively		659			678
Additional paid-in capital		98,055			9,339
Notes receivable – related parties		(152,904		)	(146,564		)
Retained earnings (accumulated deficit)		6,408,418			(1,792,881		)
Other comprehensive income		(90,391		)	—
Total stockholders’ equity		53,611,649			25,475,174
Total liabilities and stockholders’ equity		$	119,820,941		$	39,127,006

 

See accompanying notes.

 

2

 

ESP Pharma Holdings and Subsidiary

 

Consolidated Statements of Operations

 

		Year ended December 31, 2003			Period from April 15, 2002 (inception) to December 31, 2002
Revenue		$	62,544,565		$	14,746,464
Cost of goods sold		20,610,249			6,757,594
Gross profit		41,934,316			7,988,870
Selling and marketing		13,778,859			3,223,071
General and administrative		11,587,033			4,126,881
Research and development		586,993			—
Other operating expenses		2,279,505			2,043,459
Income (loss) from operations		13,701,926			(1,404,541		)
Interest expense		(1,211,695		)	(441,399		)
Interest income		107,613			53,059
Income (loss) before provision for income taxes		12,597,844			(1,792,881		)
Provision for income taxes		4,396,545			—
Net income (loss)		$	8,201,299		$	(1,792,881	)

 

See accompanying notes.

 

3

 

ESP Pharma Holdings and Subsidiary

 

Consolidated Statements of Stockholders’ Equity

 

		Series A Convertible Preferred Stock					Series B Convertible Preferred Stock					Common Stock					Additional Paid-in			Notes			Retained Earnings (Accumulated			Other Comprehensive			Total Stockholders’
		Shares		Amount			Shares		Amount			Shares		Amount			Capital			Receivable			Deficit)			Income			Equity
Balance at April 15, 2002 (inception)		—		$	—		—		$	—		—		$	—		$	—		$	—		$	—		$	—		$	—
Issuance of Series A Preferred Stock, net of issuance costs		28,200,000		27,404,602																									27,404,602
Issuance of common stock												6,775,000		678			163,172												163,850
Shares subject to repurchase rights																	(153,833		)										(153,833		)
Issuance of notes receivable																				(146,564		)							(146,564		)
Net loss																							(1,792,881		)				(1,792,881		)
Balance at December 31, 2002		28,200,000		27,404,602			—		—			6,775,000		678			9,339			(146,564		)	(1,792,881		)	—			25,475,174
Issuance of Series B Preferred Stock, net of issuance costs							12,500,000		19,943,210																				19,943,210
Issuance of common stock												50,375		5			26,075			(8,669		)							17,411
Shares no longer subject to repurchase rights																	51,119												51,119
Options issued to non-employees																	13,865												13,865
Return of unvested shares to reserve												(236,667	)	(24		)	(2,343		)	2,329									(38		)
Comprehensive income:
Net income																							8,201,299						8,201,299
Other comprehensive income, net of tax																										(90,391		)	(90,391		)
Total comprehensive income																													8,110,908
Balance at December 31, 2003		28,200,000		$	27,404,602		12,500,000		$	19,943,210		6,588,708		$	659		$	98,055		$	(152,904	)	$	6,408,418		$	(90,391	)	$	53,611,649

 

See accompanying notes.

 

4

 

ESP Pharma Holdings and Subsidiary

 

Consolidated Statements of Cash Flows

 

		Year ended December 31, 2003			Period from April 15, 2002 (inception) to December 31, 2002
Operating activities
Net income (loss)		$	8,201,299		$	(1,792,881	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation		167,406			44,829
Amortization of product rights		8,925,294			4,214,156
Interest rate swap		(90,391		)	—
Non-cash expense associated with non-employee options		13,865			—
Deferred tax assets		(3,283,042		)	(310,000		)
Changes in operating assets and liabilities:
Accounts receivable		(2,328,185		)	(3,426,265		)
Inventories		(2,762,798		)	(702,745		)
Prepaid expenses and other current assets		(2,793,335		)	(129,159		)
Accounts payable		1,008,181			1,463,820
Accrued expenses		3,304,777			1,239,789
Other current liabilities and income tax payable		5,357,677			1,294,930
Deferred financing costs		(1,289,838		)	—
Net cash provided by operating activities		14,430,910			1,896,474
Investing activities
Additions to fixed assets		(708,296		)	(560,377		)
Restricted cash		418,739			(418,739		)
Purchase of non-marketable investments		(1,200,000		)	(400,000		)
Purchase of product rights		(51,885,301		)	(22,000,000		)
Net cash used in investing activities		(53,374,858		)	(23,379,116		)
Financing activities
Proceeds from the issuance of long-term debt, net		52,051,777			—
Payment of note payable		(9,500,000		)	—
Proceeds from issuance of common stock		17,411			16,746
Proceeds from issuance of preferred stock, net of issuance costs		19,943,210			27,404,602
Net cash provided by financing activities		62,512,398			27,421,348
Net increase in cash and cash equivalents		23,568,450			5,938,706
Cash and cash equivalents at beginning of period		5,938,706			—
Cash and cash equivalents at end of period		$	29,507,156		$	5,938,706
Supplemental disclosures of cash flow information
Cash paid during the year for interest		$	1,205,453		$	412,124
Cash paid during the year for taxes		$	4,503,141		$	190,000
Other non-cash activities
Deferred tax assets		$	2,424,233		$	310,000
Note issued for product rights		$	—		$	9,500,000
Shares issued for notes		$	3,997		$	146,564

 

See accompanying notes.

 

5

 

ESP Pharma Holdings and Subsidiary

 

Notes to Consolidated Financial Statements

 

December 31, 2003

 

1.  Organization and Description of Business

 

ESP Pharma Holdings and Subsidiary (the “Company”) was incorporated on April 15, 2002 (inception) in the State of Delaware for the purpose of selling and marketing specialty pharmaceutical products. Immediately following its inception, the Company secured financing in the amount of $27.4 million and acquired the sales and marketing rights to four cardiovascular products from Wyeth Pharmaceuticals Inc.  Since its inception, the Company has focused its efforts primarily on building the infrastructure required to support the sales and marketing of its products, and expanding its product portfolio.

 

2.  Significant Accounting Policies

 

Consolidation

 

The financial statements include the accounts of ESP Pharma Holdings and Subsidiary and its wholly-owned subsidiary, ESP Pharma, Inc.  Intercompany transactions and balances are eliminated in consolidation.

 

Reclassification

 

Certain prior year balances have been reclassified to conform to the current year presentation.

 

Use of Estimates

 

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions. Assets, liabilities, revenues and expenses, and disclosure of contingent assets and liabilities are affected by such estimates and assumptions. The most significant assumptions are employed in estimates used in determining allowances for doubtful accounts, values of inventories and intangible assets, accruals for rebates, returns and chargebacks, as well as estimates used in applying the revenue recognition policy. The Company is subject to risks and uncertainties that may cause actual results to differ from those estimates.

 

6

 

Fair Value of Financial Instruments

 

The Company’s financial instruments consist primarily of cash, accounts payable, accrued compensation and related benefits, an interest rate swap, long-term debt, non-marketable investments and other accrued liabilities. The Company believes the carrying value of all of its financial instruments approximates fair value.  The fair value of the Company’s debt approximates fair value because of its variable interest rate.

 

Concentration of Credit Risk and Major Sources of Revenue

 

Financial instruments that potentially subject the Company to concentration of credit risk include cash and cash equivalents, accounts receivable, and revenue.  The Company places its cash and cash equivalents with high-credit quality financial institutions. Concentrations of credit risk, with respect to these financial instruments, exist to the extent of the amounts presented in the financial statements.

 

The following table outlines customers with revenues and/or accounts receivable that individually exceed 10% of the Company’s total revenues and/or accounts receivable during the year ended December 31, 2003 and for the period ended December 31, 2002 (in thousands):

 

		2003									2002
		Cardinal			AmeriSource Bergen			McKesson			Cardinal			AmeriSource Bergen			McKesson
Accounts receivable		$	675		$	4,336		$	1,441		$	2,021		$	965		$	494
Revenue		18,734			20,766			19,547			4,084			4,073			3,408

 

Cash and Cash Equivalents

 

The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.

 

Inventories

 

Inventories are stated at the lower of cost or market. Cost is determined using a weighted-average approach, which approximates the first-in, first-out method.  If the cost of the inventories exceeds their expected market value, provisions are recorded currently for the difference between the cost and the market value.  Inventories consist of finished goods, raw materials (active pharmaceutical ingredients), and work-in-process.

 

7

 

Property and Equipment

 

Furniture and equipment, including computer equipment and software, are stated at cost, less accumulated depreciation. Depreciation is provided over the estimated useful lives of the respective assets, generally three to five years, using the straight-line method.  Leasehold improvements are capitalized as incurred and are amortized over the estimated life of the assets or related lease term, whichever is shorter.

 

Non-Marketable Investments

 

The Company has an investment in a strategic partner whose securities are not publicly traded. Because these securities are not publicly traded, the Company reviews these investments periodically for impairment by using information acquired from industry trends, the management of the investee, financial statements, and other external sources. The Company records an investment impairment charge when it believes an investment has experienced a decline in value that is considered to be other than temporary.  No impairment charges were recorded or deemed necessary through December 31, 2003.

 

Derivative Instrument

 

The Company uses a derivative to hedge its exposure to changes in interest rates.  At December 31, 2003, the Company designated $26,750,000 in notional value of its derivative as a cash flow hedge.  The derivative is in a loss position at December 31, 2003 with the liability classified in other current liabilities and the net unrealized loss recorded as a component of other comprehensive income.  There was no impact on earnings during the period resulting from hedge ineffectiveness since the hedges qualify for the “short-cut method” assumption of no ineffectiveness under the provisions of SFAS 133.

 

Intangible Assets

 

Intangible assets represent the value of product rights purchased from Wyeth Pharmaceuticals and Orphan Medical, Inc.  In accordance with FAS 142, these intangible assets are being amortized on a straight-line basis over their estimated useful lives and are reviewed for impairment in accordance with FAS 144.  The Company uses the remaining patent life as its estimated useful life or three years, for generic pharmaceuticals.  No impairment charges were recorded or deemed necessary for the year ended December 31, 2003 or for the period ended December 31, 2002.

 

8

 

Deferred Financing Costs

 

Deferred financing costs related to the term loan are being amortized over five years, the term of the facility.  Total accumulated amortization of deferred financing costs was $311,715 at December 31, 2003.

 

Impairment of Long-Lived Assets

 

The Company reviews long-lived assets, including property and equipment, for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. An impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition are less than their carrying amount. Impairment, if any, is assessed using discounted cash flows. No impairment charges were recorded or deemed necessary for the year ended December 31, 2003 and for the period ended December 31, 2002.

 

Accruals for Rebates, Returns, and Chargebacks

 

The Company establishes accruals for rebates, returns, and chargebacks in the same period the Company recognizes the related sales and reduces revenues for these accruals.  Accrued rebates include amounts due under Medicaid, and other commercial contractual rebates. The Company estimates accrued rebates based on a percentage of selling price determined from historical experience. With respect to accruals for estimated Medicaid rebates, the Company evaluates historical rebate payments by product as a percentage of historical sales, product pricing and current contracts. At the time of rebate payment, which generally occurs with a delay after the related sale, the Company records a reduction to accrued expenses and, at the end of each period, adjust accrued expenses for any differences between estimated and actual payments. Due to estimates and assumptions inherent in determining the amount of the rebate, rebate payments remain subject to retroactive adjustment. Returns are accrued based on historical and industry experience and is currently estimated at two percent of net sales. Chargebacks are based on the estimated days of unprocessed claims using historical experience. In all cases, judgment is required in estimating these reserves, and actual claims for rebates, returns and chargebacks could be different from the estimates.

 

9

 

Revenue Recognition

 

Revenue is recognized when title and risk of loss are transferred to customers, collection of sales is reasonably assured, and the Company has no further performance obligations. This is generally at the time products are received by the customer. Accruals for estimated discounts, returns, rebates and chargebacks, determined based on historical experience, reduce revenues at the time of sale.

 

Cost of Goods Sold

 

Cost of goods sold includes manufacturing costs and allocated costs including packaging materials, labor and overhead, royalty costs, and amortization of intangible assets associated with the products rights acquisition. The Company is required to pay royalties on its marketed products Cardene I.V., Ismo, IVBusulfex, and Declomycin. Royalty expenses directly related to product sales are classified as cost of sales and range from 12-21% of net product sales.  Royalties are paid on a quarterly basis and are included as a component of cost of goods sold when the expense is incurred.

 

Advertising and Promotion

 

The Company engages in promotional activities, which typically take the form of detail aids, industry publications, journal ads, hospital grants, exhibits, speaker programs, and other forms of media.  In accordance with procedures defined under Statement of Position (“SOP”) 93-7, Reporting on Advertising Costs, advertising and promotion expenditures are expensed as incurred.  Total advertising costs incurred during the year ended December 31, 2003 and for the period ended December 31, 2002 were $6,429,822 and $1,420,892, respectively.

 

Stock-Based Compensation

 

The Company grants stock options for a fixed number of shares to employees with an exercise price equal to the fair value of the shares at the date of grant. The Company accounts for stock option grants in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and related interpretations as permitted under Financial Accounting Standards Board Statement (“FASB”) No. 123, Accounting for Stock-Based Compensation (SFAS 123) which requires the use of option valuation models that were not developed for use in valuing employee stock options.

 

10

 

The following table illustrates the effect on net income if the Company had applied the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation, to stock-based employee compensation:

 

		Year ended December 31, 2003			Period from April 15, 2002 (inception) to December 31, 2002
Net income (loss), as reported		$	8,201,299		$	(1,792,881	)
Add total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(174,621		)	(15,142		)
Pro forma net income (loss)		$	8,026,678		$	(1,808,023	)

 

The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS 123 and the Emerging Issues Task Force in Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or In Conjunction with Selling, Goods or Services, which require that such equity instruments are recorded at their fair value on the measurement date, which is typically the date the services are performed and such equity instruments may be subject to periodic revaluation over the vesting term.

 

Other Operating Expenses

 

Other operating expenses consists principally of technology transfer costs and other start-up costs that are expensed as incurred.  These expenses are separately classified as the Company does not consider these costs to be a recurring component of operating expenses.

 

Income Taxes

 

The Company accounts for income taxes under the asset and liability method whereby deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income.  Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

 

11

 

On November 21, 2002, the EITF reached a consensus on Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables, regarding whether an arrangement involving multiple deliverables contains more than one unit of accounting and how arrangement consideration should be measured and allocated to the separate units of accounting in an arrangement.  For contracts including multiple deliverables meeting the separation criteria of EITF 00-21, the Company will allocate the total arrangement consideration to each separate unit of accounting based on the relative fair values of the deliverables in each unit of accounting and recognizes revenue based on the Company’s revenue recognition policy applicable to each separate unit of accounting.  In general, EITF 00-21 limits the amount of revenue allocated to an individual deliverable under an agreement to the lesser of its relative fair value or the amount not contingent on the Company’s delivery of other elements under the agreement, regardless of the probability of the Company’s performance.  The adoption of EITF 00-21 did not impact the financial statements of the Company.

 

3.  Product Rights Acquisitions

 

Immediately following its inception in April 2002, the Company purchased the sales and marketing rights to four commercialized cardiovascular pharmaceutical products from Wyeth Pharmaceuticals for an aggregate purchase price of $31.5 million, including $22.0 million in cash and a $9.5 million note (see Note 6).

 

On June 10, 2003, the Company acquired from Orphan Medical, Inc. the worldwide sales and marketing rights (excluding Australia) and existing inventory of IVBusulfex for an aggregate purchase price of $29.3 million in cash.  On October 3, 2003, the Company acquired from Wyeth Pharmaceuticals the U.S. rights to Declomycin for a net purchase price of $22.6 million in cash.

 

13

 

These acquisitions were accounted for as asset acquisitions. The products and medical indications are summarized below:

 

Product Name		Product Indication
Cardene I.V.		For short-term treatment of hypertension when oral therapy is not feasible or desirable
IVBusulfex		For use as a conditioning regimen prior to bone marrow transplantation for chronic myelogenous leukemia
Declomycin		For use as an antibiotic in treating numerous bacterial infections
Sectral		For chronic treatment of hypertension and ventricular arrhythmias
Tenex		For chronic treatment of hypertension
Ismo		For the prevention of angina pectoris due to coronary artery disease

 

The fair value of the product rights acquisition was allocated based on discounted cash flow projections. The following tables summarize the gross carrying amount of the assets acquired and estimated useful lives at the date of acquisition with accumulated amortization through December 31, 2003 and 2002 (in thousands):

 

Product Name		Gross Carrying Amount			Accumulated Amortization			Estimated Useful Life (Years)
December 31, 2003
Cardene I.V.		$	25,626		$	(6,441	)	7
IVBusulfex		29,300			(1,424		)	12
Declomycin		22,585			(1,848		)	3
Sectral		2,685			(1,567		)	3
Tenex		2,421			(1,412		)	3
Ismo		768			(448		)	3
Total		$	83,385		$	(13,140	)
December 31, 2002
Cardene I.V.		$	25,626		$	(2,746	)	7
Sectral		2,685			(671		)	3
Tenex		2,421			(605		)	3
Ismo		768			(192		)	3
Total		$	31,500		$	(4,214	)

 

14

 

The estimated amortization expense for the next five years is as follows (in thousands):

 

For the year ending December 31:
2004		$	15,571
2005		14,103
2006		11,735
2007		6,103
2008		6,103
Thereafter		16,630

 

4.  Property and Equipment

 

Property and equipment consisted of the following:

 

		December 31
		2003			2002
Office equipment		$	578,915		$	242,862
Furniture and fixtures		472,933			229,457
Computer equipment and software		216,825			88,058
		1,268,673			560,377
Less accumulated depreciation and amortization		212,235			44,829
Property, plant and equipment, net		$	1,056,438		$	515,548

 

Depreciation expense was $167,406 and $44,829 for the year ended December 31, 2003 and for the period ended December 31, 2002, respectively.

 

5.  Non-Marketable Investments

 

On September 25, 2002, the Company entered into two agreements (the “Hydralazine Agreements”) with Barbeau Pharma, Inc. (Evanston, IL).  Under the terms of the Hydralazine Agreements, Barbeau Pharma, Inc. provided to the Company the exclusive rights to market a new formulation of hydralazine hydrochloride (“Hydralazine”), and a derivative compound in late-stage development both for treating severe hypertension in pregnancy, a potentially life-threatening condition.  Additionally, Barbeau Pharma, Inc. is responsible for preparing an NDA for submission to the FDA for the approval to market Hydralazine.  The fair value of these rights was not deemed significant at the date of acquisition.  In accordance with these arrangements, the Company purchased 900 shares of Series A cumulative preferred stock for $900,000 in a series of transactions between

15

 

September 2002 and November 2003.  Upon approval of Hydralazine by the FDA, the Company will owe Barbeau Pharma, Inc. an additional payment ranging from $750,000 to $2,000,000 based on the extent of marketing exclusivity inherent in such approval.

 

In June 2003, the Company entered into two additional agreements (the “BP104 Agreements”) with Barbeau Pharma, Inc. whereby Barbeau Pharma, Inc. provided the Company with exclusive rights to develop and market an injectable form of an anti-emetic (“BP104”) for the treatment of chemotherapy induced nausea and vomiting and post operative nausea and vomiting.  Barbeau Pharma, Inc. is responsible for preparing an NDA for submission to the FDA for the approval to market BP104.  The Company purchased 700 shares of Series A cumulative preferred stock for $700,000 in a series of transactions.  The fair value of these rights was not deemed significant at the date of acquisition.  Under the BP104 Agreements the Company is obligated to make additional investments in Barbeau Pharma, Inc. preferred stock of $600,000.  Further, the Company may be required to pay an additional $1,200,000 upon the clinical data review by the FDA, and an additional $1,000,000 upon approval by the FDA.  As of December 31, 2003, the Company had less than 10% ownership of Barbeau Pharma, Inc. and, as such, the investment is accounted for under the cost method.

 

6.  Debt

 

In connection with the 2002 products rights acquisition discussed in Note 3, the Company issued a $9.5 million Senior Secured Promissory Note.  Principal payments were due annually, commencing April 25, 2004.  Interest accrued on the unpaid principal amount at a variable rate and was payable semiannually.  This note was paid in full in October, 2003 with a portion of the proceeds of a Credit Facility (as further described below).

 

On October 3, 2003, in connection with the acquisition of Declomycin, the Company entered into a long-term financing arrangement (the “Credit Facility”) with a group of financial institutions. The Credit Facility is comprised of: (i) a $6.5 million Revolving Credit Facility (the “Revolver”), and (ii) a $53.5 million Term Loan (“Term Loan”).  The Credit Facility is secured by substantially all of the tangible and intangible assets of the Company.

 

Under the terms of the Revolver, through October 3, 2008, the Company may borrow on a revolving basis up to $6.5 million where amounts repaid may be re-borrowed.  The Revolver includes a $1.0 million letter of credit sub-facility and a $1.0 million Swingline sub-facility.  Through December 31, 2003, there were no draws on the Revolver.

 

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The Company borrowed $53.5 million under the Term Loan which fully matures on October 3, 2008.  Scheduled principal payments of $2.7 million are required on a quarterly basis commencing on September 30, 2004 with the balance due at the maturity date.  Additionally, the Term Loan also includes annual mandatory principal payments commencing in April, 2004 in amounts based on a percentage of the Company’s excess cash flow as defined in the Credit Facility. These mandatory principal payments are classified as a current liability.

 

Borrowings under the Credit Facility bear interest, which is payable monthly, at a floating rate equal to the Base Rate (as defined in the Credit Facility) plus a margin of 1.25%, or at a rate equal to LIBOR plus a margin of 3.75% based on the type of borrowing.  Additionally, a fee of 0.50% is charged on the average daily unused amount of the Revolver, and a fee of 3.75% is charged on the amount of any issued letters of credit.  Under the terms of the Credit Facility, the Company was required to execute an interest rate swap for half of the principal balance converting the variable rate note to a fixed rate (see Note 2).

 

The Credit Facility contains limitations and restrictions concerning, among other things, additional indebtedness, acquisitions and dispositions of assets, dividend payments and transactions with affiliates.  In addition, the Credit Facility requires the Company to maintain certain ratios (as defined therein).  The Company believes it is in compliance with all financial covenants at December 31, 2003.

 

The following is a summary of the scheduled principal payments of the Term Loan for the next five years and does not include the annual mandatory principal payments as such amounts are contingent on future operations:

 

2004		$	10,761,301
2005		10,700,000
2006		10,700,000
2007		10,700,000
2008		10,638,699
Total principal payments		$	53,500,000

 

7.  Stockholders’ Equity

 

Convertible Preferred Stock

 

In April and May of 2002, the Company issued 28.2 million shares of Series A convertible preferred stock for proceeds of $27.4 million.

 

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In April 2003, the Company completed its Series B convertible stock financing, which raised $19.9 million through the sale of 12.5 million shares.  The Series B preferred stock preferences are the same as the Series A convertible preferred stock.

 

Conversion

 

Each share of preferred stock is, at the option of the holder, convertible into shares of common stock on a one-for-one basis, subject to certain adjustments for dilution, if any, resulting from future stock issuances.  The initial conversion price for the preferred stock is $1.00 per share.  The convertible preferred stock shall be automatically converted into common stock upon (a) the consummation of an IPO at an offering price which is not less than $3 per share in an offering with aggregate proceeds to the Company of not less than $40,000,000 or (b) the vote of a two-thirds interest of the convertible preferred stock voting together as a single class.

 

Dividend Rights

 

Convertible preferred shareholders are entitled to cumulative dividends at an annual rate of 8% per share if and when declared by the Board of Directors.  Dividends will be paid only out of legally available funds.  No dividends have been declared or paid as of or for any period ended December 31, 2003.  The amount of cumulative dividends in arrears related to the preferred stock is $4,855,459 as of December 31, 2003.

 

Liquidation Preferences

 

In the event of any liquidation, sale or merger, or winding up of the Company, the preferred shareholders are entitled to receive, in preference to the holders of common stock, an initial preference equal to one times the original purchase price per share plus all accrued and unpaid dividends declared, then for any remaining assets, shall participate with the holders of common stock on an as-converted basis, until the preferred shareholders receive a total of three times their purchase price per share, plus all accrued and unpaid dividends declared.

 

Voting Rights

 

The preferred shareholders will vote together with the common shareholders and not as a separate class except as specifically provided in the investment agreement or required by law.  Specifically, the preferred and common stock will vote separately on mergers, acquisitions,

 

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sale of all, or substantially all assets, and transactions that would result in a change of control.  Each share of preferred shall have a number of votes equal to the number of shares of common stock then issuable upon conversion of such share of preferred.

 

Common Stock and Common Stock Options

 

Restricted Common Stock Purchases

 

Prior to closing of the Company’s Series A Preferred Stock financing, the Company issued 6,065,000 shares of $0.0001 par value restricted common stock to founders and other advisors at a price of $0.01 per share. The Company issued additional shares totaling 710,000 to management and other employees at $0.16 per share. All common shares issued to Company employees were purchased with cash or with full recourse loans with an average interest rate of 4.75%, and have certain restrictions in connection with the ownership of such shares.

 

The restricted founders shares vest (i.e. have a lapsing forfeiture provision) as follows: a) 33.33% of the common stock vests on the date each founder commences employment with the Company, b) 16.67% vests on the first anniversary of the date of employment, c) the remaining 50% vests in equal monthly installments over a three year period beginning the month following the first anniversary.  The vesting accelerates upon an approved sale or a liquidating event.

 

The Company will, at all times, reserve and keep available from its authorized but unissued shares of common stock, sufficient shares to be issued upon the conversion of the shares of the convertible preferred stock and upon the exercise of the stock options.  As of December 31, 2003, the Company reserved 29,525,000 shares of common stock for future issuance pursuant to its equity compensation plan.

 

Stock Options

 

In June 2002, the Company’s Board of Directors and shareholders approved the Company’s 2002 Stock Option Plan (the “2002 Plan”).  The 2002 Plan provides for the granting of options to purchase common stock in the Company to employees, advisors and consultants at a price to be determined by the Company’s Board of Directors.  The Options may be incentive stock options or non-statutory stock options.  Under the provisions of the 2002 Plan, no option will have a term in excess of 10 years.  At December 31, 2003, the Company reserved up to 3,025,000 shares for issuance upon exercise of options.

 

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The 2002 Plan is intended to encourage ownership of stock by employees and consultants of the Company and to provide additional incentives for them to promote the success of the Company’s business and is administered by the Board of Directors or a committee consisting of members of the Board.  The Board or committee is responsible for determining the individuals to be granted options, the number of options each individual will receive, the option price per share and the exercise period of each option.  Options granted pursuant to the 2002 Plan generally vest 25% after the first year, and the remaining 75% vest equally over the next three years.

 

The following table summarizes information about stock options outstanding at December 31, 2003 and 2002.

 

						Options Outstanding
		Shares Available for Grant		Restricted Stock		Number of Shares		Option Price Per Share Range			Weighted- Average Exercise Price
Balance at April 15, 2002 (inception)		—		—		—		$	—		$	—
Shares authorized		1,325,000		—		—		—			—
Options granted		(223,500	)	—		223,500		0.16			0.16
Options exercised		—		—		—		—			—
Options forfeited		—		—		—		—			—
Balance at December 31, 2002		1,101,500		—		223,500		0.16			0.16
Shares authorized		1,700,000		—		—		—			—
Shares issued		(20,000	)	20,000		—		—			—
Options granted		(2,652,200	)	—		2,652,200		0.16-0.46			0.28
Options exercised		—		—		(30,375	)	0.16			0.16
Options forfeited		103,625		—		(103,625	)	0.16			0.16
Balance at December 31, 2003		232,925		20,000		2,741,700		$	0.16-0.46		$	0.21

 

The following table summarizes information about stock options outstanding at December 31, 2003:

 

Exercise Price			Options Outstanding		Options Vested		Weighted- Average Remaining Contractual Life
$	0.16		1,154,250		136,438		4.00
0.22			462,500		7,500		4.25
0.25			1,083,500		10,000		4.50
0.46			41,450		5,000		4.75
			2,741,700		158,938

 

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At December 31, 2003, the average remaining contractual life of outstanding options was approximately 4 years.  The weighted-average fair value of options granted since inception was approximately $0.32.

 

If compensation cost had been determined based on the fair value of the options at the grant dates for those options for which no compensation cost has been recognized, consistent with the method of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), the Company’s net income per share would have decreased.  Such pro forma disclosures (see Note 2) may not be representative of future compensation expense because options vest over several years and additional grants may be made each year.  The fair value of these options was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions for 2003:

 

Employee Share Options
Expected life		5 years
Risk-free interest rate		3.5	%
Volatility		100	%
Dividend yield		0	%

 

8.  Income Taxes

 

Significant components of the state and federal income tax provision (benefit) for income taxes are as follows:

 

		Year ended December 31
		2003			2002
Current provision:
Federal		$	5,941,000		$	235,000
State		1,690,000			75,000
Total current provision		7,631,000			310,000
Deferred benefit:
Federal		(2,856,000		)	(946,000		)
State		(378,000		)	(174,000		)
Total deferred benefit		(3,234,000		)	(1,120,000		)
Valuation allowance		—			810,000
Net deferred benefit		(3,234,000		)	(310,000		)
Total income tax provision		$	4,397,000		$	—

 

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Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets for financial reporting and the amount used for income tax purposes.  At December 31, 2002, a valuation allowance was recorded to partially offset the net deferred tax assets.  At December 31, 2003, the Company believed it was more likely than not that it would realize its deferred tax assets and reduced the valuation allowance to zero.  The change in the valuation allowance for the year ended December 31, 2003 and the period ended December 31, 2002 was approximately ($810,000) and $810,000, respectively.  Significant components of the Company’s deferred tax assets as of December 31, 2003 and 2002 are as follows:

 

		December 31
		2003			2002
Deferred tax assets:
Accounts receivable allowances		$	1,642,000		$	394,000
Amortization of intangible assets		1,767,000			452,000
Amortization of start-up costs		231,000			270,000
Other		(47,000		)	4,000
Total deferred tax assets		3,593,000			1,120,000
Less valuation allowance		—			(810,000		)
Net deferred tax asset		$	3,593,000		$	310,000

 

The net deferred tax asset included a current portion of $1,034,078 at December 31, 2003 and a long-term portion of $2,558,964 at December 31, 2003.

 

9.  Operating Leases and Commitments

 

Minimum annual rental commitments under non-cancelable operating leases, primarily office facilities in effect at December 31, 2003 are as follows:

 

2004		$	403,440
2005		432,066
2006		433,328
2007		433,328
2008		36,111

 

Operating lease rental expense aggregated $305,578 and $199,030 for the year ended December 31, 2003 and for the period ended December 31, 2002, respectively.

 

Letter of Credit

 

In accordance with the terms of the Company’s leasing arrangement, the Company is required to maintain an irrevocable letter of credit in the amount of $309,000.  Through December 31, 2003, there were no draws on the letter of credit.

 

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