ITEM 1. BUSINESS
Because Illinois Superconductor Corporation (the "Company") wants to provide investors with more meaningful and useful information, this Annual Report on Form 10-K (the "Form 10-K") contains, and incorporates by reference, certain "forward-looking statements" (as such term is defined in Section 21E of the Securities Exchange Act of 1934, as amended) that reflect the Company's current expectations regarding the future results of operations, performance and achievements of the Company. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The Company has tried, wherever possible, to identify these forward-looking statements by using words such as "anticipates", "believes", "estimates", "expects", "plans", "intends" and similar expressions. These statements reflect the Company's current beliefs and are based on information currently available to it. Accordingly, these statements are subject to certain risks, uncertainties and contingencies, which could cause the Company's actual results, performance or achievements to differ materially from those expressed in, or implied by, such statements. These factors include, among others, the following: the Company's ability to obtain additional financing; demand for, and acceptance of, the Company's products; the timing and receipt of customer orders; the Company's ability to manufacture commercial quantities on an efficient and cost-effective basis; business conditions in the wireless telephony industry; the effects of legal proceedings and other factors described in this Form 10-K or in other filings of the Company with the Securities and Exchange Commission, including those described under the heading "Risk Factors" in the Company's Registration Statement on Form S-3 filed in December 1997. The Company undertakes no obligation to release publicly the results of any revisions to any such forward-looking statements that may be made to reflect events or circumstances after the date of this Form 10-K or to reflect the occurrence of unanticipated events.
GENERAL
The Company develops, manufactures and markets high performance front-end equipment products for wireless telephony base stations based upon its proprietary multi-pole cavity radio frequency ("RF") filter designs which utilize the Company's proprietary high temperature superconductor ("HTS") materials and cryogenic packaging technologies to attain superior filter performance.
RF filters refine the radio signals by passing radio waves through a series of resonators (poles) which allow certain frequencies to pass while rejecting other frequencies. The more poles in the RF filter, the more effective the RF filter. Each pole, however, has electrical resistance which causes the loss (insertion loss) of desired radio waves. Therefore, the more poles in a conventional RF filter, the greater the insertion loss. The advantage of using superconductors in RF filters is that more poles can be added without significant increases in insertion loss. Adding superconductors does not, however, change the fundamental fact that filter performance depends upon the number of poles. The Company's RF filters have up to 24 poles which the Company believes is significantly greater than any other commercially available filter.
Filters can be designed with a variety of structures including stripline, microstrip, cavity, dielectric, and waveguide. The Company is able to produce RF filters using any of these technologies, but has focused on cavity filters because of their high performance and tuning flexibility. The Company uses its proprietary thick-film superconducting technology for its RF filters. The Company believes that relative to other superconducting materials technologies, thick-film provides for higher RF filter performance and lower distortion levels. In addition, thick-film technology does not require clean rooms for manufacturing. Superconductors become superconducting at temperatures of roughly -200 degrees celcius. These temperature levels can be maintained using commercially available mechanical cooling systems. The Company has developed packaging systems which are highly reliable over longer durations and minimize operating costs.
The wireless telephony industry has experienced significant growth in recent years which has led to rapid growth in base station installations and increased competition among service providers. Intensifying competition has challenged operators to minimize capital expenditures per subscriber, enhance quality, and improve coverage. The Company's RF front-end equipment products address these needs by improving system quality, decreasing the number of cell sites needed, and allowing more flexible placement of new cell sites.
The Company's ultra-high performance RF front-end products, which utilize multi-pole cavity filter technology, offer the following system performance benefits:
- call quality is improved and the frequency of blocked or dropped calls is reduced because adjacent band interference from competing wireless service providers and other radio services is reduced;
- capital expenditure per subscriber is reduced because operators attain improved coverage with fewer base stations. Coverage gaps between base stations are also reduced because the radio range of these base stations is frequently extended on the uplink (receive) communications path;
- network capacity is often increased because channels which were previously unusable now because available and efficient channel utilization is improved;
- locating new cell sites is simplified because wireless telephony operators can better tolerate RF interference from nearby transmitters;
- power amplifier design is expected to be simplified because of high performance, low loss filtering; and
- the Company expects improved transmit path range and capacity through the use of high performance combiners, which are currently being developed by the Company.
The Company currently markets three product lines to address the needs of wireless telephony service providers. The SpectrumMaster(R) product line improves the RF performance of cellular and Personal Communications Services ("PCS") systems in high interference environments, including urban areas and airport properties. SpectrumMaster(R) is available with up to 24 poles depending upon specific customer needs. The RangeMaster product line combines the superior filtering of SpectrumMaster(R) RF filters with super-cooled low noise amplifiers ("LNA"). RangeMasterTM extends system range for more cost effective coverage in suburban, rural, or small city systems. The PowerMasterTM product line brings the benefits of ultra high performance filtering to the downlink (transmit) side of the communications path. PowerMasterTM duplexer is designed to improve system range, improve system quality, and allow co-location with other service providers. The Company is developing the PowerMasterTM combiner, which it expects to improve the range and capacity of multi-carrier Code Division Multiple Access ("CDMA") systems. All of the Company's currently offered products are available in both domestic and international frequencies and are offered in a variety of mounting configurations.
The Company has received orders from ten wireless telephony service providers which are located in the United States, Canada and Asia, including six of the top ten cellular operators in the United States. The Company has also sold its products to two smaller U.S. operators. Its filters are now installed in 36 cell sites in 20 different market areas across the United States. In 1997, commercial orders from service providers were generally for one or two operational cell sites, with the largest order having been for five cell sites. The Company expects that the average size of its commercial orders will increase. The Company's newest product line, the PowerMasterTM line of transmit filters, has generated significant interest from the Original Equipment Manufacturers ("OEM") that supply cellular and PCS systems to the service providers. Laboratory testing and discussion of specifications are ongoing with several major OEMs. The Company believes its thick-film superconductor technology is unique in its ability to handle high powered transmit applications while maintaining very low levels of intermodulation distortion.
INDUSTRY BACKGROUND
The wireless telephony industry has experienced significant growth, both domestically and internationally, in recent years. This growth appears to be due to the increasing popularity of wireless telephony, the entry of new service providers into the market as governments open up new RF spectrum, the continuing decline in the price of service and wireless telephones, and the introduction of new service features. Rapid growth has intensified RF interference while increasing operators' demand for improved system quality, lower capital expenditures per subscriber, and co-location of antennas with other RF transmitters.
In the United States, subscribers to wireless telephony services now frequently have a choice of at least four service providers who are competing for their allegiance. New digital technologies such as Global System for Mobile Telecommunications ("GSM"), CDMA, and Time Division Multiple Access ("TDMA") allow operators to offer such advanced features as short message service, fax and Internet access. Wireless systems are also starting to be marketed as a convenient and economical alternative to regular wireline telephone service. In addition, service providers are also trying to differentiate themselves on the basis of quality, price, coverage, and advanced service features.
Industry statistics demonstrate the rapid growth of the wireless telephony industry. The Cellular Telecommunications Industry Association ("CTIA") reports that as of March 1998 there were over 55 million wireless subscribers in the United States. Industry publications indicate that the worldwide wireless telephony market was approximately three times the size of such market in the United States at the end of 1997 for an estimated total worldwide wireless subscriber base of approximately 150 million subscribers. CTIA reports that there were over 36,000 base stations in the United States at the end of 1997 and the Company believes there are approximately 90,000 base stations world wide. The Company further believes that this number is growing at a rate of over 35% per year. For example, industry sources estimate that over 100,000 new base stations will be built in the United States over the next four years. The Company estimates that the need to provide improved service on a cost effective basis in an increasingly congested environment will lead service providers to invest in new infrastructure technologies such as high performance RF filters.
The rapid growth and increased competition experienced by the wireless telephony industry have increased the difficulty of providing quality wireless services. Wireless service providers face the challenge of providing quality services in an environment increasingly characterized by RF interference and congestion. In addition, the rapid rate of growth and community concerns have affected the manner in which service providers locate their base stations. Many communities are objecting to the proliferation of new towers to provide wireless services. Base stations which provide the link between a wireless user and the telecommunications network are being positioned closer together and often in the same location, which results in RF interference problems. There has also been an increase in the use of portable handheld phones which transmit weaker signals than mobile or car-mounted phones. As a result, cellular networks which were laid out based on mobile phone power levels have in many areas developed coverage gaps which operators must fill in to satisfy their goals of providing seamless coverage. Furthermore, in order to compete with these already broadly deployed cellular networks, new PCS service providers need to deploy coverage quickly and with the lowest possible capital investment.
The Company believes that in order to improve quality and manage growth, system providers will invest in new infrastructure technologies, such as high performance RF filters or transmitters. RF filters are used in wireless networks to process radio signals received from a base station's antenna and provide as "clean" and strong a signal as possible to the other radio equipment in the wireless base station system. Traditional filters suffer substantial performance limitations due to energy loss experienced by the types of materials used. Wireless service providers therefore have a need for RF filtering with much higher performance characteristics than are currently available using conventional technology. The Company believes that the changing market conditions, the drive to implement new technologies and the technical issues faced by wireless service providers creates opportunities for new equipment suppliers.
THE COMPANY'S SOLUTION
The Company's products are designed to address the high performance RF front-end needs of domestic and international commercial wireless telephony systems by providing the following advantages:
- IMPROVED CALL QUALITY. The Company's RF filter products improve call quality by reducing dropped and blocked calls. During field trials and all installations in urban cellular locations, the Company's RF filter products have demonstrated a 20 to 40% reduction in dropped calls caused by out-of-band interference and base station front-end overloading. During these field trials and commercial installations, the Company's RF filter products have also demonstrated a similar reduction in blocked calls experienced in urban cellular locations. The Company believes that its RF filter products also improve audio fidelity by reducing noise and interference.
- IMPROVED BASE STATION RANGE. The Company's RF front-end systems (high performance filter and super-cooled LNA) extend the uplink range of a wireless system by up to 30%. Greater range can reduce a service operator's capital expenditure per subscriber in lower density areas by filling in coverage gaps in existing systems or by reducing the number of required cell sites for new system deployments.
- GREATER NETWORK CAPACITY AND UTILIZATION. The Company's RF front-end products increase the capacity and utilization of a wireless base station. In some cases, capacity increases because channels which were previously unusable due to interference are recovered. In other cases, system utilization increases because of lower levels of blocked and dropped calls, and increases in the ability of the system to permit weak signals to be processed with acceptable call quality.
- IMPROVED FLEXIBILITY IN LOCATING BASE STATIONS. The Company's RF front-end products allow wireless telephony service providers to co-locate base stations near other RF transmitters. The Company's products allow the base station radio to better tolerate RF interference while reducing out-of-band signals that could interfere with other nearby wireless telephony operators.
- SIMPLER TRANSMITTER SYSTEM DESIGNS. The Company believes that its line of RF transmit filters can allow for simpler less costly transmitters, particularly for digital systems. This should improve performance while diminishing system costs.
- IMPROVED DIGITAL SYSTEM CAPACITY. The Company believes that the line of transmit combiners currently under development should allow increased capacity and range in CDMA systems as system loading increases. CDMA systems appear unable to offer multi-carrier systems without the use of a combiner, but traditional combiners reduce the power transmitted from the base station antenna. The Company's high power filter technology should allow operators to use combiners with lower loss of desired signals.
PRODUCTS
The Company currently offers three products lines, SpectrumMaster(R), RangeMasterTM, and PowerMasterTM to serve a variety of system challenges faced by wireless telephony system operators. Each product line is available in a variety of performance levels to meet the varying needs of different operators and in several mounting configurations to fit specific customer situations. All of the Company's currently offered products can be supplied in domestic and international frequencies for both cellular (800 Mhz) and PCS (1.9 Ghz) applications.
The Company believes that SpectrumMaster(R) is the world's highest performance commercial receive pre-select RF filter for wireless telephony cell sites. SpectrumMaster(R) improves the performance of cellular and PCS systems in high interference environments such as urban areas and airport properties. SpectrumMaster(R) is available in two models. SpectrumMaster(R) Ultra is a very high performance filter with 24 filter poles for extremely congested RF environments. Ultra provides 10,000 times better rejection of unwanted signals then conventional filters, while losing very little of the desired signal. SpectrumMaster(R) Classic is a 16 pole filter and provides 1,000 times better rejection then conventional filters while having very low loss of desired signals and extremely linear filter response. Both SpectrumMaster(R) models meet all analog and digital protocol specifications for cellular and PCS systems in the United States. SpectrumMaster's(R) modular design allows rapid design modification to meet other customer requirements. The Company sold its first SpectrumMaster(R) product to cellular service providers in the second half of 1996 and continued sales of SpectrumMaster(R) in 1997.
RangeMasterTM combines a high performance superconducting cavity filter with a high performance super-cooled LNA to lower noise resulting from interference and thermal noise. Lowering noise extends radio propagation range by up to 30%. RangeMasterTM is available in two models. RangeMasterTM Classic combines the 16 pole SpectrumMaster Classic with a high performance super-cooled LNA to reduce signal noise resulting from both interference and amplifier thermal noise. RangeMasterTM Omega combines a high performance eight pole superconducting filter with the Company's high performance super-cooled LNA to provide range extension for rural locations at an economical price. RangeMasterTM meets all analog and digital protocol specifications for cellular and PCS systems in the United States RangeMaster'sTM modular design allows rapid design modification to meet other customer requirements. The Company shipped its first RangeMasterTM product to cellular service providers in the first quarter of 1997. The Company field tested a PCS version of RangeMasterTM with a major U.S. PCS operator in the fourth quarter of 1997.
PowerMasterTM is a family of high performance transmit filter systems for use in the base stations of wireless telephony operators. The Company began marketing its two models of PowerMasterTM products -- a transmitter filter and a duplexer -- in February 1997. These PowerMasterTM products, which incorporate the Company's new power handling technology, are used in transmit applications. Unique to the Company, this technology extends the Company's filter applications to include transmit, in addition to the receive applications already in commercial use. PowerMasterTM duplexer is expected to improve system quality, extend range and simplify the location of cell sites for both cellular and PCS systems. PowerMasterTM technology provides an ultra-high performance duplexer, which handles continuous power levels of up to 30 watts and is designed for use in 1.9Ghz PCS service. The PowerMasterTM duplexer allows a PCS operator to obtain the benefits of very high performance filtering on both the forward and reverse paths in a system. These benefits include improved call quality, extended range, improved transmit/receive isolation, and a reduction in the transmit amplifier output power required to achieve forward path coverage. The Company is currently developing a PowerMasterTM combiner, which is a low-loss transmit combiner with superior separation. The Company expects to begin OEM customer testing of the PowerMasterTM combiner in the first half of 1998.
International Cellular Products Offerings. The Company is adapting its SpectrumMaster(R), RangeMasterTM, and PowerMasterTM product lines for international wireless markets to address their specific interference rejection and range extension needs. The Company is developing products for both Asian and European cellular and PCS markets, including GSM filters in various configurations. In December 1997, the Company sold two SpectrumMaster(R) units to its first international customer, a major Asian cellular operator, as a basis for potential nationwide deployment in the operator's CDMA networks.
TECHNOLOGY
The Company possesses proprietary technology in three areas: the design of high performance RF cavity filters, thick-film superconducting materials fabrication and cryogenic packaging.
The Company's products are based on its proprietary RF cavity filter designs. The Company believes that cavity filter technology provides superior filter performance with lower intermodulation distortion when compared with alternative technologies, such as RF stripline filter technology (which the Company is also capable of using). The Company has been able to use its cavity filter technology to offer filters with up to 24 poles. The more poles in a filter, the better its rejection of unwanted signals. The Company believes its products are superior to other RF filters with regard to rejection of unwanted signals.
The Company is able to offer RF cavity filters with superior filtering, low loss of unwanted signals, and high power handling because of its proprietary thick-film superconducting fabrication technology. The Company's thick-film fabrication technology allows the Company to utilize a variety of filter technologies including cavity and strip line designs. The Company's superconducting technology is simple and inexpensive to manufacture and offers superconducting yields well above 90%. The Company believes the electrical performance of the Company's products are superior to any alternative superconducting technology currently being developed for RF devices today. The Company's thick-film superconducting technology can handle up to 30 watts of continuous power at PCS frequencies.
High temperature superconductors become superconducting at -200 C. This temperature can be attained using widely available mechanical refrigerators. The Company has developed proprietary technologies which provide an efficient, low cost cryogenic package with a long life cycle and minimum power consumption. Together, the Company believes that its technological excellence in filter design, superconducting materials and cryogenic packaging provide it with a unique and well-protected technology lead over its competitors.
SALES AND MARKETING
The Company has focused its sales and marketing effort on U.S. cellular service providers for retrofit applications. To date, the Company has sold its products to six of the top ten cellular operators in the U.S. as well as to two smaller United States operators. The Company has also sold filters to two major international operators and has successfully tested its PCS RangeMasterTM product with one of the largest U.S. PCS operators. The Company has also tested its PowerMasterTM line with two major OEMs and is discussing specifications with other large OEMs. The Company primarily uses a direct sales force to sell its products.
The Company has recently emerged from the development stage and believes it has entered the volume purchase stage of commercial development. Until recently, most purchases were for one or two cell sites, with the largest order having been for five cell sites. At the end of 1997, the Company began to see an increase in order size. The Company has begun the stage of commercialization with a new structure for achieving system-wide orders for its products, whereby customers, through a corporate purchase agreement, give direct purchase capabilities to their operating regions. One major operator recently placed an order for fifteen cell sites worth of the Company's products. Another major operator, Bell Atlantic Mobile, executed a corporate purchase agreement. The Company is currently negotiating a second corporate purchase agreement with another major U.S. operator, and, based on indications from other major operators, the Company believes it will enter into corporate purchase agreements with other major operators in the future. The Company believes that it has reached this stage of sales development by a systematic process of testing, small-scale implementation, and growing relationships with its customers.
The Company also believes that the sales cycle of its RF products shortened dramatically at the end of 1997. Previously, a period of six to nine months was required to complete the sales cycle to first orders. By the end of 1997, however, the Company's sales cycle began shortening, in some cases, to less than two months from first discussions to the receipt of commercial orders. The Company believes that this improvement is due to increasing customer confidence in the Company's technology and customer support.
The Company's marketing and sales personnel work directly with both PCS service providers and PCS OEMs to enhance the probability of sales success in this rapidly growing market. The Company is undergoing technical discussions with two PCS OEM's regarding integrating the Company's RF filter products into such OEM's PCS product line. To date, the Company's PowerMasterTM PCS transmit filter/duplexer has been tested in the laboratories of two PCS equipment OEMs.
MANUFACTURING
The Company's state-of-the-art manufacturing process provides predictable product yields and can be easily expanded to meet increased customer demand. Superconducting component yields are now consistently above 90%, with low scrap levels. Manufacturing costs were reduced by 50% during 1997 due to volume, design and yield efficiencies, and the Company expects further cost reductions in 1998 and beyond. The Company has focused its manufacturing efforts on maintaining control of key technologies while avoiding the cost and complexities of vertical integration. The Company's manufacturing operations consist primarily of the manufacture of superconducting components from raw materials, and the assembly, tuning, testing and quality verification of the Company's products. All of these activities occur at the Company's manufacturing facility in Mount Prospect, Illinois, which began operations during 1996. The Company believes that manufacturing of its RF filter products requires only moderate capital investments and is scaleable. The Company also believes that capacity can be rapidly expanded to meet growing demand without the need for large, upfront capital investments. The Company purchases all of the components for its filter products, except for superconducting components, from third party suppliers. The Company believes it has access to adequate supplies of these purchased components, most of which are produced according to the Company's proprietary designs and specifications. The Company is using its just-in-time manufacturing capability to maximize quality, insure flexibility, limit management complexity and minimize inventory cost.
RESEARCH AND DEVELOPMENT
The Company's research and development ("R&D") efforts have been focused on developing and improving RF filter products for wireless telephony systems. Filter performance has been improved, product size has been reduced, costs have been lowered, reliability has been increased, and packaging has been streamlined. The Company expects to continue to invest in R&D to further improve and adapt its filter products to meet and exceed market expectations. The Company also intends to develop related products that are synergistic with its core filter offerings and which utilize the Company's core technical competencies in RF design, superconducting materials, and cryogenic cooling systems.
The Company's total R&D expenses during 1995, 1996 and 1997 were approximately, $5,205,000, $6,623,000 and $4,132,000, respectively. R&D costs reimbursed under government contracts and cooperative agreements during 1995, 1996 and 1997 were approximately $650,000 $200,000, and $0, respectively.
INTELLECTUAL PROPERTY AND PATENTS
The Company regards certain elements of its product design, fabrication technology and manufacturing process as proprietary and protects its rights in them through a combination of patents, trade secrets and nondisclosure agreements. The Company also has obtained exclusive and non-exclusive licenses for technology developed with or by its research partners, Argonne National Laboratory ("Argonne") and Northwestern University, and expects to continue to obtain licenses from such research partners and others. The Company believes that its success will depend in part upon the protection of its proprietary information, its patents and licenses of key technologies from third parties, and its ability to operate without infringing on the proprietary rights of others.
As of March 16, 1998, the Company has been issued seven U.S. patents and has filed and is actively pursuing applications for 26 other U.S. patents, and is the licensee of 11 patents and patent applications held by others. Such patents and patent applications relate to various aspects of the Company's superconductor technology and to its current and proposed products. One of the Company's patent applications has been filed jointly with Lucent Technologies and relates to superconducting filters. Additional inventions are the subject of a group of patent applications currently under preparation. Furthermore, the Company expects to pursue foreign patent rights on certain of its inventions and technologies critical to its products.
In 1994, the Company purchased from Ceramic Process Systems two additional patents and the related technical know-how covering a process for producing Yttrium Barium Copper Oxide (YBCO) powder and manufacturing YBCO electrical fibers. In 1994, the Company also purchased technology relating to the fabrication of HTS thick-film components from the University of Birmingham (UK). This thick-film technology complements the Company's existing patented processes for making thick-film superconducting components.
Through collaborative relationships with Argonne and Northwestern University, the Company has licensed patents and patent applications issued or filed in the United States and in certain foreign countries arising under or related to such collaborative relationships. These licenses primarily relate to the processing and composition of HTS materials, including the preferential orientation of HTS materials and the processing of YBCO on a variety of metals, as well as design technology for some of the Company's current and proposed products. The Company's licenses from ARCH Development Corporation and Northwestern University continue for the lives of the patent rights licensed thereby, subject to termination on certain events, and permit the Company to retain rights to its patentable improvements to the licensed technology. Certain of the Company's research has been or is being funded in part by Small Business Innovation Research ("SBIR") and other government contracts. Although the U.S. Government has or will have certain rights in the technology developed with this funding, the Company does not believe that these rights will have a material impact on the Company's current RF filter products.
STRATEGIC RELATIONSHIPS
During 1997, the Company retained Salomon Brothers to advise and assist it in establishing strategic industry relationships with one or more major electronics companies. The Company believes that such strategic industry relationships will benefit it by (i) providing the Company with access to the technical and financial resources of its partner(s); (ii) providing the Company with international distribution channels, and (iii) offering the Company greater credibility with potential customers. To date, no such relationship has been entered into by the Company.
COMPETITION
The market for wireless telecommunications products is very competitive. The Company views its competition as (i) conventional RF filter products, (ii) RF filters based on new technologies and (iii) other superconductor-based RF products.
The Company's RF filter products compete against conventional RF filter products produced by such companies as Celwave, certain divisions of the Allen Telecom Group, Inc., Filtronic Comtek, Sinclair Radio Labs, Inc., K&L Microwave, Inc., Wacom Technology Corp., EMR Corp. and TX-RX Systems, Inc., among others. Although these conventional RF filter products are generally less expensive than the Company's products, the Company believes its RF filter products are superior on a cost/benefit basis.
Other competitive RF filter products based on new technologies may provide competition in the future to the Company's RF filter products. In addition to competitive RF filter products, other companies including Hazeltine Corp., Metawave Communications Corporation, Allen Telecom Group, Inc., Repeater Technologies, Inc. and Array Com, Inc., among others, are developing products based on "smart" antenna, digital signal processing technologies, microcells and repeaters which are also aimed at reducing interference problems or providing range extension by means other than RF filtering. The Company does not believe that these technologies pose a direct competitive threat at present, but cannot exclude them as competition to the Company's RF filter products at some point in the future.
Various filter companies appear to be experimenting with cooled dielectric filters or with filters that combine dielectric materials and superconducting technology. K&L Microwave, Inc. has been experimenting with a cooled dielectric filter design. In addition, COM DEV International, Ltd. a Canadian corporation, has published research in which a dielectric material is mounted on a superconducting ground plane. The Company does not believe that either of these efforts currently pose a competitive threat but cannot exclude them as competition to the Company's product lines at some point in the future.
Two other companies, Conductus, Inc. and Superconducting Technologies, Inc. are currently attempting to market superconducting filters to the wireless telephony marketplace. A previous competitor, Superconducting Core Technologies, Inc. recently ceased commercial operations. In addition, a number of large multinational companies are engaged in R&D programs that could lead to the commercialization of superconducting filters for the wireless telephony marketplace. These include, among others, E.I. DuPont de Nemours & Co., Fujitsu Corporation, NEC Corporation, Kyocera Corporation, and Matsushita Electric Industrial Co., Ltd. The Company believes that all of these companies are working on RF stripline filters using epitaxial thin film superconducting technology. The Company believes that RF stripline superconducting filters, while smaller, are technically unable to provide equivalent rejection of unwanted signals, competitively low levels of intermodulation distortion, as large a number of filter poles, or similar levels of power handling.
The Company believes that it competes on the basis of product performance, cost, quality, reliability and focus on the wireless telecommunications market. Many of the Company's competitors have substantially greater financial resources, larger R&D staffs and greater manufacturing and marketing capabilities than the Company.
GOVERNMENT REGULATIONS
Although the Company believes that its wireless telecommunications products themselves are not licensed or governed by approval requirements of the Federal Communications Commission ("FCC"), the operation of base stations is subject to FCC licensing and the radio equipment into which the Company's products would be incorporated is subject to FCC approval. Base stations and the equipment marketed for use therein must meet specified technical standards. The Company's ability to sell its RF filter products is dependent on the ability of wireless base station equipment manufacturers and of wireless base station operators to obtain and retain the necessary FCC approvals and licenses. In order to be acceptable to base station equipment manufacturers and to base station operators, the characteristics, quality, and reliability of the Company's base station products must enable them to meet FCC technical standards.
The Company uses certain hazardous materials in its research, development and manufacturing operations. As a result, the Company is subject to stringent federal, state and local regulations governing the storage, use and disposal of such materials. It is possible that current or future laws and regulations could require the Company to make substantial expenditures for preventive or remedial action, reduction of chemical exposure, or waste treatment or disposal. The Company believes it is in material compliance with all environmental regulations and to date the Company has not had to incur significant expenditures for preventive or remedial action with respect to the use of hazardous materials. However, there can be no assurance that the operations, business or assets of the Company will not be materially and adversely affected by the interpretation and enforcement of current or future environmental laws and regulations. In addition, although the Company believes that its safety procedures for handling and disposing of such materials comply with the standards prescribed by state and federal regulations, there is the risk of accidental contamination or injury from these materials. In the event of an accident, the Company could be held liable for any damages that result. Furthermore, the use and disposal of hazardous materials involves the risk that the Company could incur substantial expenditures for such preventive or remedial actions. The liability in the event of an accident or the costs of such actions could exceed the Company's resources or otherwise have a material adverse effect on the Company's business, results of operations and financial condition.
EMPLOYEES
As of February 28, 1998, the Company had a total of 63 employees, 13 of whom hold advanced degrees. Of the employees, 21 are engaged in manufacturing and production, 21 are engaged in research, development and engineering, and 21 are engaged in general management, marketing, finance and administration. The Company also periodically employs a number of consultants and independent contractors. The Company considers its relations with its employees to be satisfactory.
ITEM 2.
ITEM 2. PROPERTIES
The Company maintains its corporate headquarters in a 35,000 square foot building located in Mount Prospect, Illinois under a lease which expires in October 2004. This facility also houses the Company's manufacturing, research, development, engineering and marketing activities. The Company believes that this facility is adequate and suitable for its current needs and that additional space would be available on commercial terms as necessary to meet any future needs.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On June 5, 1996, Craig M. Siegler filed a complaint against the Company in the Circuit Court of Cook County, Illinois, County Department, Chancery Division. The complaint alleged that, in connection with the Company's private placement of securities in November 1995, the Company breached and repudiated an oral contract with Mr. Siegler for the issuance and sale by the Company to Mr. Siegler of 370,370.37 shares of Common Stock, plus warrants (immediately exercisable at $12.96 per share) to purchase an additional 370,370.37 shares of the Common Stock, for a total price of $4,000,000. The remedy sought by Mr. Siegler was a sale to him of such securities on the terms of the November 1995 private placement. On August 16, 1996, the Company's motion to dismiss Mr. Siegler's complaint was granted with leave to amend. On September 19, 1996, Mr. Siegler's motion for reconsideration was denied.
On October 10, 1996, Mr. Siegler filed his First Amended Verified Complaint and Jury Demand, seeking a jury trial and money damages equal to the difference between $8,800,000 (370,370.37 shares at $10.80 per share and 370,370.37 shares at $12.96 per share) and 740,740.74 multiplied by the highest price at which the Common Stock traded on The Nasdaq Stock Market between November 20, 1995 and the date of judgment. Mr. Siegler also preserved his claim for specific performance for purposes of appeal. On November 1, 1996, the case was transferred to the Circuit Court of Cook County, Illinois, County Department, Law Division. The Company's Answer was filed on November 21, 1996 and the parties are in the midst of discovery. The Company believes that the suit is without merit and intends to continue to defend itself vigorously in this litigation. However, if Mr. Siegler prevails in this litigation and is awarded damages in accordance with the formula described above, such judgment would have a material adverse effect on the Company's operating results and financial condition.
On July 10, 1997, the Company filed a complaint against Sheldon Drobny; Howard L. "Buzz" Simons, joint tenant with Aric and Corey Simons; Aaron Fischer; Stewart Shiman; Sharon D. Gonsky, d/b/a SDG Associates; Gregg Rosenberg; Stacey Rosenberg; Merrill Weber & Co., Inc.; Drobny/Fischer Partnership, an Illinois general partnership; and Rueben Rosenberg (collectively, the "Borrowers"), and Paradigm Venture Investors, L.L.C. (the "Guarantor") in the Circuit Court of Cook County, Illinois, County Department, Law Division. The complaint seeks to enforce the terms of loans made to the Borrowers by the Company and evidenced by promissory notes dated December 12, 1996, in the aggregate principal amount of $698,508 and the guarantee by the Guarantor of the Borrowers' obligations under these promissory notes. The Borrowers' notes were issued to the Company in connection with the Borrowers' exercise of warrants to purchase shares of the Company's common stock (the "Common Stock") in December 1996.
On September 30, 1997, the Borrowers and the Guarantor responded to the Company's complaint and filed a counterclaim alleging that they exercised the warrants in reliance on the Company's alleged fraudulent representations to one of the Borrowers concerning a third-party's future underwriting of a secondary public offering of the Common Stock. The counterclaim sought an amount of damages which the Borrowers allege "cannot currently be determined." On October 21, 1997, the Company filed a motion to strike the Borrowers' fraud defense and dismiss their counterclaim.
Following the submission of briefs, the court granted the Company's motion to dismiss at a hearing on December 10, 1997. On January 14, 1998, the Borrowers filed amended defenses and counterclaims based on substantially similar allegations of supposed fraud by the Company. The Company regards the amended fraud claim as without factual or legal merit and the Company intends to vigorously pursue this litigation. Accordingly, on January 29, 1998, the Company filed a motion to strike the Borrowers' amended fraud defense and dismiss their amended counterclaims. Following the submission of briefs, the court scheduled a hearing on the Company's motion for April 2, 1998.
On November 21, 1997, a stockholder, Sheldon Drobny, sued the Company and seven of its former or current directors: Edward W. Laves, Leonard A. Batterson, Paul G. Yovovich, Peter S. Fuss, Steven Lazarus, Tom L. Powers and Ora E. Smith (collectively, the "Directors") in the Circuit Court of Cook County, Illinois, County Department, Law Division. The complaint alleged that the Directors breached their duties of loyalty and due care to Mr. Drobny by selecting financing for the Company in June 1997 which supposedly entrenched the Directors, eroded the Common Stock price and diluted Mr. Drobny's equity in the Company. Mr. Drobny's complaint sought an unspecified amount of compensatory damages in excess of $50,000.
The Company and the Directors regard the suit as without factual or legal merit. Accordingly, on January 16, 1998, the Company and the Directors filed a motion to dismiss Mr. Drobny's complaint. The motion presented arguments that Mr. Drobny's claims are barred by the business judgment rule, Mr. Drobny lacks standing to assert his claims against the Directors and the complaint has various technical pleading defects. To date, Mr. Drobny has not responded to the Company's and the Directors' motion to dismiss. Instead, Mr. Drobny filed a motion seeking voluntary dismissal of his complaint on February 25, 1998. Mr. Drobny's motion alleges that he "wishes to become part of the class action" filed by Mr. Lipman (as described below), "instead of prosecuting [his] separate but parallel case." On March 11, 1998, the court continued Mr. Drobny's motion for voluntary dismissal and then scheduled a further hearing on that motion for May 1, 1998.
On January 6, 1998, Jerome H. Lipman, individually and on behalf of all others similarly situated, filed a complaint against the Company and eight of its former or current directors: Leonard A. Batterson, Michael J. Friduss, Peter S. Fuss, Edward W. Laves, Steven Lazarus, Tom L. Powers, Ora E. Smith and Paul G. Yovovich (collectively, the "Board") in the Circuit Court of Cook County, Illinois, County Department, Chancery Division. The complaint alleged that the Board breached its duty of loyalty and due care to the putative class of stockholders by selecting financing for the Company in June 1997 which supposedly entrenched the Board and reduced the Common Stock price. The complaint also alleged that the Board breached its duty of disclosure by not informing the stockholders that the selected financing would erode the Common Stock price. Mr. Lipman's complaint sought certification of a class consisting of all owners of the Company's Common Stock during the period from June 6, 1997 through November 21, 1997, excluding the Board and Sheldon Drobny. The complaint also seeks an unspecified amount of compensatory and punitive damages, and attorneys' fees.
The Company and the Board regard the suit as without factual or legal merit. Accordingly, on February 17, 1998, the Company and the Board filed a motion to dismiss Mr. Lipman's complaint. The motion presented arguments that the claims of Mr. Lipman and the putative class are barred by the business judgment rule and the plaintiff's failure to fulfill the legal prerequisites for filing an action against the Board. Following the completion and filing of briefs, the Company's and the Board's motion to dismiss will be decided at a hearing scheduled by the court for May 1, 1998.
On March 16, 1998, Mr. Lipman filed a motion seeking both to amend his proposed putative class to include Mr. Drobny and to certify the class. That motion is set for an initial hearing on March 30, 1998, at which time the court may schedule further proceedings on Mr. Lipman's motion to amend and certify the proposed putative class.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of 1997.
[THIS SPACE IS INTENTIONALLY LEFT BLANK]
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock has been traded on the Nasdaq National Market under the symbol ISCO since the Company's initial public offering on October 26, 1993. The following table sets forth for the periods indicated the range of high and low closing sale prices for the Common Stock:
On March 27, 1998, the last reported sale price for the Common Stock was $1.40625 and there were approximately 278 holders of record of the Common Stock.
The Company has never paid cash dividends on its Common Stock and the Company does not expect to pay any dividends on its Common Stock in the foreseeable future. Dividends on the Company's outstanding shares of Series B Convertible Preferred Stock ("Series B Stock"), Series C Convertible Preferred Stock ("Series C Stock") and Series G Convertible Preferred Stock ("Series G Stock") are payable at the rate of 5% per annum and are payable in cash or shares of Common Stock at the Company's option. To date, all dividends paid by the Company on its Series B Stock, Series C Stock and Series G Stock have been in the form of shares of Common Stock. As of March 23, 1998, the Company's Series B Stock is no longer outstanding. While the Series C or Series G Stock is outstanding, the Company is limited in its ability to pay dividends on Common Stock.
On October 29, 1997, the Company issued 290 additional shares of Series C Stock to Southbrook International Investments, Ltd. ("Southbrook"), 10 shares of Series C Stock to Brown Simpson Strategic Growth Fund, L.P. ("Brown Simpson"), and 350 shares of Series G Stock to each of Elliott Associates, L.P. and Westgate International, L.P. for $5,000 per share, or a total of $5 million. Dividends on the Series C Stock and Series G Stock are payable at the rate of 5% per annum and are payable in cash or shares of Common Stock at the option of the Company. The Series C Stock and Series G Stock are convertible into Common Stock at a conversion price equal to the lesser of (a) $8.05 or (b) 101% of the average of the lowest per share market value for the five consecutive trading days during the 60 trading days immediately preceding the date of conversion. This conversion ratio is subject to adjustment.
The sales of the Series C Stock and Series G Stock were exempt from the registration requirements of the Securities Act of 1933, as amended (the "Act"), pursuant to Section 4 (2) of the Act and/or Regulation D promulgated thereunder as transactions by an issuer not involving a public offering, in that the transactions involved the issuance and sale by the Company of its securities to financially sophisticated institutions, which represented that they were aware of the Company's activities and business and financial condition, and which represented that they acquired such securities for investment purposes for their own accounts and not for distribution. All certificates representing the Series C Stock and Series G Stock have been legended. The Company registered for resale under the Act the shares of Common Stock into which the Series C Stock and Series G Stock issued on October 29, 1997 are convertible, which registration statement was declared effective by the Securities and Exchange Commission on December 19, 1997.
As of March 27, 1998, (i) all 600 shares of Series B Stock (including dividends accrued thereon) were converted into an aggregate of 1,100,462 shares of Common Stock, (ii) 495 shares of Series C Stock, (including dividends accrued thereon), including all shares of Series C Stock held by Brown Simpson, were converted into an aggregate of 2,177,127 shares of Common Stock and (iii) 568 shares of Series G stock (including dividends accrued thereon) were converted into an aggregate of 2,901,290 shares of Common Stock.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table presents selected financial data with respect to the Company as of and for the years ended December 31, 1993, 1994, 1995, 1996 and 1997. The selected financial data for each of the years in the five-year period ended December 31, 1997 have been derived from the audited financial statements of the Company. The information set forth below should be read in conjunction with "Item 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information contained in this Form 10-K contains forward-looking statements which involve certain risks, uncertainties and contingencies which could cause the Company's actual results, performance or achievements to differ materially from those expressed, or implied, by such statements. See the italicized introductory language in "Item 1. Business."
The Company was founded in 1989 by ARCH Development Corporation, an affiliate of The University of Chicago, to commercialize superconducting technologies developed initially at Argonne. The Company uses its patented and proprietary HTS materials technologies to develop and manufacture RF front-end products designed to enhance the quality, capacity, coverage and flexibility of cellular, PCS and other wireless telephony services. The Company has incurred cumulative losses of $38,310,030 from inception to December 31, 1997.
During the second half of 1996, the Company made the first commercial sales of its RF filter products. The Company continued to sell its RF filter products during 1997 and into 1998. Product revenues in 1997 were derived from commercial sales of the Company's RF front-end products. The Company expects sales of its RF front-end products to continue to increase in 1998.
RESULTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1997 AND 1996
The Company's net revenues increased $828,312 from $209,822 in 1996 to $1,038,134 in 1997, as a result of increased sales of the Company's RF front-end products. Net revenues from product sales represent gross product shipments less reserves for potential returns. Such reserves are based on the Company's historical product return rates. A government contract accounted for $53,122 of the Company's net revenues in 1996, while all of the net revenues in 1997 were from commercial product sales. The Company has concentrated its efforts on its commercial product development programs and does not expect revenues to increase dramatically unless and until it ships a significant amount of its commercial products.
Cost of revenue was $4,401,077 for the year ended 1997, as compared to $49,534 for the year ended 1996. The cost of revenue for 1997 consisted of direct material, labor and overhead costs associated with the products that were shipped during the year, plus approximately $529,000 of costs which consist primarily of allocated overhead costs, incurred to produce units in ending finished goods inventory that exceed net realizable value. With the recent introduction of the SpectrumMaster(R) Ultra product into the Company's product line, management has determined that there is little marketability for an early SpectrumMaster(R) filter product model. Management has decided, therefore, to write down the costs associated with this early SpectrumMaster(R) inventory. Consequently, a total of $309,000 has been charged to cost of revenue in the fourth quarter of 1997. The cost of revenue for the year ended 1996 consisted primarily of research and development, material and overhead expenses associated with a government contract. Due to low utilization levels and excess capacity in the Company's manufacturing facility, cost of revenue exceeded total revenue for the year ending 1997. The Company expects the cost of revenues to exceed net revenues until it manufactures and ships a significantly higher amount of its commercial products.
The Company's internally funded research and development expenses decreased $2,290,902 from $6,422,921 in 1996 to $4,132,019 in 1997. Research and development costs were reduced during 1997, as compared to 1996, primarily due to the initiation of full-scale manufacturing activities during 1997. Costs associated with manufacturing activities during 1997 were recorded as manufacturing overhead expenses and were charged as cost of revenue. Costs associated with the development of manufacturing activities and processes during 1996 were recorded as research and development expenses during that period. Additional reductions of research and development costs in 1977 as compared to 1996 are due to reductions in personnel, materials and other operating costs. The
Company expects to continue reducing its research and development expenses during 1998.
Selling and marketing expenses increased to $1,918,044 in 1997 from $1,834,640 in 1996. This increase was due to the addition of sales personnel and expanded product marketing and advertising efforts. The increase was partially offset by reduced consulting costs during 1997.
General and administrative expenses decreased $518,536 from $3,290,810 in 1996, to $2,772,274 in 1997. The decrease in the general and administrative expenses was due primarily to lower administrative personnel, consultant and legal expenses during 1997 as compared to 1996.
Other income, which consisted of investment income, decreased $249,130 from $503,911 in 1996 to $254,781 in 1997. This decrease was due to a lower average investment portfolio during the year.
Other expenses, which included interest expense on long-term debt, decreased $11,633 from $29,602 in 1996, to $17,969 in 1997. The decrease is primarily due to a lower average outstanding debt balance during 1997.
YEARS ENDED DECEMBER 31, 1996 AND 1995
The Company's revenues increased in 1996 to $209,822 from $27,830 in 1995, primarily as a result of sales of the Company's RF filter products. A government research and development contract begun during the fourth quarter of 1995 generated $53,122 in revenues in 1996.
Cost of government contract revenue was $49,534 in 1996, as compared to $19,286 for 1995. The increase of these costs resulted from increased activity under government contracts. Costs associated with RF filter products sales during 1996 were associated with development stage production and were reflected as research and development expenses.
The Company's internally funded research and development expenses for 1996 were $6,422,921 compared to $4,554,946 for 1995. The Company incurred increased expenditures to expand its RF filter product lines, develop and implement its manufacturing processes and also to conduct advanced research and development activities. These expenditures consisted primarily of personnel costs, materials and supplies expenses and costs associated with the Company's product sales. Under the terms of a government contract entered into in March 1993 and amended in March 1994 and March 1995, the U.S. Government agreed to share costs of certain of the Company's research and development efforts. This contract was completed in March 1996. Funding of $200,445 for 1996 was offset against the related research and development costs, as compared to $649,660 for 1995.
Selling and marketing expenses for 1996 were $1,834,640, as compared to $469,600 for 1995. This increase was attributable to the addition of sales, marketing and field service personnel, increases in expenditures to conduct customer field trials and expansion of product marketing and advertising efforts.
General and administrative expenses for 1996 were $3,290,810, as compared to $2,763,615 for 1995. This increase was attributable to increased administrative expense necessary to support growth in Company personnel and increased outside service provider costs.
Investment income for 1996 increased to $503,911 in 1996 from $487,543 in 1995. This increase was primarily due to a larger average investment portfolio during 1996 which was attributable primarily to the Company's private placement completed in February 1996.
Interest expense decreased to $29,602 from $39,600 in 1995 primarily due to a lower average debt balance outstanding in 1996 as compared to 1995.
IMPACT OF YEAR 2000 Based on a recent assessment, the Company has determined that it will require very little modification to its software to comply with Year 2000 transition requirements. Most of the software used by the Company in operational applications has been acquired within the past 18 months and such software already addresses Year 2000 issues. The Company expects to complete any other modifications that may be necessary by December 31, 1998, which is prior to any anticipated impact to the Company's operating systems. The Company realizes, however, that the failure by it or those with which it transacts business to address the Year 2000 issue could adversely affect the Company.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 1997, the Company's cash, cash equivalents and investments, including certain restricted investments, were $3,647,000, reflecting a decrease of $2,391,000 from $6,038,000 at December 31, 1996.
During 1995 and 1996, the Company financed a portion of its leasehold improvements and capital equipment additions through various borrowings approximating $743,000, of which $92,000 was outstanding at December 31, 1997. This remaining balance is due in monthly installments through May 1999 and bears interest at 8.5% per annum. Approximately $699,000 in principal amount of promissory notes, plus approximately $87,000 of accrued interest thereon, from certain stockholders is outstanding as of March 23, 1998. This receivable was due on April 30, 1997. The Company has filed a lawsuit to collect on the outstanding balance, but there can be no assurance when and if such promissory notes will be repaid. (See "Item 3. Legal Proceedings").
The Company to date has generated limited revenues from product sales. The continuing development of and expansion in sales of the Company's RF filter product lines will require continued commitment of substantial funds to undertake continued product development and manufacturing activities and to market and sell its RF front-end products. The actual amount of the Company's future funding requirements will depend on many factors, including: the amount and timing of future revenues, the level of product marketing and sales efforts to support the Company's commercialization plans, the magnitude of its research and product development programs, the cost of additional plant and equipment for manufacturing and the costs involved in protecting the Company's patents or other intellectual property. As a result of its funding requirements, on June 6, 1997, the Company entered into a Preferred Stock Purchase Agreement for up to an aggregate of $15 million, which is available in up to five tranches (two of which have been received to date). Under this Preferred Stock Purchase Agreement, (i) on June 6, 1997 the Company issued 600 shares of Series B Stock for $3 million; and (ii) on August 29, 1997 and October 29, 1997 the Company issued an aggregate of 600 shares of Series C Stock for a total of $3 million. Cumulative dividends, which are payable in cash or Common Stock, accrued at the rate of 5% per annum on outstanding Series B Stock and Series C Stock from their respective dates of issuance through December 31, 1997 were $113,096. Also, as a result of its funding requirements, on October 29, 1997, the Company entered into another Preferred Stock Purchase Agreement whereby it issued an aggregate of 700 shares of Series G Stock for $3.5 million. The Series G Stock also accrues dividends, which are payable in cash or Common Stock, at the rate of 5% per annum and from its date of issuance through December 31, 1997, cumulative accrued dividends on the Series G Stock equaled $30,206. (See "Item 5. Market for Registrant's Common Equity and Related Stockholder Matters".)
Without consideration of further proceeds from financings, the Company believes that its available cash, cash equivalents and investments are sufficient to finance the Company's current operating plans through the end of May 1998. Pursuant to the June 6, 1997 Preferred Stock Purchase Agreement, the Company has the option to issue up to $9 million of additional convertible preferred stock in up to three additional tranches, if certain conditions, including, without limitation,
maintaining certain price levels for its Common Stock, are satisfied by the Company, or waived by the purchaser. The Company does not currently expect to issue any additional convertible preferred stock under the June 6, 1997 Preferred Stock Purchase Agreement. The Company is actively seeking financing in order to obtain working capital to continue its operations according to its current operating plan and is currently contemplating several proposals from third parties relating to a near-term equity financing. Although there can be no assurance as to the structure of such financing, the Company currently expects to issue shares of Common Stock, or securities which are convertible into shares of Common Stock at a fixed conversion price.
The Company has called a Special Meeting of Stockholders to be held on April 22, 1998 to approve an amendment to the Company's Certificate of Incorporation, as amended, to increase the Company's authorized capital stock and the number of authorized shares of Common Stock. If the Company's stockholders fail to approve the proposed amendment to the Certificate of Incorporation, the Company will be limited in its ability to act promptly with respect to potential financing opportunities which are presented to it. If the Company cannot obtain adequate funds when needed, the Company may be required to delay, scale-back or eliminate the manufacturing, marketing or sales of one or more of its products or some of all of its research and development programs. Inadequate funding also could impair the Company's ability to compete in the marketplace. In particular, if the Company is unable to secure adequate financing by early May 1998, it will have to begin substantially reducing its operating plans in order to continue operations.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and financial statement schedules, with the report of independent auditors, listed in Item 14 are included in this Form 10-K.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information in response to this item is incorporated by reference from the "Election of Directors", "Executive Officers", and "Section 16(a) Beneficial Ownership Compliance" sections of the Company's Definitive Proxy Statement to be filed with Securities and Exchange Commission in connection with the Company's 1998 Annual Meeting of Stockholders, scheduled to be held on June 11, 1998 (the "1998 Proxy Statement").
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information in response to this item is incorporated by reference from the section of the 1998 Proxy Statement captioned "Executive Compensation and Certain Transactions."
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information in response to this item is incorporated by reference from the section of the 1998 Proxy Statement captioned "Security Ownership of Management and Principal Stockholders."
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information in response to this item is incorporated by reference from the section of the 1998 Proxy Statement captioned "Executive Compensation and Certain Transactions."
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this Form 10-K:
1. The following financial statements of the Company, with the report of independent auditors, are filed as part of this Form 10-K:
Report of Independent Auditors
Balance Sheets as of December 31, 1997 and 1996
Statements of Operations for the Years Ended December 31, 1997, 1996, and 1995 Statements of Stockholders' Equity for the Years Ended December 31, 1997, 1996, and 1995 Statements of Cash Flows for the Years Ended December 31, 1997, 1996 and 1995 Notes to Financial Statements
2. The following financial statement schedules of the Company are filed as part of this Form 10-K:
Schedule II -- Valuation and Qualifying Accounts
All other financial schedules are omitted because such schedules are not required or the information required has been presented in the aforementioned financial statements.
3. The following exhibits are filed with this Report or incorporated by reference as set forth below.
Exhibit Number
3.1 Certificate of Incorporation of the Registrant, incorporated by reference to Exhibit 3.1 to the Company's Registration Statement on Form S-1, Registration Statement No. 33-67756 (the "IPO Registration Statement").
3.2 Bylaws of the Registrant, incorporated by reference to Exhibit 3.2 to the IPO Registration Statement.
3.3 Certificate of Amendment of Certificate of Incorporation of the Registrant, incorporated by reference to Exhibit 3.3 to the IPO Registration Statement.
4.1 Specimen stock certificate representing Common Stock, incorporated by reference to Exhibit 4.1 to the IPO Registration Statement.
4.2 Form of Series B Warrants, incorporated by reference to Exhibit 4.2 to the IPO Registration Statement.
4.3 Form of Series C Warrants, incorporated by reference to Exhibit 4.3 to the IPO Registration Statement.
4.4 Form of Representative Warrant, incorporated by reference to Exhibit 4.4 to the IPO Registration Statement.
4.5 Rights Agreement dated as of February 9, 1996 between the Company and LaSalle National Trust, N.A., to the Exhibit to the Company's Registration Statement on Form 8-A, filed February 12, 1996.
4.6 Convertible Preferred Stock Purchase Agreement dated as of June 6, 1997, by and between the Company and Southbrook International Investments, Ltd., incorporated by reference to Exhibit 4.3 to the Company's Registration Statement on Form S-3 dated June 23, 1997, Reg No. 333-29797 ("June S-3").
4.7 Registration Rights Agreement dated as of June 6, 1997, by and between the Company and Southbrook International Investments, Ltd., incorporated by reference to Exhibit 4.5 to June S-3.
4.8 Warrant dated June 6, 1997 issued to Southbrook International Investments, Ltd., incorporated by reference to Exhibit 4.5 to June S-3.
4.9 Certificate of Designation, Preferences and Rights relating to the Company's Series C Convertible Preferred Stock, incorporated by reference to Exhibit 4.9 to the Company's Registration Statement on Form S-3 dated September 22, 1997, Reg. No. 333-36089.
4.10 Certificate of Designation, Preferences and Rights relating to the Company's Series G Convertible Preferred Stock, incorporated by reference to Exhibit 4.8 to the Company's Registration Statement on Form S-3 dated December 8, 1997, Reg. No. 333-41731 ("December S-3").
4.11 Convertible Preferred Stock Purchase Agreement dated as of October 29, 1997, by and between the Company and Elliott Associates, L.P. and Westgate International, L.P., incorporated by reference to Exhibit 4.9 to December S-3.
4.12 Registration Rights Agreement dated as of October 29, 1997, by and between the Company and Elliott Associates, L.P. and Westgate International, L.P., incorporated by reference to Exhibit 4.10 to December S-3.
4.13 Agreement dated as of October 29, 1997, by and between the Company and Brown Simpson Strategic Growth Fund, L.P. and Southbrook International Investments, Ltd., incorporated by reference to Exhibit 4.11 to December S-3.
10.1 The Company's 1993 Amended and Restated Stock Option Plan, incorporated by reference to Exhibit B to the Company's Proxy Statement filed May 6, 1997.*
10.2 Directors Indemnification Agreement, incorporated by reference to Exhibit 10.2 to the IPO Registration Statement.
10.3 Third Amended and Restated Registration Rights Agreement dated as of July 14, 1993, as amended, incorporated by reference to Exhibit 10.4 to the IPO Registration Statement.
10.4 Public Law Agreement dated February 2, 1990 between Illinois Department of Commerce and Community Affairs and the Company, incorporated by reference to Exhibit 10.5 to the IPO Registration Statement.
10.5 Public Law Agreement dated December 30, 1991 between Illinois Department of Commerce and Community Affairs and the Company, amended as of June 30, 1992, incorporated by reference to Exhibit 10.6 to the IPO Registration Statement.
10.6 Representative Warrant Agreement, incorporated by reference to Exhibit 10.7 to the IPO Registration Statement.
10.7 Subcontract and Cooperative Development Agreement dated as of June 1, 1993 between American Telephone and Telegraph Company and the Company, incorporated by reference to Exhibit 10.9 to the IPO Registration Statement.
10.8 Intellectual Property Agreement dated as of June 1, 1993 between American Telephone and Telegraph Company and the Company, incorporated by reference to Exhibit 10.10 to the IPO Registration Statement.
10.10 License Agreement dated January 31, 1990 between the Company and Northwestern University, incorporated by reference to Exhibit 10.13 to the IPO Registration Statement.
10.11 License Agreement dated February 2, 1990 between the Company and ARCH Development Corporation, incorporated by reference to Exhibit 10.14 to the IPO Registration Statement.
10.12 License Agreement dated August 9, 1991 between the Company and ARCH Development Corporation, incorporated by reference to Exhibit 10.15 to the IPO Registration Statement.
10.13 License Agreement dated October 11, 1991 between the Company and ARCH Development Corporation, incorporated by reference to Exhibit 10.16 to the IPO Registration Statement.
10.14 Public Law Agreement dated August 18, 1993 between Illinois Department of Commerce and Community Affairs and the Company, incorporated by reference to Exhibit 10.17 to the IPO Registration Statement.
10.16 Employment Agreement dated July 7, 1997 between the Company and Stephen G. Wasko.*
10.17 Employment Agreement dated July 7, 1997 between the Company and Edward W. Laves, Ph.D.*
10.18 Employment Agreement dated July 7, 1997 between the Company and Ora E. Smith.*
10.19 Single-Tenant Industrial building Lease between Teachers' Retirement System of the State of Illinois, landlord, and Illinois Superconductor Corporation, tenant, dated June 24, 1994, Incorporated by reference to Exhibit 10.1 to the Form 10-Q for the period ending June 30, 1994.
23. Consent of Ernst & Young LLP
27. Financial Data Schedule
__________________
* Management contract or compensatory plan or arrangement required to be filed as an exhibit on this Form 10-K.
(b) Reports on Form 8-K:
The Company filed a Current Report on Form 8-K dated October 31, 1997, reporting Items 5 and 7.
Financial Statements
Illinois Superconductor Corporation
Years ended December 31, 1997, 1996, and 1995 with Report of Independent Auditors
Illinois Superconductor Corporation
Financial Statements
Years ended December 31, 1997, 1996, and 1995
CONTENTS
Report of Independent Auditors........................................... 1
Financial Statements
Balance Sheets as of December 31, 1997 and 1996.......................... 2
Statements of Operations for the Years Ended December 31, 1997, 1996, and 1995................................................ 4
Statements of Stockholders' Equity for the Years Ended December 31, 1997, 1996, and 1995....................................... 5
Statements of Cash Flows for the Years Ended December 31, 1997, 1996, and 1995 ...................................... 6
Notes to Financial Statements............................................ 7
Report of Independent Auditors
The Board of Directors Illinois Superconductor Corporation
We have audited the accompanying balance sheets of Illinois Superconductor Corporation as of December 31, 1997 and 1996, and the related statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1997. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Illinois Superconductor Corporation at December 31, 1997 and 1996, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
The accompanying financial statements have been prepared assuming that Illinois Superconductor Corporation will continue as a going concern. As more fully described in Note 3, Illinois Superconductor Corporation has incurred ongoing operating losses and does not currently have financing commitments in place to meet expected cash requirements through 1998. These conditions raise substantial doubt about Illinois Superconductor Corporation's ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 3. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.
/s/ Ernst & Young LLP Chicago, Illinois
February 27, 1998
Illinois Superconductor Corporation
Balance Sheets
See notes to financial statements
Illinois Superconductor Corporation
Balance Sheets (continued)
See notes to financial statements.
Illinois Superconductor Corporation
Statements of Operations
Years ended December 31, 1997, 1996, and 1995
See notes to financial statements.
Illinois Superconductor Corporation
Statements of Stockholders' Equity
Years ended December 31, 1997, 1996, and 1995
See notes to financial statements
Illinois Superconductor Corporation Statements of Cash Flows Years ended December 31, 1997, 1996, and 1995
See notes to financial statements
Illinois Superconductor Corporation Notes to Financial Statements
1. DESCRIPTION OF BUSINESS
Illinois Superconductor Corporation (Company) was founded in 1989 by ARCH Development Corporation ("ARCH"), an affiliate of The University of Chicago, to commercialize superconducting technologies developed initially at Argonne National Laboratory. The Company uses its patented and proprietary high-temperature superconducting materials technologies to develop and manufacture radio frequency front-end products designed to enhance the quality, capacity, coverage and flexibility of cellular, PCS and other wireless telephony services located primarily in the United States. In prior years, the Company was in the developmental stage.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CASH, CASH EQUIVALENTS AND INVESTMENTS
Cash and cash equivalents consist of demand deposits, time deposits, money market funds, and commercial paper which have maturities of three months or less from the date of purchase. Investments consist of U.S. corporate debt securities, U.S. Treasury securities, and other U.S. government obligations. Management believes that the financial institutions in which it maintains such deposits are financially sound and, accordingly, minimal credit risk exists with respect to these deposits.
Management determines the appropriate classification of debt securities at the time of purchase and reevaluates such designation as of each balance sheet date. All of the Company's investments are classified as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses, net of tax, reported in a separate component of stockholders' equity. The amortized cost of debt securities in this category is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization and accretion is included in investment income. Realized gains and losses and declines in value judged to be other-than-temporary on available-for - -sale securities are included in investment income.
Illinois Superconductor Corporation Notes to Financial Statements (continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
The cost of securities sold is based on the specific identification method. Interest and dividends on securities classified as available-for-sale are included in investment income.
INVENTORIES
Inventories are stated at the lower of cost (determined on a first in, first out basis) or market.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost, less accumulated depreciation, and are depreciated over the estimated useful lives of the assets using accelerated methods. Leasehold improvements are amortized using the straight-line method over the shorter of the useful life of the asset or the term of the lease. Amortization of leasehold improvements is included in depreciation expense. The useful lives assigned to property and equipment for the purpose of computing book depreciation are as follows:
PATENTS AND TRADEMARKS
Patents and trademarks are recorded at cost and are amortized using the straight-line method over the shorter of their estimated useful lives or 17 years. The recoverability of the carrying values of patents and trademarks is evaluated on an ongoing basis. Patents and trademarks are net of accumulated amortization of $91,230 and $98,223 at December 31, 1997 and 1996, respectively. Capitalized patent costs related to pending patents are $471,933 and $270,779 at December 31, 1997 and 1996, respectively.
INCOME TAXES
Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.
Illinois Superconductor Corporation Notes to Financial Statements (continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REVENUE RECOGNITION
Revenues from product sales are recognized at the time of shipment.
ADVERTISING COSTS
Advertising costs are charged to expense in the period incurred. Advertising expense for the years ended December 31, 1997, 1996, and 1995 was approximately $176,000, $135,000, and $87,000, respectively.
RESEARCH AND DEVELOPMENT COSTS
Research and development costs related to both present and future products are charged to expense in the period incurred.
NET LOSS PER COMMON SHARE
In 1997, the Financial Accounting Standards Board issued Statement No. 128, Earnings per Share. Statement 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. Basic and diluted net loss per common share are computed based upon the weighted-average number of common shares outstanding. Common shares issuable upon the exercise of options and warrants are not included in the per share calculations since the effect of their inclusion would be antidilutive. All earnings per share amounts for all periods have been presented and, where appropriate, restated to conform to the Statement 128 requirements.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Illinois Superconductor Corporation Notes to Financial Statements (continued)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
DESCRIPTION OF CERTAIN CONCENTRATIONS AND RISKS
The Company operates in a highly competitive and rapidly changing industry. Product revenues are currently concentrated with a limited number of customers and the supply of certain materials is concentrated among a few providers. The development and commercialization of new technologies by any competitor could adversely affect the Company's results of operations.
LONG-LIVED ASSETS
In March 1995, the Financial Accounting Standards Board issued Statement No. 121, Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to Be Disposed Of ((FASB 121), which requires impairment losses to be recorded on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets' carrying amount. FASB 121 also addresses the accounting for long-lived assets that are expected to be disposed of. The Company adopted FASB 121 in the first quarter of 1996. The effect of adoption was not material.
3. GOING CONCERN AND MANAGEMENT'S PLANS
The Company has incurred, and continues to incur, losses from operations and the Company's available resources are not presently sufficient to fund its expected cash requirements through the end of 1998. These conditions raise substantial doubt about the Company's ability to continue as a going concern. The Company is actively seeking financing to continue its operations under its current operating plan beyond the end of 1998. The Company is currently contemplating several proposals from third parties to provide the resources to execute its business plan in the form of near-term equity financing.
Illinois Superconductor Corporation Notes to Financial Statements (continued)
4. INVENTORIES
Inventories consist of the following:
Cost of product sales for the year ending December 31, 1997, includes approximately $529,000 of costs in excess of the net realizable value of finished goods inventory.
5. INVESTMENTS
Investments at December 31, 1997 and 1996 consist of a U.S. government security, due in March 2001, with a cost and fair value of $500,313. During the year ended December 31, 1996, available-for sale debt securities with a fair value at the date of sale of $2,500,000 were sold. The gross realized gains on such sales were $43,171.
6. CAPITAL STOCK
The Company has an authorized class of undesignated preferred stock consisting of 100,000 shares. Preferred stock may be issued in series from time to time with such designations, relative rights, priorities, preferences, qualifications, limitations and restrictions thereof, to the extent that such are not fixed in the Company's certificate of incorporation, as the board of directors determines.
On February 9, 1996, the board of directors adopted a rights plan (Rights Plan). In conjunction with the adoption of the Rights Plan, the Company has created one series of preferred stock, consisting of 10,000 shares of Series A Junior Participating Preferred Stock (Series A Preferred). Each share of Series A Preferred would entitle the holder to receive dividends equal to 1,000 times the dividends per share declared with respect to the Company's common stock and , in the event of liquidation, such holders would receive a preference of 1,000 times the aggregate amount to be distributed per share to the holders of the Company's common stock. Pursuant to the Rights Plan, a Series A Right is associated with, and trades with, each share of common stock outstanding.
Illinois Superconductor Corporation Notes to Financial Statements (continued)
6. CAPITAL STOCK (CONTINUED)
The record date for distribution of such Series A Rights was February 22, 1996, and for so long as the Series A Rights are associated with the common stock, each new share of common stock issued by the Company will include a Series A Right.
Each Series A Right will entitle its holder to purchase one one-thousandth of a share of Series A Preferred for $200, subject to adjustment as defined in the Rights Plan. The Series A Rights are not exercisable until the earlier of (i) 10 days after any person or group becomes the beneficial owner of 15% or more of the Company's outstanding common stock, or (ii) 10 business days (unless extended by the board of directors) after the commencement of a tender offer or exchange offer that would result in a person or group beneficially owning 15% or more of the Company's outstanding common stock.
If any person or group (Acquiring Party) acquires 15% or more of the Company's outstanding common stock (Shares Acquisition Date), each holder of a Series A Right, except the Acquiring Party, has the right to receive upon exercise (i) shares of the Company's common stock having a market value equal to two times the exercise price of the Series A Right, and (ii) one Series B Right (Series A Rights and Series B Rights are hereinafter collectively referred to as the Rights). The board of directors has the option, after the Shares Acquisition Date but before there has been a 50% acquisition of the Company, to exchange one share of common stock (or one one-thousandth of a share of preferred stock) and one Series B Right for each Series A Right (other than Series A Rights held by the Acquiring Party).
If, after the Series A Rights become exercisable, the Company is involved in a merger or other business combination, or if the Company sells or transfers more than 50% of its assets or earning power, or if an acquiring party engages in certain "self-dealing" transactions with the Company, as defined in the Rights Plan, each Right then outstanding (other than Rights held by the Acquiring Party) will be exercisable for common stock of the other party to such transaction having a market value of two times the exercise price of the Right. The Company has the right to redeem each Series A Right for $0.01 prior to the Shares Acquisition Date. The Series B Rights, once issued, are not redeemable. The Rights expire on February 9, 2006.
On November 14, 1995, the Company completed the private placement and issuance of 356,473 Units, which raised $3,581,282, net of related expenses. Each Unit consists of one share of common stock and one detachable common stock purchase warrant. Each warrant had a term of two years and was exercisable for the purchase of one share of common stock at $13.00 per share. Warrants for 15,700 of these shares were exercised prior to December 23, 1996. The remaining 340,773 of warrants were redeemed by the Company on December 23, 1996. In conjunction with the redemption, the Company
Illinois Superconductor Corporation Notes to Financial Statements (continued)
6. CAPITAL STOCK (CONTINUED)
issued 340,773 shares of its common stock in exchange for $3,287,304 in cash plus $1,142,754 of notes. The notes bear interest at 8.25% per annum, were due on April 30, 1997, and are guaranteed by an affiliate of a stockholder. Payments made during 1997 on the notes receivable totaled $444,246. The remaining balance due of $698,508, plus accrued interest of $70,470 at December 31, 1997, is currently being disputed by the issuers and is in litigation (Note 14).
On February 23, 1996, the Company completed the private placement and issuance of 408,526 shares of its common stock at $21.80 per share. Proceeds, net of related expenses, were $8,333,654.
On June 6, 1997, the Company issued 600 shares of Series B Convertible Preferred Stock(Series B Stock) for $5,000 per share, or $3,000,000. In connection with this sale, the Company issued a warrant to purchase 62,500 shares of Common Stock at $14.8125 per share, expiring on June 6, 2001. On each of August 29, 1997 and October 29, 1997, the Company issued 300 shares of Series C Convertible Preferred Stock (Series C Stock) for $5,000 per share, or $3,000,000 in aggregate. In addition, on October 29, 1997 the Company issued 700 shares of Series G Convertible Preferred Stock (Series G Stock) for $5,000 per share, or $3,500,000. In connection with the sale of Series G Stock, the Company issued warrants to purchase an aggregate of 34,782 shares of Common Stock at $10.0625 per share, expiring on October 29, 2001. Total proceeds from the above issuances, net of related expenses, was $9,163,428. None of the Preferred Stock has voting rights. The Series B Stock is convertible into Common Stock at a conversion price equal to the lessor of (a) $11.85, or (b) 101% of the average of the lowest per share market value for the five consecutive trading days during the 60 trading days immediately preceding the date of conversion. The Series C Stock and Series G Stock are convertible into Common Stock at the conversion price equal to the lesser of (a) $8.05 or (b) 101% of the average of the lowest per share market value for the five consecutive tradings days during the 60 trading days immediately preceding the date of conversion. The conversion ratio is subject to adjustment. Dividends on the Series B, Series C and Series G Convertible Preferred Stock are payable at the rate of 5% per annum, and are payable in cash or shares of Common Stock, at the option of the Company. Accrued Preferred Stock dividends at December 31, 1997 totaled $81,164.
Illinois Superconductor Corporation
Notes to Financial Statements (continued)
6. CAPITAL STOCK (CONTINUED)
On November 19, 1997, $1,200,000 (240 shares) of Series B Stock was converted into 259,347 shares of Common Stock. Accrued dividends of $26,958 were also converted into 5,826 shares of Common Stock. On December 2, 1997, $700,000 (140 shares) of Series B Stock was converted into 251,446 shares of Common Stock. Accrued dividends of $16,972 were also converted into 6,096 shares of Common Stock. On December 23, 1997, $625,000 (125 shares) of Series B Stock was converted into 291,199 shares of Common Stock. Accrued dividends of $17,208 were also converted into 8,018 shares of Common Stock.
At December 31, 1997, authorized but unissued shares of common stock have been reserved for future issuance as follows:
7. STOCK OPTIONS AND WARRANTS
On August 19, 1993, the Board of Directors adopted the 1993 Stock Option Plan (the Plan) for employees, consultants, and directors who are not also employees of the Company (outside directors). The maximum number of shares issuable under the Plan, as amended in 1997, is 1,705,000, of which 80,000 are reserved for issuance to outside directors. The Plan is administered by a committee (the "Committee") consisting of two or more outside directors appointed by the board of directors of the Company.
For employees and consultants, the Plan provides for granting of Incentive Stock Options (ISOs) and Nonstatutory Stock Options (NSOs). In the case of ISOs, the exercise price shall not be less than 100% (110% in certain cases) of the fair value of the common stock, as determined by the Committee, on the date of grant. In the case of NSOs, the exercise price shall not be less than 85% (110% in certain cases) of the fair value of the common stock, as determined by the Committee, on the date of grant. The term of options granted to employees and consultants will be for a period not to exceed 10 years (five years in certain cases). Options granted under the Plan on or before May 31, 1995 generally vest over a five year period (One-fifth of options granted vest after one year from the grant date and the remaining options vest ratably each month thereafter).
Illinois Superconductor Corporation Notes to Financial Statements (continued)
7. STOCK OPTIONS AND WARRANTS (CONTINUED)
Options granted under the Plan subsequent to May 31, 1995 generally vest over a four year period (One-fourth of options granted vest after one year from the grant date and the remaining options vest ratably each month thereafter). In addition, the Committee may authorize option grants with vesting provisions that are not based solely on employees' rendering of additional service to the Company.
For outside directors, NSOs only will be granted with an exercise price of 100% of the fair value of the common stock, as determined by the Committee, on the date of grant.
The Plan provides that each outside director will be automatically granted 10,000 NSOs on the date of their initial election to the board of directors. On the date of the annual meeting of the stockholders of the Company each outside director who is elected, reelected, or continues to serve as a director, shall be granted 3,000 NSOs, except for those outside directors who are first elected to the Board of Directors at the meeting or three months prior. The options granted vest ratably over three years and expire after seven years from the grant date.
The Company entered into stock option agreements with certain employees and a consultant prior to the adoption of the Plan. These stock options generally become exercisable over a five-year period, commencing from the date of grant, and expire 10 years from the date of grant. Exercise prices were determined by the Board of Directors and, for options granted through December 31, 1992, represented estimated fair values of the Company's common stock at the grant date.
The Company has elected to follow Accounting Principals Board Opinion No. 25, "Accounting for Stock Issued to Employees," (APB 25) and related Interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under Financial Accounting Standards Board No. 123, "Accounting for Stock-Based Compensation," (FASB 123) requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, since the exercise price of the Company's employee stock option grants has equaled the market price of the underlying stock on the date of grant, no compensation expense is recognized.
Pro forma information regarding net income and earnings per share is required under FASB 123, and has been determined as if the Company had accounted for its stock options granted subsequent to December 31, 1994, under the fair value method of that Statement.
Illinois Superconductor Corporation
Notes to Financial Statements (continued)
7. STOCK OPTIONS AND WARRANTS (CONTINUED)
The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for the years ended December 31, 1997, 1996 and 1995: risk-free interest rate of 6.3%, 6.2% and 6.3%, respectively; a dividend yield of 0%; volatility factor of the expected market price of the Company's common stock of .74, .75 and .75, respectively; and expected life of the options of 4.0, 4.1 and 4.1 years, respectively.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information is as follows:
YEAR ENDED DECEMBER 31 1997 1996 1995 ----------------------------------------
Pro forma net loss $(13,063,962) $(11,590,957) $(7,428,018) Pro forma net loss per common share $ (2.53) $ (2.56) $ (2.04)
Because FASB 123 is applicable only to options granted subsequent to December 31, 1994, its pro forma effect will not be fully reflected until 1999.
Illinois Superconductor Corporation
Notes to Financial Statements (continued)
7. STOCK OPTIONS AND WARRANTS (CONTINUED)
The table below summarizes option activity during the three year period ended December 31, 1997:
The weighted-average exercise price of options outstanding at December 31, 1997 and 1996, was $12.92 and $13.40, respectively. The weighted-average exercise price of options granted, exercised, and forfeited during 1997 was $ 13.18, $3.94, and $15.32, respectively. The weighted-average fair value of options granted during 1997, 1996 and 1995, was $7.94, $ 11.35, and $7.08, respectively.
Following is additional information with respect to options outstanding at December 31, 1997:
Illinois Superconductor Corporation Notes to Financial Statements (continued)
7. STOCK OPTIONS AND WARRANTS (CONTINUED)
The total number of unvested options outstanding at December 31, 1997 was 346,949, all of which vest based on employees' continued service to the Company.
On January 7, 1998, the Company granted an additional 355,000 options to certain executive officers of the company.
In December 1991 and January 1992, the Company issued common stock purchase warrants for 34,063 and 74,938 shares, respectively, to preferred stockholders in conjunction with short-term loans from the stockholders. These warrants have an exercise price of $1.4679 per share and expire 10 years from the date of issue. Warrants for 19,869, 34,063 and 13,625 of these shares were exercised in 1997, 1996 and 1995, respectively.
In connection with the July 1992 issuance of Series B convertible preferred stock, the Company issued common stock purchase warrants for 213,780 shares to the Series B convertible preferred stockholders. These warrants have an exercise price of $2.29 (71,260 shares), $2.75 (71,260 shares), and $3.21 (71,260 shares) per share and expire upon the seventh anniversary of issuance. Warrants for 96,437 of these shares (36,107 shares at $2.29 per share, 36,107 shares at $2.75 per share and 24,223 shares at $3.21 per share) were exercised during 1996. Warrants for 54,337 of these shares (17,779 shares at $2.29 per share, 17,779 shares at $2.75 per share, and 18,779 shares at $3.21 per share) were exercised during 1997.
The Company also issued warrants to purchase 470,589 shares of common stock in connection with the July 1993 issuance of Series C preferred stock. The warrants are exercisable at $9.56 per share and expire in November 2000. Warrants for 64,614 and 69,020 of these shares were exercised during 1997 and 1996, respectively.
In conjunction with the Company's initial public offering in October 1993, warrants to purchase an aggregate of 100,000 shares of common stock at an exercise price of $13.50 (120% of the initial public offering price) per share were issued for $100 to the managing underwriter of the initial public offering. The warrants are exercisable through October 26, 1998. Warrants for 10,000 of these shares were exercised during 1996.
As discussed in Note 6, the Company issued warrants to purchase 62,500 shares of common stock on June 6, 1997 in connection with the issuance of Series B Convertible Preferred Stock and warrants to purchase 34,782 shares of common stock on October 29, 1997 in connection with the issuance of Series G Convertible Preferred Stock.
Illinois Superconductor Corporation
Notes to Financial Statements (continued)
8. LONG-TERM DEBT
The Company's long-term debt consists of two equipment financing notes with a bank that mature in October 1998 and May 1999, respectively. The notes bear interest at 8.5% per annum. Payments of principal plus accrued interest are due monthly in arrears. Borrowings are collateralized by the related equipment purchased, which has a carrying value of approximately $110,000 at December 31, 1997. The notes require the Company to maintain a minimum net worth and leverage ratio, as defined. The Company's outstanding obligations under these notes was $91,618 at December 31, 1997, with aggregate debt maturities of $78,077 in 1998, and $13,541 in 1999.
9. INCOME TAXES
The Company has net operating loss and research and development credit carryforwards for tax purposes of approximately $40,027,000 and $881,000, respectively, at December 31, 1997. The net operating loss carryforwards expire in the following years:
Illinois Superconductor Corporation
Notes to Financial Statements (continued)
9. INCOME TAXES (CONTINUED)
Significant components of the Company's deferred tax assets and liabilities are as follows:
The valuation allowance increased during 1997 and 1996 by $4,815,000 and $4,479,000, respectfully, due primarily to the increase in the net operating loss carryforward. Based on the Internal Revenue Code and changes in the ownership of the Company, utilization of the net operating loss carryforwards will be subject to annual limitations.
10. FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amount of cash equivalents, the restricted certificates of deposit, and the stockholder notes receivable approximates fair value due to the short maturity of those instruments. The fair value of the Company's investments approximates the carrying value based on quoted market prices for those or similar investments. The fair value of the Company's long-term debt approximates the carrying value based on current rates available to the Company for debt with similar remaining maturities.
Illinois Superconductor Corporation
Notes to Financial Statements (continued)
11. RESEARCH AND DEVELOPMENT AGREEMENTS
In March 1993, the Company entered into a three-year cost-sharing cooperative agreement with the U.S. government under the Department of Commerce Advanced Technology Program. Funding totaling $200,000 and $650,000 for the years ended December 31, 1996 and 1995, respectively, has been offset against the related research and development expenses.
12. COMMITMENTS
OPERATING LEASES
The Company leases its manufacturing and office space. Under the terms of the lease, which expires October 2004, the Company is responsible for all real estate taxes and operating expenses. The lease provides for a security deposit ($300,000 at December 31, 1997) that is secured by a certificate of deposit owned by the Company.
Future minimum payments under the operating lease consist of the following at December 31, 1997:
Rent expense totaled $226,938, $227,334, and $267,991 for the years ended December 3l, 1997, 1996, and 1995, respectively.
Illinois Superconductor Corporation Notes to Financial Statements (continued)
12. COMMITMENTS (CONTINUED)
CONSULTING AND RESEARCH AGREEMENTS
During 1994, the Company entered into consulting and research agreements related to the development of certain technology. The consulting agreement requires an annual payment of $50,000 in 1998, while the research agreement provides for annual payments of $140,000 through 1998 with the right to renew for one additional year at the Company's option. The research agreement was amended in 1997 and again in 1998 and expires at the end of 1998, unless renewed at the Company's option.
13. 401(K) PLAN
The Company has a 401(k) plan covering all employees who meet prescribed service requirements. The plan provides for deferred salary contributions by the plan participants and a Company contribution. Company contributions, if any, are at the discretion of the Board of Directors and are not to exceed the amount deductible under applicable income tax laws. No Company contribution was made for the years ended December 31, 1997, 1996, and 1995.
14. LEGAL PROCEEDINGS
In 1996, a stockholder filed a complaint against the Company alleging that, in connection with the Company's private placement of securities in November 1995, the Company breached and repudiated an oral contract with the stockholder for the issuance and sale by the Company of 370,370 shares of the Company's common stock at $10.80 per share, plus warrants (immediately exercisable at $12.96 per share) to purchase an additional 370,370 shares of the Company's common stock. The stockholder is seeking a jury trial and money damages equal to the difference between $8,800,000 (370,370 shares at $10.80 per share and 370,370 shares at $12.96 per share) and 740,740 shares multiplied by the highest price at which the Company's stock traded on the NASDAQ Stock Market between November 20, 1995 and the date of judgment.
Illinois Superconductor Corporation
Notes to Financial Statements (continued)
14. LEGAL PROCEEDINGS (CONTINUED)
The Company believes that the suit is without merit and intends to continue to defend itself vigorously in this litigation. As such, the Company believes that the resolution of this matter will not have a material adverse effect on the financial condition or results of operations of the Company.
In July 1997, the Company filed a complaint against a group of Borrowers and a Guarantor to enforce the terms of loans made by the Company to the Borrowers and guaranteed by the Guarantor in the aggregate principal amount of $698,508. The Borrowers' notes were issued to the Company in connection with the Borrowers' exercise of warrants to purchase shares of the Company's common stock in December 1996.
In September 1997, the Borrowers and the Guarantor responded to the Company's complaint and filed a counterclaim alleging that they exercised the warrants in reliance on the Company's alleged fraudulent representations to one of the Borrowers concerning a third-party's future underwriting of a secondary public offering of the Common Stock. The counterclaim sought an amount of damages which the Borrowers allege "cannot currently be determined." The Company regards the fraud claim as without factual or legal merit and the Company intends to vigorously pursue this litigation.
In November 1997, a Stockholder sued the Company and seven of its former or current Directors for breaching their duties of loyalty and due care to the Stockholder by selecting financing for the Company in June 1997 which allegedly entrenched the Directors, eroded the Company's stock price and diluted the Stockholder's equity in the Company. The Stockholder's complaint sought an unspecified amount of compensatory damages in excess of $50,000 . The Company and the Directors regard the suit as without factual or legal merit and intends to defend itself vigorously in this litigation.
In January 1998, a Stockholder, individually and on behalf of all other Stockholders similarly situated, filed a complaint against the Company and eight of its former or current directors. The complaint alleged that the Directors breached their duties of loyalty and due care to the putative class of stockholders by selecting financing for the Company in June 1997 which supposedly entrenched the Directors and reduced the Company's stock price. The complaint also alleged that the Directors breached their duty of disclosure by not informing the stockholders that the selected financing would erode the Company's stock price. The Stockholder's complaint sought certification of a class consisting of all owners of the Company's common stock during the period from June 6, 1997 through November 21, 1997, excluding the Directors and a Stockholder.
Illinois Superconductor Corporation Notes to Financial Statements (continued)
14. LEGAL PROCEEDINGS (CONTINUED)
The complaint also seeks an unspecified amount of compensatory and punitive damages, and attorneys' fees. The Company and the Directors regard the suit as without factual or legal merit and intends to continue to defend itself vigorously in this litigation.
15. SUBSEQUENT EVENTS
During the period from January 1, 1998 to March 23, 1998, the following conversions of Preferred stock have taken place. Series B Convertible Preferred Stock of $475,000 (95 shares) has been converted into 270,671 shares of common stock. Accrued dividends of $13,794 were also converted into 7,860 shares of common stock. Series C Convertible Preferred Stock of $2,475,000 (495 shares) has been converted into 2,133,331 shares of common stock. Accrued dividends of $50,885 were also converted into 43,797 shares of common stock. Series G Convertible Preferred Stock of $2,840,000 (568 shares) has been converted into 2,847,404 shares of common stock. Accrued dividends of $53,747 were also converted into 53,888 shares of common stock.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 31st day of March, 1998.
ILLINOIS SUPERCONDUCTOR CORPORATION
By:/s/ EDWARD W. LAVES ---------------------------------- Edward W. Laves, Ph.D. President and Chief Executive Officer
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 indicated on the 31st day of March, 1998.
SIGNATURE TITLE /s/ EDWARD W. LAVES President, Chief Executive Officer (Principal Executive - -------------------- Officer) and a Director Edward W. Laves
/s/ STEPHEN G. WASKO Chief Financial Officer, Treasurer and Secretary - -------------------- (Principal Financial and Accounting Officer) Stephen G. Wasko
/s/ PETER S. FUSS Director - -------------------- Peter S. Fuss
/s/ ROBERT D. MITCHUM Director - --------------------- Robert D. Mitchum
/s/ STEVEN LAZARUS Director - -------------------- Steven Lazarus
/s/ TERRY S. PARKER Director - --------------------- Terry S. Parker
/s/ THOMAS L. POWERS Director - -------------------- Thomas L. Powers
/s/ ORA E. SMITH Chairman of the Board and Director - -------------------- Ora E. Smith
ILLINOIS SUPERCONDUCTOR CORPORATION
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
S-1
INDEX TO EXHIBITS