Item 1B.
Unresolved Staff Comments
None.
Our corporate headquarters and manufacturing operations are located in Exton, Pennsylvania. We currently lease approximately 86,500 square feet. This lease is noncancelable through March 31, 2013.
During 2006, we entered into a lease for approximately 2,200 square feet of office space in Santa Barbara, California to support the Office of the Chief Executive and his staff, Investor Relations and our Business Development management team. This lease is noncancelable through August 31, 2008. We will not renew this lease as we are in the process of closing this Santa Barbara, California office.
We currently lease approximately 14,800 square feet of office and laboratory space in Houston, Texas. Our lease expires April 30, 2008 and we do not expect to renew this lease. During 2006, we relocated our research and development activities to our Exton, Pennsylvania facility and we also subleased approximately 50% of the Houston, Texas facility to a third-party tenant.
During 2006, the Board of Directors approved the proposed closing of our UK operation, including our commercial manufacturing facility and cellular laboratory located in London, England. This London, England facility consists of approximately 11,800 square feet under a lease that expires in March 2010. The facility was closed during the first half of 2007. We are attempting to sublease the facility to a third-party.
In April 2005, we acquired a two-building, 100,000 square foot corporate campus in Bevaix, Canton of Neuchâtel, Switzerland. During 2006, management placed the corporate campus on the real estate market for sale. See “Assets Held for Sale” in Note 3 of Notes to Consolidated Financial Statements.
Federal Securities Litigation
The Company and certain of its current and former officers and directors are defendants in class action cases pending in the United States District Court for the Eastern District of Pennsylvania.
In August 2005 and September 2005, various lawsuits were filed alleging securities fraud and asserting claims on behalf of a putative class of purchasers of publicly traded Isolagen securities between March 3, 2004 and August 1, 2005. These lawsuits were Elliot Liff v. Isolagen, Inc. et al., C.A. No. H-05-2887, filed in the United States District Court for the Southern District of Texas; Michael Cummiskey v. Isolagen, Inc. et al., C.A. No. 05-cv-03105, filed in the United States District Court for the Southern District of Texas; Ronald A. Gargiulo v. Isolagen, Inc. et al., C.A. No. 05-cv-4983, filed in the United States District Court for the Eastern District of Pennsylvania, and Gregory J. Newman v. Frank M. DeLape, et al., C.A. No. 05-cv-5090, filed in the United States District Court for the Eastern District of Pennsylvania.
The Liff and Cummiskey actions were consolidated on October 7, 2005. The Gargiolo and Newman actions were consolidated on November 29, 2005. On November 18, 2005, the Company filed a motion with the Judicial Panel on Multidistrict Litigation (the “MDL Motion”) to transfer the Federal Securities Actions and the Keene derivative case (described below) to the United States District Court for the Eastern District of Pennsylvania. The Liff and Cummiskey actions were stayed on November 23, 2005 pending resolution of the MDL Motion. The Gargiulo and Newman actions were stayed on December 7, 2005 pending resolution of the MDL Motion. On February 23, 2006, the MDL Motion was granted and the actions pending in the Southern District of Texas were transferred to the Eastern District of Pennsylvania, where they have been captioned In re Isolagen, Inc. Securities & Derivative Litigation, MDL No. 1741 (the “Federal Securities Litigation”).
On April 4, 2006, the United States District Court for the Eastern District of Pennsylvania appointed Silverback Asset Management, LLC, Silverback Master, Ltd., Silverback Life Sciences Master Fund, Ltd., Context Capital Management, LLC and Michael F. McNulty as Lead Plaintiffs, and the law firms of Bernstein Litowitz Berger & Grossman LLP and Kirby McInerney & Squire LLP as Lead Counsel in the Federal Securities Litigation.
On July 14, 2006, Lead Plaintiffs filed a Consolidated Class Action Complaint in the Federal Securities Litigation on behalf of a putative class of persons or entities who purchased or otherwise acquired Isolagen common stock or convertible debt securities between March 3, 2004 and August 9, 2005. The complaint purports to assert claims for securities fraud in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against Isolagen and certain of its former officers and directors. The complaint also purports to assert claims for violations of Section 11 and 12 of the Securities Act of 1933 against the Company and certain of its current and former directors and officers in connection with the registration and sale of certain shares of Isolagen common stock and certain convertible debt securities. The complaint also purports to assert claims against CIBC World Markets Corp., Legg Mason Wood Walker, Inc., Canaccord Adams, Inc. and UBS Securities LLC as underwriters in connection with an April 2004 public offering of Isolagen common stock and a 2005 sale of convertible notes. On November 1, 2006, the defendants moved to dismiss the complaint. On September 26, 2007, the court denied the Company’s motions to dismiss the complaint. On November 6, 2007, the court entered a scheduling order that provides for discovery to be complete by June 8, 2009.
The Company intends to defend these lawsuits vigorously. However, the Company cannot currently estimate the amount of loss, if any, that may result from the resolution of these actions, and no provision has been recorded in the consolidated financial statements. The Company will expense its legal costs as they are incurred and will record any insurance recoveries on such legal costs in the period the recoveries are received.
Derivative Actions
The Company is the nominal defendant in derivative actions (the “Derivative Actions”) pending in State District Court in Harris County, Texas, the United States District Court for the Eastern District of Pennsylvania, and the Court of Common Pleas of Chester County, Pennsylvania.
On September 28, 2005, Carmine Vitale filed an action styled, Case No. 2005-61840, Carmine Vitale v. Frank DeLape, et al. in the 55th Judicial District Court of Harris County, Texas and in February 2006 Mr. Vitale filed an amended petition. In this action, the plaintiff purports to bring a shareholder derivative action on behalf of the Company against certain of the Company’s current and former officers and directors. The Plaintiff alleges that the individual defendants breached their fiduciary duties to the Company and engaged in other wrongful conduct. Jeffrey Tomz, who formerly served as Isolagen’s Chief Financial Officer, was accused of engaging in insider trading of Isolagen stock through a proxy. The plaintiff did not make a demand on the Board of Isolagen prior to bringing the action and plaintiff alleges that a demand was excused under the law as futile.
On December 2, 2005, the Company filed its answer and special exceptions pursuant to Rule 91 of the Texas Rules of Civil Procedure based on pleading defects inherent in the Vitale petition. The plaintiff filed an amended petition on February 15, 2006, to which the defendants renewed their special exceptions. On September 6, 2006, the Court granted the special exceptions and permitted the plaintiff thirty days to attempt to replead. Thereafter the plaintiff moved the Court for an order compelling discovery, which the Court denied on October 2, 2006. On October 18, 2006, the Court entered an order explaining its grounds for granting the special exceptions. On November 3, 2006, the plaintiff filed a second amended petition. On February 8, 2007, the Company filed its answer and special exceptions to the second amended petition. On August 9, 2007, the Court granted the special exceptions and dismissed the second amended petition with prejudice. On September 4, 2007, the plaintiff moved for reconsideration of the dismissal with prejudice of the second amended petition, for a new trial, and for leave to further amend the petition, and the defendants opposed that motion on September 20, 2007. On October 23, 2007, that motion was deemed denied by operation of law because the court had not acted on it by that date.
On October 8, 2005, Richard Keene filed an action styled, C.A. No. H-05-3441, Richard Keene v. Frank M. DeLape et al., in the United States District Court for the Southern District of Texas. This action makes substantially similar allegations as the original complaint in the Vitale action. The plaintiff also alleges that his failure to make a demand on the Board prior to filing the action is excused as futile.
The Company sought to transfer the Keene action to the United States District Court for the Eastern District of Pennsylvania as part of the MDL Motion. On January 21, 2006, the court stayed the Keene action pending resolution of the MDL Motion. On February 23, 2006, the Keene action was transferred with the Federal Securities Actions from the Southern District of Texas to the Eastern District of Pennsylvania. Thereafter, on May 15, 2006, the plaintiff filed an amended complaint, and on June 5, 2006, the defendants moved to dismiss the amended complaint. On August 21, 2006, the plaintiff moved for leave to file a second amended complaint, and on September 15, 2006, defendants filed an opposition to that motion. On January 24, 2007, the court denied the plaintiff’s motion to file a second amended complaint, and on April 10, 2007 the court granted the defendants’ motion to dismiss and dismissed the amended complaint without prejudice. On May 9, 2007, plaintiff filed a notice of appeal from the January 24, 2007 order denying plaintiff’s motion to file a second amended complaint, and from the April 10, 2007 order dismissing plaintiff’s amended complaint without prejudice. The appeal is fully briefed.
On October 31, 2005, William Thomas Fordyce filed an action styled, C.A. No. GD-05-08432, William Thomas Fordyce v. Frank M. DeLape, et al., in the Court of Common Pleas of Chester County, Pennsylvania. This action makes substantially similar allegations as the original complaint in the Vitale action. The plaintiff also alleges that his failure to make a demand on the Board prior to filing the action is excused as futile.
On January 20, 2006, the Company filed its preliminary objections to the complaint. On August 31, 2006, the Court of Common Pleas entered an opinion and order sustaining the preliminary objections and dismissing the complaint with prejudice. On September 19, 2006, Fordyce filed a motion for reconsideration, which the Court of Common Pleas denied. On September 28, 2006, Fordyce filed a notice of appeal to the Superior Court of Pennsylvania. On July 27, 2007, the Superior Court affirmed the decision of the Court of Common Pleas.
On February 14, 2008, Ronald Beattie filed an action styled C.A. No. 08-724, Ronald Beattie v. Michael Macaluso, et al., in the United States District Court for the Eastern District of Pennsylvania. This action makes substantially similar allegations as the original complaint in the Vitale action. The complaint has not yet been served on the Company.
The Derivative Actions are purportedly being prosecuted on behalf of the Company and any recovery obtained, less any attorneys’ fees awarded, will go to the Company. The Company is advancing legal expenses to certain current and former directors and officers of the Company who are named as defendants in the Derivative Actions and expects to receive reimbursement for those advances from its insurance carriers. The Company will expense its legal costs as they are incurred and will record any insurance recoveries on such legal costs in the period the recoveries are received. The Company cannot currently estimate the amount of loss, if any, that may result from the resolution of these actions, and no provision has been recorded in the consolidated financial statements.
Indemnity Demands
Mr. Jeffrey Tomz
After the above referenced litigations were commenced, Mr. Jeffrey Tomz, who formerly served as Isolagen’s Chief Financial Officer, demanded reimbursement of his costs of defense, and reimbursement for the costs of responding to a Securities and Exchange Commission investigation of his alleged insider trading in Isolagen stock. It is understood that Tomz’s defense costs to date amount to approximately $0.3 million.
As the Vitale matter has now been resolved in favor of all defendants, including Mr. Tomz, the Company is presently obligated to reimburse him for the reasonable and necessary costs of defending all claims asserted therein other than the insider trading allegations. Although decided on jurisdictional grounds, it is likely the Company is also obligated to reimburse Mr. Tomz for the reasonable and necessary costs incurred in defending the Fordyce matter given that it has also been resolved in favor of all defendants. The Company would be liable to reimburse Mr. Tomz for the reasonable and necessary costs of defense in the Keene case if it is affirmed on appeal and in the putative securities cases should he prevail in that action. The Company has refused to pay the amount of fees and expenses for which Mr. Tomz has sought reimbursement because it believes they are excessive, duplicative and have not been properly segregated between reimbursable and non-reimbursable claims. The Company has negotiated an acceptable compromise for the amounts billed by Mr. Tomz’s local Pennsylvania counsel for an amount less than $0.1 million.
Prior to the resolution of the various derivative actions, Mr. Tomz filed a demand for arbitration seeking advancement of his defense costs. He subsequently agreed to stay those proceedings. At present, Mr. Tomz has not sought to lift this stay and it is uncertain whether he will attempt to do so in the future.
The Company has accrued less than $0.1 million in the accompanying Consolidated Financial Statements as of December 31, 2007 with respect to Mr. Tomz’s existing defense costs in dispute. The Company intends to seek reimbursement under its directors and officers liability policy for any amounts paid to reimburse Mr. Tomz for his defense costs, which includes less than $0.1 million paid to date.
Underwriters
The Underwriters have each demanded that the Company indemnify, hold harmless and defend them with respect to the claims asserted in the putative securities actions. The total amount demanded to date is less than $0.3 million, however, we believe that cumulative future amounts of these defense costs are likely to be significant, although these cumulative future amounts cannot be estimated at this time.
Isolagen has denied this demand on numerous grounds, including that: (i) as to the November 2004 convertible notes offering, it only agreed to indemnify the Underwriters for any losses resulting from any untrue statement, or alleged untrue statement, of material fact in the offering documents provided by the Company to a holder or prospective purchaser of securities, and plaintiffs’ claims in the securities action are not based upon alleged untrue statements in any such documents; (ii) as to the June 2004 secondary offering, it only agreed to indemnify the Underwriters for untrue statements, or alleged untrue statements, of material fact, in the preliminary prospectus, registration statement, prospectus or any amendment thereof, and there were no such untrue statements in any such document; (iii) Isolagen assumed no duty to defend or advance defense costs; and (iv) Isolagen satisfied whatever duty to defend it may have to the Underwriters by offering to assume the Underwriters’ defense. Accordingly, we have not accrued any amounts related to the Underwriters’ defense costs in our Consolidated Financial Statements.
United Kingdom
Subsequent to the Company’s public announcement regarding the closure of the United Kingdom operation, the Company received negative publicity and negative correspondence from former patients in the United Kingdom that previously received our treatment. More recently, the Company received a written demand by an attorney representing approximately 82 former patients each claiming negligent misstatements were made and each claiming, on average, £3,500 (or approximately $7,000), plus unquantified interest and incidental expenses. The Company is in the process of evaluating the merits of the claims made in the demand. To date, no formal legal action has been brought by the attorney against the Company, and no provision has been recorded in the consolidated financial statements related to this matter.
Other
We are involved in various other legal matters that are being defended and handled in the ordinary course of business. Although it is not possible to predict the outcome of these matters, management believes that the results will not have a material impact on the Company’s financial statements.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders
On November 5, 2007, we held our 2007 Annual Meeting of Stockholders at our office in Exton, Pennsylvania. Dr. Kenneth A. Selzer, Mr. Steven Morrell, and Mr. Marshall G. Webb were elected as directors by our stockholders at the meeting to serve until the 2010 annual meeting of stockholders or until their respective successors have been duly elected and qualified. The Company’s stockholders ratified the appointment of BDO Seidman, LLP as the Company’s auditors for the year ending December 31, 2007.
The results of the vote were as follows:
Shares voted FOR / AGAINST / ABSTAINING:
33,120,713 / 136,638 / 54,576
2.
To elect three directors to hold office until the Company’s 2010 annual meeting of stockholders, or until his successor is duly elected and qualified.
Shares voted FOR / WITHHELD Mr. Steven Morrell:
31,935,719 / 1,376,208
Shares voted FOR / WITHHELD Mr. Marshall G. Webb:
32,069,017 / 1,242,910
Shares voted FOR / WITHHELD Dr. Kenneth A. Selzer:
33,009,911 / 302,016
Part II
Item 5.
Item 5.
Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
Since December 11, 2002, our common stock has been traded on the American Stock Exchange under the symbol “ILE.” Prior to December 11, 2002, our common stock was quoted on the OTC Bulletin Board under the symbol “ISLG.” The market for our common stock is limited and volatile. The following table sets forth the high and low sales prices, as applicable, for our common stock for each of the periods indicated as reported by the AMEX.
The closing price of our common stock on March 3, 2008 was $0.61.
Holders
As of March 1, 2008, we had 383 stockholders of record of our common stock.
Dividends
We have never paid any cash dividends on our common stock. We anticipate that we will retain future earnings, if any, to support operations and to finance the growth and development of our business. Therefore, we do not expect to pay cash dividends in the foreseeable future.
Recent Sales of Unregistered Securities
We did not sell unregistered securities during the fourth quarter of 2007.
Purchases of Equity Securities.
We did not repurchase any of our equity securities during the fourth quarter of 2007.
Stock Performance Graph
The following graphs our performance in the form of cumulative total return to holders of our common stock since December 31, 2002 in comparison to the AMEX Composite Index, and the AMEX Biotech Index for that same period. The graph assumes that $100 was invested on December 31, 2002 in each of our common stock, the AMEX Composite Index, and the AMEX Biotech Index, and that all dividends were reinvested. The comparisons shown in the graph below are based upon historical data. The stock price performance shown in the graph below is not necessarily indicative of, or intended to forecast, the potential future performance of our common stock. The stock performance graph shall not be deemed to be “soliciting material” or to be “filed” with the SEC under the Securities Act or the Exchange Act, or incorporated by reference in any document so filed.
Our selected consolidated financial information presented as of December 31, 2007, 2006, 2005, 2004 and 2003 and for each of the five years ended December 31, 2007 was derived from our audited consolidated financial statements.
This information should be read in conjunction with the historical consolidated financial statements and related notes included herein, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” We have classified our discontinued operations as discontinued operations for all periods presented herein (see Note 5 of Notes to Consolidated Financial Statements).
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
General
We are an aesthetic and therapeutic company focused on developing novel skin and tissue rejuvenation products. Our clinical development product candidates are designed to improve the appearance of skin injured by the effects of aging, sun exposure, acne and burns with a patient’s own, or autologous, fibroblast cells produced in our proprietary Isolagen Process. Our clinical development programs encompass both aesthetic and therapeutic indications. Our most advanced indication utilizing the Isolagen Process is for the treatment of wrinkles and is currently in Phase III clinical development. We have also initiated a Phase II/III study in acne scars, a Phase II study for restrictive burn scars and have ongoing Phase II trials in full face rejuvenation and periodontal disease. We also develop and market an advanced skin care product line through our Agera Laboratories, Inc. subsidiary, in which we acquired a 57% interest in August 2006.
We sometimes refer to our product candidates in the aggregate as Isolagen Therapy. From 2002 through 2006, we made Isolagen Therapy available to physicians primarily in the United Kingdom. In the fourth quarter of 2006, our Board of Directors approved closing our United Kingdom operation. Our United Kingdom operation was shutdown on March 31, 2007 (as more fully discussed in Note 5 in Notes to the Consolidated Financial Statements and below). We have refocused our management and capital resources on the management of our clinical trials, and funding thereof.
We market and sell an advanced skin care line through our majority-owned subsidiary, Agera, which we acquired in August 2006. Agera offers a complete line of skincare systems based on a wide array of proprietary formulations, trademarks and nano-peptide technology. Agera markets its product in both the United States and Europe (primarily the United Kingdom).
We are considered to be a “development stage” enterprise.
Going Concern
At December 31, 2007, we have cash, cash equivalents and restricted cash of $17.0 million and working capital of $13.8 million (including our cash, cash equivalents and restricted cash). We believe that its existing capital resources are adequate to finance our operations through at least September 1, 2008. We estimate that we will require additional cash resources during the third quarter of 2008 based upon our current operating plan and condition. This estimate excludes any proceeds that would be realized upon the sale of the Swiss campus (discussed further below under Factors Affecting Our Capital Resources).
Through December 31, 2007, we have been primarily engaged in developing our initial product technology and recruiting personnel. In the course of our development activities, we have sustained losses and expect such losses to continue through at least 2008. We expect to finance our operations primarily through our existing cash and any future financing, including the sale of assets. However, there exists substantial doubt about our ability to continue as a going concern. We will be required to obtain additional capital in the future to continue our operations. There is no assurance that we will be able to obtain any such additional capital as we need to finance these efforts, through asset sales, equity or debt financing, or any combination thereof, or on satisfactory terms or at all. Additionally, no assurance can be given that any such financing, if obtained, will be adequate to meet our ultimate capital needs and to support our growth. If adequate capital cannot be obtained on a timely basis and on satisfactory terms, our operations would be materially negatively impacted. Further, if we do not obtain additional funding prior to or during the third quarter of 2008, we may enter into bankruptcy during 2008 and possibly cease operations thereafter.
We filed a shelf registration statement on Form S-3 during June 2007, which was subsequently declared effective by the SEC. The shelf registration allows us the flexibility to offer and sell, from time to time, up to an original amount of $50 million of common stock, preferred stock, debt securities, warrants or any combination of the foregoing in one or more future public offerings. In August 2007, we sold under this shelf registration statement 6,746,647 shares of common stock to institutional investors, raising proceeds of $13.8 million, net of offering costs. We may offer and sell up to an additional $36.2 of common stock pursuant to this shelf registration.
Our ability to complete additional offerings, including any additional offerings under our shelf registration statement, is dependent on the state of the debt and/or equity markets at the time of any proposed offering, and such market’s reception of our company and the offering terms. In addition, our ability to complete an offering may be dependent on the status of our clinical trials, and in particular, the status of our Phase III clinical trial for the treatment of wrinkles, which cannot be predicted. We are also continuing its efforts to sell our Swiss campus (see Note 3). We will add any proceeds from the sale of the Swiss campus to our working capital, which would partially alleviate our need to obtain financing from other sources. There is no assurance that capital in any form would be available to us, and if available, on terms and conditions that are acceptable.
As a result of the above discussed conditions, and in accordance with generally accepted accounting principles in the United States, there exists substantial doubt about our ability to continue as a going concern, and our ability to continue as a going concern is contingent upon our ability to secure additional adequate financing or capital prior to or during the third quarter of 2008. If we are unable to obtain additional sufficient funds during this time, we will be required to terminate or delay our efforts to obtain regulatory approval of one, more than one, or all of our product candidates, curtail or delay the implementation of manufacturing process improvements and/or delay the expansion of our sales and marketing capabilities. Any of these actions would have an adverse effect on our operations, the realization of our assets and the timely satisfaction of our liabilities. Our financial statements are presented on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The financial statements do not include any adjustments relating to the recoverability of the recorded assets or the classification of liabilities that may be necessary should it be determined that we are unable to continue as a going concern.
The report of our independent registered public accounting firm, BDO Seidman, LLP, contains a modification concerning our ability to continue as a going concern.
Closure of the United Kingdom Operation
As part of our continuing efforts to evaluate the best uses of our resources, in the fourth quarter of 2006 our Board of Directors approved the proposed closing of the United Kingdom operation. On March 31, 2007, we completed the closure of the United Kingdom manufacturing facility. The United Kingdom operation was located in London, England with two locations; a manufacturing site and an administrative site. Both sites are under operating leases. The manufacturing site lease expires February 2010 and, as of December 31, 2007, the remaining lease obligation approximated $0.5 million. The administrative site lease expired in April 2007.
Since our public announcement regarding the closure of the United Kingdom operation, we have received negative publicity and negative correspondence from former patients in the United Kingdom that previously received our treatment. More recently, we received a written demand by an attorney representing approximately 82 former patients each claiming negligent misstatements were made and each claiming, on average, £3,500 (or approximately $7,000), plus unquantified interest and incidental expenses. We are in the process of evaluating the merits of the claims made in the demand. To date, no formal legal action has been brought by the attorney against the Company, and no provision has been recorded in the consolidated financial statements related to this matter.
With the closure of the United Kingdom operation on March 31, 2007, our European operations (both the United Kingdom and Switzerland) and Australian operations have been presented in the financial statements as discontinued operations for all periods presented. See Note 5 of Notes to Consolidated Financial Statements.
Critical Accounting Policies
The following discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America. Our significant accounting policies are more fully described in Note 3 of the Notes to the Consolidated Financial Statements. However, certain accounting policies and estimates are particularly important to the understanding of our financial position and results of operations and require the application of significant judgment by our management or can be materially affected by changes from period to period in economic factors or conditions that are outside of the control of management. As a result they are subject to an inherent degree of uncertainty. In applying these policies, our management uses their judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on our historical operations, our future business plans and projected financial results, the terms of existing contracts, our observance of trends in the industry, information provided by our customers and information available from other outside sources, as appropriate. The following discusses our critical accounting policies and estimates.
Going Concern: As disclosed in Note 2 to the Consolidated Financial Statements, management has concluded that substantial doubt exists about the Company’s ability to continue as a going concern. This conclusion is based on estimates of our future spending and future funding required during 2008. We will be required to obtain additional capital in 2008 to continue and expand our operations. There is no assurance that we will be able to obtain any such additional capital as it needs to finance these efforts, through asset sales, equity or debt financing, or any combination thereof, or on satisfactory terms or at all.
At December 31, 2007, our cash, cash equivalents and restricted cash balance was $17.0 million. For the year ended December 31, 2007, our cash used in operations and investing activities was nearly $30 million. These factors, as well as our future spending estimates, were important factors in concluding that substantial doubt exists about our ability to continue as a going concern. We believe these estimates are particularly important to the understanding of our financial position.
Our financial statements are presented on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The financial statements do not include any adjustments relating to the recoverability of the recorded assets or the classification of liabilities that may be necessary should it be determined that we are unable to continue as a going concern.
Stock-Based Compensation: In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123 (R)”). SFAS No. 123 (R) replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and amends SFAS No. 95, “Statement of Cash Flows.” SFAS No. 123 (R) requires entities to recognize compensation expense for all share-based payments to employees and directors, including grants of employee stock options, based on the grant-date fair value of those share-based payments, adjusted for expected forfeitures.
We adopted SFAS No. 123(R) as of January 1, 2006 using the modified prospective application method. Under the modified prospective application method, the fair value measurement requirements of SFAS No. 123(R) is applied to new awards and to awards modified, repurchased, or cancelled after January 1, 2006. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered that were outstanding as of January 1, 2006 is recognized as the requisite service is rendered on or after January 1, 2006. The compensation cost for that portion of awards is based on the grant-date fair value of those awards as calculated for pro forma disclosures under SFAS No. 123. Changes to the grant-date fair value of equity awards granted before January 1, 2006 are precluded.
The fair value of stock options is determined using the Black-Scholes valuation model, which is consistent with our valuation techniques previously utilized for awards in footnote disclosures required under SFAS No. 123. Prior to the adoption of SFAS No. 123(R), we followed the intrinsic value method in accordance with APB No. 25 to account for our employee and director stock options. Historically, substantially all stock options have been granted with an exercise price equal to the fair market value of the common stock on the date of grant. Accordingly, no compensation expense was recognized from substantially all option grants to employees and directors prior to the adoption of SFAS No. 123(R). However, compensation expense was recognized in connection with the issuance of stock options to non-employee consultants in accordance with EITF 96-18, “Accounting for Equity Instruments That are Issued to Other than Employees for Acquiring, or in Conjunction with Selling Goods and Services.” SFAS No. 123(R) did not change the accounting for stock-based compensation related to non-employees in connection with equity based incentive arrangements.
The adoption of SFAS No. 123(R) requires additional accounting related to the income tax effects and additional disclosure regarding the cash flow effects resulting from share-based payment arrangement. This change in accounting resulted in the recognition of compensation expense of $1.8 million and $1.1 million related to our employee and director stock options for the years ended December 31, 2007 and 2006, respectively. During the year ended December 31, 2007, we granted stock options to purchase 0.7 million shares of our common stock. As of December 31, 2007, there was $1.8 million of total unrecognized compensation cost related to non-vested director and employee stock options which vest over time. That cost is expected to be recognized over a weighted-average period of 1.6 years. As of December 31, 2007, there was $0.8 million of total unrecognized compensation cost related to performance-based, non-vested employee stock options. That cost will begin to be recognized when the performance criteria within the respective performance-base option grants become probable of achievement.
During December 2005, the board of directors approved the full vesting of all unvested, outstanding stock options issued to current employees and directors. The board decided to take this action (the “acceleration event”) in anticipation of the adoption of SFAS No. 123 (R). As a result of this acceleration event, stock options to purchase approximately 1.4 million shares of our common stock were vested that would have otherwise vested during 2006 and later periods. At the time of the acceleration event, the unamortized grant date fair value of the affected options was approximately $3.6 million (for SFAS No. 123 and SFAS No. 148 pro forma disclosure purposes), which was charged to pro forma expense in the fourth quarter of 2005. Substantially all of the unvested employee stock options that were subject to the acceleration event had exercise prices above market price of our common stock at the time the board approved the acceleration event. However, in accordance with SFAS 123 (R) if we had not completed this acceleration event in December 2005, the majority of the $3.6 million amount discussed above would have been charged against the future results of operations, beginning in the first quarter of fiscal 2006 and continuing through later periods as the options vested. As discussed above, substantially all of the unvested employee stock options which were accelerated had exercise prices above market price at the time of acceleration. For the purposes of applying APB No. 25 to such stock options in the statement of operations for the year ended December 31, 2005, the acceleration event was treated as the acceleration of the vesting of employee and director options that otherwise would have vested as originally scheduled, and accordingly was not a modification requiring the remeasurement of the intrinsic value of the options, or the application of variable option accounting, under APB No. 25. For stock options that had exercise prices below market price at the time of acceleration and that would not have vested originally, a charge of approximately $15,000 was recorded in the statement of operations for the year ended December 31, 2005.
In March 2007, and in connection with the separation of the Company’s President, the Company agreed to modify certain of the President’s stock options such that (1) 120,000 unvested, time-based stock options would vest immediately and (2) of 400,000 performance based stock options, 100,000 would be cancelled and the remaining 300,000 would be extended such that the 300,000 options would expire 10 years from the original grant date, as opposed to expiring upon termination of employment. The 300,000 performance based stock options will continue to be subject to the same performance based vesting requirements. The 120,000 modified stock options were valued using the Black-Scholes valuation model, and resulted in $0.3 million charge to selling, general and administrative expense during the year ended December 31, 2007. The 300,000 modified performance stock options were valued using the Black-Scholes valuation model, and resulted in $0.8 million charge to selling, general and administrative expense during the year ended December 31, 2007. Two other employee stock option modifications resulted in less than $0.1 million charge to selling, general and administrative expense during the year ended December 31, 2007.
Accounting for Legal Matters: As discussed in Note 11 of Notes to Consolidated Financial Statements, set forth elsewhere in this Report, we are currently defending ourselves against various class and derivative actions. We have also received threats of litigation and demands from former patients associated with our United Kingdom operation. We intend to defend ourselves vigorously against these actions. We cannot currently estimate the amount of loss, if any, that may result from the resolution of these actions, and no provision has been recorded in our consolidated financial statements. Generally, a loss must be both reasonably estimable and probable in order to record a provision for loss. We will expense our legal costs as they are incurred and will record any insurance recoveries on such legal costs in the period the recoveries are received. Although we have not recorded a provision for loss regarding these matters, a loss could occur in a future period.
We are involved in various other legal matters that are being defended and handled in the ordinary course of business. Although it is not possible to predict the outcome of these matters, management currently believes that the results will not have a material impact on our financial statements.
Research and Development Expenses: Research and development costs are expensed as incurred and include salaries and benefits, costs paid to third-party contractors to perform research, conduct clinical trials, develop and manufacture drug materials and delivery devices, and a portion of facilities cost. Clinical trial costs are a significant component of research and development expenses and include costs associated with third-party contractors. Invoicing from third-party contractors for services performed can lag several months. We accrue the costs of services rendered in connection with third-party contractor activities based on our estimate of management fees, site management and monitoring costs and data management costs. Actual clinical trial costs may differ from estimated clinical trial costs and are adjusted for in the period in which they become known.
Results of Operations-Comparison of Years Ending December 31, 2007 and 2006
REVENUES. Revenue increased $1.0 million to $1.4 million for the year ended December 31, 2007, as compared to $0.4 million for the year ended December 31, 2006. Our revenue from continuing operations is from the operations of Agera which we acquired on August 10, 2006. Agera markets and sells a complete line of advanced skin care systems based on a wide array of proprietary formulations, trademarks and non-peptide technology. On a pro forma basis, assuming that Agera had been acquired on January 1, 2006, our revenue would have been $1.2 million for the year ended December 31, 2006. Due to our financial statement presentation of our United Kingdom operation as a discontinued operation, our revenue for all periods presented is representative of only Agera, as all historical United Kingdom revenue is reflected in loss from discontinued operations. We currently expect first quarter 2008 revenue to be approximately $0.2 million.
COST OF SALES. Costs of sales increased to $0.7 million for the year ended December 31, 2007, as compared to $0.2 million for the year ended December 31, 2006. Our cost of sales relates to the operation of Agera.
As a percentage of revenue, Agera cost of sales were approximately 47% for the year ended December 31, 2007 and approximately 50% for the year ended December 31, 2006. On a pro forma basis, assuming Agera had been acquired on January 1, 2006, our cost of sales as a percentage of revenue would have been 50% for the full year ended December 31, 2006. The decrease in 2007 cost of sales as a percentage of revenue, as compared to 2006, is primarily due to selling price increases implemented during 2007.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative expenses increased approximately $5.6 million, or 42%, to $18.7 million for the year ended December 31, 2007, 2007, as compared to $13.2 million for the year ended December 31, 2006. The increase in selling, general and administrative expense is primarily due to the following:
a) Additional severance expense and related costs associated with the termination of our President, pursuant to a settlement agreement executed in June 2007, resulted in an additional $4.6 million of selling, general and administrative expense for the year ended December 31, 2007 (see Notes 11 and 13 of Notes to Consolidated Financial Statements).
b) Salaries, bonuses and payroll taxes increased by approximately $0.1 million to $5.3 million for the year ended December 31, 2007, as compared to $5.2 million for the year ended December 31, 2006, due to an increase in the average number of our employees, primarily at the executive management level, which resulted in higher salary expense. The higher salary expense was partially offset by lower bonuses earned for the year ended December 31, 2007 as compared to December 31, 2006.
c) Marketing expense increased by approximately $0.2 million to $0.8 million for the year ended December 31, 2007, as compared to $0.6 million during the year ended December 31, 2006 due primarily to marketing and promotional efforts related to marketing and selling our Agera line of advanced skin care systems.
d) Travel expense increased by approximately $0.1 million to $0.7 million for the year ended December 31, 2007, as compared to $0.6 million for the year ended December 31, 2006 due to the increase in the number of our employees, primarily at the executive management level, and increase in business development activities during 2007.
e) Other general and administrative operating costs increased by approximately $1.6 million to $6.8 million for the year ended December 31, 2007, as compared to $5.2 million for the year ended December 31, 2006 due primarily to costs of approximately $0.8 million related to our withdrawn and terminated debt offering, increased business development activities and increased investor relations costs of $0.6 million for the year ended December 31, 2007, as well as the addition of general expenses related to our August 2006 acquisition of Agera. We incurred non-cash amortization expense related to our Agera intangible assets of approximately $0.3 million for the year ended December 31, 2007, as compared to $0.1 million for the year ended December 31, 2006.
f) Legal expenses decreased by approximately $1.0 million to $0.6 million for the year ended December 31, 2007, as compared to $1.6 million for the year ended December 31, 2006. For the years ended December 31, 2007 and December 30, 2006, we received $1.7 million and $0.9 million, respectively, of reimbursements from our insurance carrier as reimbursement for defense costs related to our class action and derivative matters. If we had not received these reimbursements, our legal expenses would have been $2.3 million for the year ended December 31, 2007 and $2.5 million for the year ended December 31, 2006. Excluding the insurance carrier reimbursement, legal expenses remained relatively consistent. In general, our legal expense, net, fluctuates primarily as a result of the level of class action and derivative action defense costs incurred during a particular period and as a result of the timing of related insurance carrier reimbursements for defense costs. Such reimbursements are recorded when received. As discussed in Note 11 of Notes to Consolidated Financial Statements, on September 26, 2007 the Court denied our motion to dismiss the complaint in the federal securities litigation against us, and on November 6, 2007 the court entered a scheduling order that provides that discovery be completed by June 8, 2009. The commencement of the discovery process in this matter will likely cause legal expenses to increase in 2008.
RESEARCH AND DEVELOPMENT. Research and development expenses increased by approximately $4.5 million for the year ended December 31, 2007 to $13.3 million, as compared to $8.8 million for the year ended December 31, 2006. Research and development costs are composed primarily of costs related to our efforts to gain FDA approval for our Isolagen Therapy for specific dermal applications in the United States, as well as costs related to other potential indications for our Isolagen Therapy, such as acne scars and burn scars. Also, research and development expense includes costs to develop manufacturing, cell collection and logistical process improvements. Research and development costs primarily include personnel and laboratory costs related to these FDA trials and certain consulting costs. The total inception to date cost of research and development as of December 31, 2007 was $44.0 million.
The FDA approval process is extremely complicated and is dependent upon our study protocols and the results of our studies. In the event that the FDA requires additional studies for our dermal product candidate or requires changes in our study protocols or in the event that the results of the studies are not consistent with our expectations, as occurred during 2005 with respect to our previously conducted Phase III wrinkle/nasolabial fold trial, the process will be more expensive and time consuming. Due to the complexities of the FDA approval process, we are unable to predict what the cost of obtaining approval for our dermal product candidate will be at this time.
The major changes in research and development expenses are due primarily to the following:
a) Consulting expense increased by approximately $3.0 million to $6.6 million for the year ended December 31, 2007, as compared to $3.6 million for the year ended December 31, 2006, as a result of increased expenditures related to our current wrinkle/nasolabial fold study and acne scar study, and preparations related to other clinical trials such as restrictive burn scars.
b) Salaries, bonuses and payroll taxes increased by approximately $0.6 million to $3.0 million for the year ended December 31, 2007, as compared to $2.4 million for the year ended December 31, 2006, as a result of increased employees engaged in research and development activities.
c) Laboratory costs increased by approximately $0.6 million to $1.5 million for the year ended December 31, 2007, as compared to $0.9 million for the year ended December 31, 2006, as a result of increased clinical and manufacturing activities in our Exton, Pennsylvania location.
d) Contract labor support related to our clinical manufacturing operation increased $0.5 million to $0.5 million for the year ended December 31, 2007, as compared to less than $0.1 million for the year ended December 31, 2006, as a result of increased clinical activities in our Exton, Pennsylvania location.
e) Facilities, depreciation and travel costs decreased $0.2 million to $1.7 million for the year ended December 31, 2007, as compared to $1.9 million for the year ended December 31, 2006.
LOSS FROM DISCONTINUED OPERATIONS. As discussed above under “-Closure of the United Kingdom Operation,” during the three months ended December 31, 2006, the Board of Directors approved the closure of our United Kingdom operation. The United Kingdom operation was closed in March 2007, as compared to normal operations during the year ended December 31, 2006.
The loss from discontinued operations decreased by approximately $11.0 million for the year ended December 31, 2007 to $1.7 million, as compared to $12.7 million for the year ended December 31, 2006. The $1.7 million loss from discontinued operations during the year ended December 31, 2007 consisted of $1.1 million of losses incurred during the first quarter 2007, which was the United Kingdom’s last quarter of full operations, and $0.6 million of second, third and fourth quarter 2007 losses (which, after closure of the operation, primarily consisted of facility expense, legal expense and public relations costs, as well as costs to maintain our Switzerland corporate campus held for sale). The $1.1 million loss from discontinued operations during the three months ended March 31, 2007 primarily consisted of the following:
a) Salaries, severance expense and payroll taxes were approximately $0.3 million for the three months ended March 31, 2007.
b) Other general and administrative operating costs were approximately $0.5 million primarily related to lease expense and operating costs incurred during the three months ended March 31, 2007.
c) Gross loss was $0.3 million during the three months ended March 31, 2007, primarily due to low production volumes during the shutdown period and due to the write-off of unrealizable inventory used in the manufacturing process.
INTEREST INCOME. Interest income decreased approximately $1.4 million to $0.9 million for the year ended December 31, 2007, as compared to $2.3 million for the year ended December 31, 2006. The decrease in interest income of $1.4 million resulted from a decrease in the amount of cash, cash equivalents and restricted cash balances, as a result of our use of these balances primarily to fund our normal operating activities related to our efforts to gain FDA approval for our Isolagen Therapy.
INTEREST EXPENSE. Interest expense remained constant at $3.9 million for the year ended December 31, 2007, as compared to the year ended December 31, 2006. Our interest expense is related to our $90.0 million, 3.5% convertible subordinated notes, as well as the related amortization of deferred debt issuance costs of $0.8 million for each of the years ended December 31, 2007 and 2006, respectively.
NET LOSS. Net loss decreased $0.2 million to $35.6 million for the year ended December 31, 2007, as compared to a net loss of $35.8 million for the year ended December 31, 2006. This decrease in net loss primarily represents the effects of our decrease in loss from discontinued operation and additional gross profit of $0.6 million, offset by the increases in our selling, general and administrative expenses and research and development expenses and reductions in interest income, as discussed above.
Results of Operations-Comparison of Years Ending December 31, 2006 and 2005
REVENUE. Revenue increased $0.4 million for the year ended December 31, 2006, as compared to zero for the year ended December 31, 2005. The increase in revenue is due to the acquisition of Agera on August 10, 2006, which markets and sells a complete line of advanced skin care systems based on a wide array of proprietary formulations, trademarks and nano-peptide technology. On a pro forma basis, assuming that Agera had been acquired on January 1, 2006 and 2005, respectively, our revenue would have been $1.2 million and $1.0 million for the years ended December 31, 2006 and 2005, respectively.
COST OF SALES. Costs of sales increased to $0.2 million for the year ended December 31, 2006, as compared to zero for the year ended December 31, 2005.
As a percentage of revenue, Agera cost of sales were approximately 50% for the year ended December 31, 2006. Agera’s cost of sales, as a percentage of revenue, for all of 2006 and 2005 (including the periods prior to our August 10, 2006 acquisition of a 57% interest in Agera) were 46% and 37%, respectively.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative expenses decreased approximately $0.8 million, or 6%, to $13.2 million for the year ended December 31, 2006, as compared to $14.0 million for the year ended December 31, 2005. This decrease was net of the effect of a $0.6 million increase in selling, general and administrative expenses for expenses of Agera for the period August 10, 2006 to December 31, 2006. The decrease in selling, general and administrative expense is primarily due to the following:
a) Salaries, bonuses and payroll taxes increased by approximately $2.1 million to $5.2 million for the year ended December 31, 2006, as compared to $3.1 million for year ended December 31, 2005, due to an increase in the number of our employees, primarily at the executive management level, which resulted in higher salary and bonus expense of $1.3 million during the year ended December 31, 2006. Additionally, as the result of the adoption of SFAS 123(R) on January 1, 2006, equity-based compensation was approximately $1.1 million higher in 2006 as compared to the prior year. These increases were offset by a decrease in severance expense during 2006 of $0.3 million. We incurred $0.2 million of severance expense in the year ended December 31, 2006, as compared to $0.5 million in the year ended December 31, 2005.
b) Marketing expense increased by approximately $0.2 million to $0.6 million for the year ended December 31, 2006, as compared to $0.4 million for year ended December 31, 2005 due primarily to increased marketing and promotional efforts related to marketing and selling our complete line of advanced skin care systems under the trade name Agera, since our acquisition of Agera on August 10, 2006.
c) Travel expense decreased by approximately $0.2 million to $0.6 million for the year ended December 31, 2006, as compared to $0.8 million for year ended December 31, 2005, due to less travel between our Houston, Texas and Exton, Pennsylvania facilities as a result of our closing of the Houston office during 2006.
d) Consulting expense decreased by approximately $0.1 million to $0.7 million for the year ended December 31, 2006, as compared to $0.8 million for the year ended December 31, 2005 primarily due to decreased recruiting costs during 2006.
e) Legal expenses, net, increased approximately $0.3 million to $1.6 million for the year ended December 31, 2006, as compared to $1.3 million for the year ended December 31, 2005, due primarily to costs related to the securities and derivative lawsuits, for which we are defendants, and employment termination matters. While the change in legal expense, net, is not significant, included in the net legal expenses are insurance refunds of $0.9 million and $0 in the years ended December 31, 2006 and 2005, respectively. Insurance refunds received related to the reimbursement of legal defense costs are recorded in the period that they are received.
f) Other general and administrative operating costs decreased approximately $3.1 million to $4.5 million for the year ended December 31, 2006, as compared to $7.6 million for the year ended December 31, 2005, due primarily to the write-off of third party developed software costs of approximately $1.4 million in the year ended December 31, 2005. In addition, with the completion of the Exton laboratory in the latter half of 2005, there were costs of approximately $1.4 million that were allocated from selling, general and administrative cost to research and development costs. Additionally, there was a decrease of approximately $0.3 million related to other corporate expenses, including public relations, investor relations and accounting fees.
RESEARCH AND DEVELOPMENT. Research and development expenses decreased by approximately $1.8 million during the year ended December 31, 2006 to $8.8 million, as compared to $10.6 million for the year ended December 31, 2005. Research and development costs are composed primarily of costs related to our efforts to gain FDA approval for the Isolagen Therapy for specific dermal applications in the United States and also include costs to develop manufacturing, cell collection and logistical process improvements. Research and development costs include personnel and laboratory costs related to these FDA trials and certain consulting costs. The total inception to date cost of research and development as of December 31, 2006 was $30.7 million. The FDA approval process is extremely complicated and is dependent upon our study protocols and the results of our studies. In the event that the FDA requires additional studies for dermal applications or requires changes in our study protocols or in the event that the results of the studies are not consistent with our expectations, as occurred during 2005 with respect to our first pivotal Phase III dermal trial, the process will be more expensive and time consuming. Due to the complexities of the FDA approval process, we are unable to predict what the costs of obtaining approval for the dermal applications will be at this time. We have other research projects currently underway. However, research and development costs related to these projects were not material during 2006 and 2005.
The major changes in research and development expense are due primarily to the following: a) consulting expense decreased by approximately $2.4 million to $4.5 million for the year ended December 31, 2006, as compared to $6.9 million for the year ended December 31, 2005, as a result of decreased expenditures related to our clinical trials and manufacturing process research and development, b) salaries and payroll taxes decreased by approximately $0.9 million to $2.4 million for the year ended December 31, 2006, as compared to $3.3 million for the year ended December 31, 2005, as a result of the closure of our research and development facility in Houston, Texas, during 2006, and termination of related personnel, as well as the termination of certain Exton, Pennsylvania personnel during 2006 and c) facility costs, including rent, utilities, depreciation and other related costs, increased approximately $1.5 million, due primarily to the new Exton, Pennsylvania lease which commenced during 2005.
LOSS FROM DISCONTINUED OPERATIONS. As discussed above under “Closure of the United Kingdom Operation,” during the three months ended December 31, 2006, the Board of Directors approved the closure of our United Kingdom operation, and on March 31, 2007, the United Kingdom manufacturing facility was closed.
The loss from discontinued operations increased by approximately $2.6 million for the year ended December 31, 2006 to $12.7 million, as compared to $10.1 million for the year ended December 31, 2005, and primarily consisted of the following:
a) Gross loss increased by approximately $0.7 million to $1.2 million for the year ended December 31, 2006, as compared to $0.5 million for the year ended December 31, 2005, due to a decrease in the number of biopsies, thus resulting in a decrease in revenue. With a decrease in revenue as a result of less marketing and promotional activities, and a large portion of relatively fixed manufacturing costs, our gross loss increased.
b) Salaries, bonuses and payroll taxes increased by approximately $1.0 million to $2.9 million for the year ended December 31, 2006, as compared to $1.9 million for year ended December 31, 2005, due primarily to an increase in the number of our employees dedicated to sales and marketing and customer service of our Isolagen Therapy in the United Kingdom. Further, severance expenses related to the decision to shutdown the United Kingdom operation were approximately $0.3 million for the year ended December 31, 2006.
c) Marketing expense decreased by approximately $1.1 million to $1.7 million for the year ended December 31, 2006, as compared to $2.8 million for year ended December 31, 2005 due primarily to decreased marketing and promotional efforts related to our Isolagen Therapy in the United Kingdom as a result of continued losses from the sale of the Isolagen Therapy and our related decision to shutdown the United Kingdom operations.
d) Other general and administrative operating costs increased by approximately $1.6 million to $5.7 million for the year ended December 31, 2006, as compared to $4.1 million for the year ended December 31, 2005, due primarily to impairment charges of approximately $2.6 million related to the United Kingdom and Switzerland fixed assets; offset by approximately $1.0 million in decreased United Kingdom and Swiss general office costs due to the anticipated United Kingdom shutdown and due to placing the Swiss campus for sale during the year ended December 31, 2006.
e) The United Kingdom customer settlement charge was $0.8 million for the year ended December 31, 2006, as compared to zero for the year ended December 31, 2005. As discussed further under Note 11, the United Kingdom customer settlement occurred during the first quarter of 2006.
f) Research and development expenses decreased by approximately $0.4 million to $0.4 million for the year ended December 31, 2006, as compared to $0.8 million for the year ended December 31, 2005, due to a decrease in consulting related to process improvements related to our Isolagen manufacturing process as a result of the decision to shutdown the United Kingdom operation.
INTEREST INCOME. Interest income decreased approximately $0.5 million to $2.3 million for the year ended December 31, 2006, as compared to $2.8 million for the year ended December 31, 2005. The decrease in interest income resulted principally from a decrease in the amount of cash, restricted cash and short-term investment balances, as a result of our normal operating activities related to our efforts to gain FDA approval for the Isolagen Therapy for specific dermal applications in the United States.
INTEREST EXPENSE. Interest expense remained constant at $3.9 million for the year ended December 31, 2006, as compared to the year ended December 31, 2005. Our interest expense is related to the issuance in November 2004 of $90 million in principal amount of 3.5% convertible subordinated debt, as well as the related amortization of deferred debt issuance costs of $0.8 million for each of the years ended December 31, 2006 and 2005.
NET LOSS. Net loss for the year ended December 31, 2006 was $35.8 million as compared to a net loss of $35.8 million for the year ended December 31, 2005. Our net loss, in total, was unchanged from 2005. However, the individual components of net loss have fluctuated, as discussed above.
Liquidity and Capital Resources
Net cash provided by (used in) operating, investing and financing activities for the three years ended December 31, 2007 were as follows:
OPERATING ACTIVITIES. Cash used in operating activities during the year ended December 31, 2007 amounted to $29.7 million, an increase of $0.1 million over the year ended December 31, 2006. The increase in our cash used in operating activities over the prior year is primarily due to an increase in net losses (adjusted for non-cash items) of $1.7 million, offset by changes in operating assets and liabilities of $1.6 million. While our 2007 net loss was $0.2 million lower than the prior year, our net loss (adjusted for non-cash items) increased by $1.7 million; specifically our depreciation and amortization, impairment losses and bad debt provision were $3.4 million lower in 2007 as compared to 2006 (primarily due to the March 31, 2007 closing of our United Kingdom operation), offset by $1.6 million of additional stock option expense (primarily due to stock option modification expense incurred during 2007; see Note 13 to the Consolidated Financial Statements). In part as the result of the closure of our United Kingdom operation during 2007, the majority of our operating assets and liabilities have fluctuated as compared to the prior year. For example, the closure of our United Kingdom operations eliminated the accounts receivable, prepaid expenses and deferred revenue related to those operations. In addition, cash outflows related to inventory purchases have increased due to large inventory purchases by Agera during the first half of 2007.
Our negative operating cash flows in 2007 were funded from cash on hand at December 31, 2006 and the proceeds from the sale of our common stock in August 2007 (discussed further below under Financing Activities).
INVESTING ACTIVITIES. Cash used in investing activities during the year ended December 31, 2007 amounted to $0.1 million, an decrease of $19.9 million over the year ended December 31, 2006 cash inflow of $19.8 million. The cash used in investing activities of $0.1 million during the year ended December 31, 2007 related to capital expenditures of $0.2 million offset by $0.1 million of proceeds from property and equipment sold.
The cash provided by investing activities of $19.8 million during the year ended December 31, 2006 was generated from the liquidation of $23.0 million of short-term investments (net of purchases) offset by $2.0 million of cash used (net of cash acquired) for the acquisition of a 57% interest in Agera, and further offset by $1.2 million of capital expenditures during 2006. The reduction of short-term investments was used to fund our 2006 purchases of property and equipment, our acquisition of Agera and to partially fund our negative operating cash flows.
FINANCING ACTIVITIES. Cash provided by financing activities was $14.7 million during the year ended December 31, 2007, as compared to cash provided of $0.2 million during the year ended December 31, 2006. In June 2007, we filed a shelf registration statement on Form S-3, which was subsequently declared effective by the SEC. The shelf registration allowed us the flexibility to offer and sell, from time to time, up to an original amount of $50 million of common stock, preferred stock, debt securities, warrants or any combination of the foregoing in one or more future public offerings. In August 2007, the Company sold under this shelf registration statement 6,767,647 shares of common stock to institutional investors, raising proceeds of $13.8 million, net of offering costs. In addition, during the year ended December 31, 2007 we generated $0.9 million of cash proceeds related to the exercise of stock options and warrants. The 2006 cash proceeds of $0.2 million related solely to stock option exercises.
Cash Flows Related to Discontinued Operations
Cash flows related to discontinued operations, which are included in the table of cash flows above, were as follows:
Total cash flows used in discontinued operations during the year ended December 31, 2007 was $2.5 million, as compared to $11.1 million during the year ended December 31, 2006. The large majority of cash outflow associated with discontinued operations related to the first quarter of 2007. Cash flows used in discontinued operations during the three months ended March 31, 2007 was $2.1 million. Our United Kingdom was in operation during the three months ended March 31, 2007, and was shutdown on March 31, 2007. The net loss from our United Kingdom operation during the three months ended March 31, 2007 was $1.1 million. In addition, accrued expenses and deferred revenue decreased by $1.2 million during this shutdown period (cash outflows), primarily related to the payment of severance and refunds to customers. The United Kingdom net loss and the large decrease in United Kingdom accrued expenses and United Kingdom deferred revenue during the three months ended March 31, 2007 is what primarily generated the cash outflow from discontinued operations for the year ended December 31, 2007. The remaining cash outflows associated with discontinued operations during the second, third and fourth quarters of 2007 primarily related to the payment of our lease obligation, public relations costs and legal costs in the United Kingdom, as well as operating costs to maintain our Switzerland campus.
Cash outflows from operating activities related to the years ended December 31, 2006 and 2005 related primarily to the normal, historical operation of the United Kingdom and Swiss operations, prior to the decision to shutdown the United Kingdom operation. The cash outflow from investing activities of $13.0 million during the year ended December 31, 2005 is primarily due to the purchase of the Swiss campus, and related capital improvements.
WORKING CAPITAL: At December 31, 2007, we had cash, cash equivalents and restricted cash of $17.0 million and working capital of $13.8 million (including our cash, cash equivalents and restricted cash). The substantial majority of our working capital change, as compared to December 31, 2006, relates to the use of our cash, cash equivalents, restricted cash and available-for-sale investments for the purpose of funding and operating our business, offset by the cash proceeds from our $13.8 million common stock sale in August 2007. Our ability to operate profitably is contingent upon our success in obtaining additional capital or financing, obtaining regulatory approval of our product candidates, development of markets for our products, and development of profitable scalable manufacturing processes. We believe our existing capital resources are adequate to finance our operations through at least September 1, 2008, but we will need to engage in a capital-raising transaction during 2008 or we will need to significantly modify our business plan in order to sustain our operations. We can not assure you that we will be able to obtain regulatory approvals of our product candidates, successfully develop the markets for our product candidates or develop profitable scalable manufacturing processes or obtain the capital we require, on a timely basis or on terms that we would find acceptable, or at all. Further, if we do not obtain additional funding prior to or during the third quarter of 2008, we may enter into bankruptcy during 2008 and possibly cease operations thereafter. Our ability to raise equity or debt financing may be dependent on the status of our Phase III clinical trial related to our lead facial aesthetic product candidate, which cannot be predicted. If we are able to raise additional capital, it will likely result in dilution to our current stockholders, which may be substantial.
FACTORS AFFECTING OUR CAPITAL RESOURCES: In April 2005, we acquired a two-building, 100,000 square foot corporate campus in Bevaix, Canton of Neuchâtel, Switzerland for $10 million. The $10 million purchase price was paid using cash on hand from the proceeds of our 2004 issuances of common stock and 3.5% convertible subordinated notes. Our initial estimate of the total cost of acquisition and renovation of the facility, including the purchase of required equipment, was $25 million, which includes approximately $1.8 million we had spent in renovations. The corporate campus is classified as “assets of discontinued operations held for sale” at December 31, 2007 with a value of $11.2 million, reflecting the fair value of the corporate campus. Fair value is defined as the price at which an asset would change hands in a transaction between a willing buyer and willing seller in an unforced transaction. However, if we were to sell the Swiss campus in a forced transaction or a distress sale, it is likely that the price we would receive would be less, and we would recognize a loss, which may be significant, upon such sale. As the result of our cash position at December 31, 2007 and our need for funding, it is possible that we will choose or be required to sell the Swiss campus under such conditions.
Contractual Obligations
The following table summarizes the amounts of payments due under specified contractual obligations as of December 31, 2007:
*
The table above assumes that our 3.5% convertible subordinated notes will be called due on November 1, 2009. Refer to the below for a description of our 3.5% convertible subordinated notes.
**
In addition to the above, we have, in the ordinary course of business, various contractual agreements with various consultants and service providers whereby a fee or rate per hour has been agreed to, but no guaranteed minimums have been established. Generally, such agreements are related to our research and development efforts or general operating matters. The above table should be read in conjunction with our consolidated financial statements, which illustrate a 2007 net loss of $35.6 million and net cash used in operations of $29.7 million during 2007.
***
In August 2006, we paid $2.7 million in cash to acquire a 57% interest in Agera and also we agreed to contribute $0.3 million to the working capital of Agera to support marketing and inventory acquisitions. In addition, the acquisition agreement includes future contingent payments up to a maximum of $8.0 million. Such additional purchase price is based upon certain percentages of Agera’s cost of sales incurred after June 30, 2007. Accordingly, based upon the financial performance of Agera, up to an additional $8.0 million of purchase price may be due to the selling shareholder in future periods. We believe any such payments will not be significant in fiscal year 2007. The timing of future payments may differ from the estimates above, and will depend on the future operating performance of Agera.
In November 2004, we issued $90.0 million in principal amount of 3.5% convertible subordinated notes due November 1, 2024, although these notes may be due sooner as discussed below. The notes are our general, unsecured obligations. The notes are subordinated in right of payment, which means that they rank in right of payment behind other indebtedness of ours. In addition, the notes are effectively subordinated to all existing and future liabilities of our subsidiaries. We will be required to repay the full principal amount of the notes on November 1, 2024 unless they are previously converted, redeemed or repurchased.
The notes bear interest at an annual rate of 3.5% from the date of issuance of the notes. We will pay interest twice a year, on each May 1 and November 1, until the principal is paid or made available for payment or the notes have been converted. Interest will be calculated on the basis of a 360-day year consisting of twelve 30-day months.
The note holders may convert the notes into shares of our common stock at any time before the close of business on November 1, 2024, unless the notes have been previously redeemed or repurchased. The initial conversion rate (which is subject to adjustment) for the notes is 109.2001 shares of common stock per $1,000 principal amount of notes, which is equivalent to an initial conversion price of approximately $9.16 per share. Holders of notes called for redemption or submitted for repurchase will be entitled to convert the notes up to and including the business day immediately preceding the date fixed for redemption or repurchase.
At any time on or after November 1, 2009, we may redeem some or all of the notes at a redemption price equal to 100% of the principal amount of such notes plus accrued and unpaid interest (including additional interest, if any) to, but excluding, the redemption date.
The note holders will have the right to require us to repurchase their notes on November 1 of 2009, 2014 and 2019. In addition, if we experience a fundamental change (which generally will be deemed to occur upon the occurrence of a change in control or a termination of trading of our common stock), note holders will have the right to require us to repurchase their notes. In the event of certain fundamental changes that occur on or prior to November 1, 2009, we will also pay a make-whole premium to holders that require us to purchase their notes in connection with such fundamental change.
Off-Balance Sheet Transactions
We do not engage in material off-balance sheet transactions.
Other
INFLATION. Inflation did not have a significant impact on our results for year ended December 31, 2007.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
Market risk is the potential loss arising from adverse changes in market rates and prices, such as foreign currency exchange rates or interest rates. We are exposed to market risk in the form of foreign exchange rate risk and interest rate risk.
Foreign Exchange Rate Risk
The effect of U.S. dollar currency fluctuations against the foreign currency in these countries is somewhat mitigated by the fact that expenses are generally incurred in the same currencies in which the revenue is generated. Our income will be higher or lower depending on the weakening or strengthening of the U.S. dollar against the respective foreign currency. Additionally, approximately 29% of our assets at December 31, 2007 (see Note 5 to our Consolidated Financial Statements, “Discontinued Operations”) were based in our foreign operations and translated into U.S. dollars at the foreign currency exchange rate in effect as of the end of each accounting period, with the effect of such translation reflected as a separate component of consolidated shareholders’ deficit. Substantially all of the 28% in foreign assets relates to our Swiss campus held for sale, with a value of $11.2 million at December 31, 2007. Accordingly, our consolidated shareholders’ deficit will fluctuate depending on the weakening or strengthening of the U.S. dollar against the respective foreign currency.
As a result of changing foreign currency exchange rates since December 31, 2006, specifically the exchange rate between the US dollar and the Swiss franc, our accumulated other comprehensive loss of $0.1 million at December 31, 2006 has swung to an accumulated other comprehensive gain of $0.7 million at December 31, 2007; or a change of approximately $0.8 million. However, this $0.8 million gain is considered unrealized and is reflected on the Consolidated Balance Sheet. Accordingly, this unrealized gain may increase or decrease in the future, based on the movement of foreign currency exchange rates, but will not have an impact on net income (loss) until the related foreign capital investments are sold or otherwise realized.
Interest Rate Risk
Our 3.5%, $90.0 million convertible subordinated notes, pay interest at a fixed rate and, accordingly, we are not exposed to interest rate risk as a result of this debt. However, the fair value of our $90.0 million convertible subordinated notes does vary based upon, among other factors, the price of our common stock and current interest rates on similar instruments.
We do not enter into derivatives or other financial instruments for trading or speculative purposes.
Item 8.
Item 8.
Financial Statements and Supplementary Data
The financial statements, including the notes thereto and report of the independent auditors thereon, are included in this report as set forth in the “Index to Financial Statements.” See for Index to Consolidated Financial Statements.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
During the fourth quarter of 2007, management, including our principal executive officer and principal financial officer, evaluated the disclosure controls and procedures related to the recording, processing, summarization and reporting of information in the periodic reports that the Company files with the SEC. These disclosure controls and procedures have been designed to ensure that (a) material information relating to the Company, including its consolidated subsidiaries, is made known to management, including these officers, by other employees of the Company, and (b) this information is recorded, processed, summarized, evaluated and reported, as applicable, within the time periods specified in the SEC’s rules and forms.
Accordingly, as of December 31, 2007, these officers (the principal executive officer and principal financial officer) concluded that the Company’s disclosure controls and procedures were effective.
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles in the United States of America. Our internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Based on our evaluation under the framework in Internal Control - Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2007.
BDO Seidman, LLP, the independent registered public accounting firm who also audited our consolidated financial statements, has issued its own attestation report on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2007, which is filed herewith.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of Isolagen, Inc. (a development stage company)
Exton, Pennsylvania
We have audited Isolagen, Inc.’s (in the development stage) internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Isolagen, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying “Management’s Report on Internal Control Over Financial Reporting”. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Isolagen, Inc., maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Isolagen, Inc. as of December 31, 2007 and 2006, and the related consolidated statements of operations and comprehensive loss, shareholders’ equity (deficit), and cash flows for each of the three years in the period ended December 31, 2007 and the statements of shareholders’ equity (deficit) for the period from December 28, 1995 (inception) to December 31, 2004, and our report dated March 5, 2008 contains an explanatory paragraph regarding the Company’s ability to continue as a going concern.
/s/ BDO Seidman, LLP
Houston, Texas
March 5, 2008
Changes in Internal Controls
There was no change in our internal control over financial reporting that occurred during the fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
None.
Part III
Item 10.
Item 10.
Directors, Executive Officers and Corporate Governance
The information required by this Item 10 will be included in the Company’s Proxy Statement for the 2008 Annual Meeting of Stockholders which will be filed with the Securities and Exchange Commission no later than April 29, 2008 and is incorporated into this Item 10 by reference.
Code of Ethics. We have adopted a written code of ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller and any persons performing similar functions. The code of ethics is incorporated into this Item 10 by reference.
The information required by this Item 11
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Except as provided below, the information required by this Item 12 will be included in the Company’s Proxy Statement for the 2008 Annual Meeting of Stockholders which will be filed with the Securities and Exchange Commission no later than April 29, 2008 and is incorporated into this Item 12 by reference.
Securities Authorized for Issuance Under Equity Compensation Plans
As of December 31, 2007, our equity compensation plan information was as follows:
(1)
Represents options issued to employees, in connection with initial employment, outside of our approved plans.
Item 13.
Item 13.
Certain Relationships and Related Transactions, and Director Independence
The information required by this Item 13 will be included in the Company’s Proxy Statement for the 2008 Annual Meeting of Stockholders which will be filed with the Securities and Exchange Commission no later than April 29, 2008 and is incorporated into this Item 13 by reference.
Item 14.
Item 14.
Principal Accountant Fees and Services
The information required by this Item 14 will be included in the Company’s Proxy Statement for the 2008 Annual Meeting of Stockholders which will be filed with the Securities and Exchange Commission no later than April 29, 2008 and is incorporated into this Item 14 by reference.
Part IV
Item 15.
Item 15.
Exhibits and Financial Statement Schedule
(a)(1) Financial Statements.
(a)(2) Financial Statement Schedule.
All schedules are omitted because of the absence of conditions under which they are required or because the required information is presented in the Financial Statements or Notes thereto.
(a)(3) The exhibits listed under Item 15(b) are filed or incorporated by reference herein.
(b) Exhibits.
The following exhibits are filed as part of this annual report:
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.
Date: March 6, 2008
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
Isolagen, Inc.
(A Development Stage Company)
Index to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of Isolagen, Inc. (a development stage company)
Exton, Pennsylvania
We have audited the accompanying consolidated balance sheets of Isolagen, Inc. (in the development stage) as of December 31, 2007 and 2006 and the related consolidated statements of operations and comprehensive loss, shareholders’ equity (deficit), and cash flows for each of the three years in the period ended December 31, 2007. We have also audited the statements of shareholders’ equity (deficit) for the period from December 28, 1995 (inception) to December 31, 2004. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Isolagen, Inc. at December 31, 2007 and 2006, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2007 and the statements of shareholders’ equity (deficit) for the period from December 28, 1995 (inception) to December 31, 2007 in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Isolagen, Inc.’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 5, 2008 expressed an unqualified opinion thereon.
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company has suffered recurring losses from operations and has a net capital deficit that raise substantial doubt about its ability to continue as a going concern. Management’s plan in regard to these matters is also described in Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ BDO Seidman, LLP
Houston, Texas
March 5, 2008
Isolagen, Inc.
(A Development Stage Company)
Consolidated Balance Sheets
The accompanying notes are an integral part of these consolidated financial statements.
Isolagen, Inc.
(A Development Stage Company)
Consolidated Statements of Operations
The accompanying notes are an integral part of these consolidated financial statements.
Isolagen, Inc.
(A Development Stage Company)
Consolidated Statements of Shareholders’ Equity (Deficit) and Comprehensive Loss
The accompanying notes are an integral part of these consolidated financial statements.
The accompanying notes are an integral part of these consolidated financial statements.
The accompanying notes are an integral part of these consolidated financial statements.
The accompanying notes are an integral part of these consolidated financial statements.
The accompanying notes are an integral part of these consolidated financial statements.
The accompanying notes are an integral part of these consolidated financial statements.
The accompanying notes are an integral part of these consolidated financial statements.
The accompanying notes are an integral part of these consolidated financial statements.
The accompanying notes are an integral part of these consolidated financial statements.
Isolagen, Inc.
(A Development Stage Company)
Consolidated Statements of Cash Flows
The accompanying notes are an integral part of these consolidated financial statements.
Isolagen, Inc.
(A Development Stage Company)
Notes to Consolidated Financial Statements
Note 1-Basis of Presentation, Business and Organization
Isolagen, Inc. f/k/a American Financial Holding, Inc., a Delaware corporation (“Isolagen”) is the parent company of Isolagen Technologies, Inc., a Delaware corporation (“Isolagen Technologies”) and Agera Laboratories, Inc., a Delaware corporation (“Agera”). Isolagen Technologies is the parent company of Isolagen Europe Limited, a company organized under the laws of the United Kingdom (“Isolagen Europe”), Isolagen Australia Pty Limited, a company organized under the laws of Australia (“Isolagen Australia”), and Isolagen International, S.A., a company organized under the laws of Switzerland (“Isolagen Switzerland”). The common stock of the Company, par value $0.001 per share, (“Common Stock”) is traded on the American Stock Exchange (“AMEX”) under the symbol “ILE.”
The Company is an aesthetic and therapeutic company focused on developing novel skin and tissue rejuvenation products. The Company’s clinical development product candidates are designed to improve the appearance of skin injured by the effects of aging, sun exposure, acne and burns with a patient’s own, or autologous, fibroblast cells produced in the Company’s proprietary Isolagen Process. The Company also develops and markets an advanced skin care line with broad application in core target markets through its Agera subsidiary.
The Company acquired 57% of the outstanding common shares of Agera on August 10, 2006. Agera offers a complete line of skincare systems based on a wide array of proprietary formulations, trademarks and nano-peptide technology. These technologically advanced skincare products can be packaged to offer anti-aging, anti-pigmentary and acne treatment systems. Agera markets its product in both the United States and Europe (primarily the United Kingdom). The results of Agera’s operations and cash flows have been included in the consolidated financial statements from the date of the acquisition. The assets and liabilities of Agera have been included in the consolidated balance sheet since the date of the acquisition.
In October 2006, the Company reached an agreement with the FDA on the design of a Phase III pivotal study protocol for the treatment of nasolabial folds. The randomized, double-blind protocol was submitted to the FDA under the agency’s Special Protocol Assessment (“SPA”) regulations. Pursuant to this assessment process, the FDA has agreed that the Company’s study design for two identical trials, including patient numbers, clinical endpoints, and statistical analyses, is acceptable to the FDA to form the basis of an efficacy claim for a marketing application. The randomized, double-blind, pivotal Phase III trials will evaluate the efficacy and safety of Isolagen Therapy against placebo in approximately 400 patients with approximately 200 patients enrolled in each trial. The Company completed enrollment of the study and commenced injection of subjects in early 2007.
In March 2004, the Company announced positive results of a first Phase III exploratory clinical trial for the Company’s lead facial aesthetics product candidate, and in July 2004 we commenced a 200 patient Phase III study of Isolagen Therapy for facial wrinkles consisting of two identical, simultaneous trials. The study was concluded during the second half of 2005. In August 2005 we announced that results of this study failed to meet co-primary endpoints. Based on the results of this study, the Company commenced preparations for our second Phase III pivotal study discussed in the preceding paragraph.
During 2006, 2005 and 2004, the Company sold its aesthetic product primarily in the United Kingdom. However, during the fourth quarter of fiscal 2006, the Company decided to close the United Kingdom operation. The Company completed the closure of the United Kingdom operation on March 31, 2007, and as of March 31, 2007, the United Kingdom, Swiss and Australian operations were presented as discontinued operations for all periods presented, as more fully discussed in Note 5.
Through December 31, 2007, the Company has been primarily engaged in developing its initial product technology and recruiting personnel. In the course of its development activities, the Company has sustained losses and expects such losses to continue through at least 2008. The Company expects to finance its operations primarily through its existing cash and any future financing. However, as described in Note 2, there exists substantial doubt about the Company’s ability to continue as a going concern. The Company’s ability to operate profitably is largely contingent upon its success in obtaining financing, obtaining regulatory approval to sell one or a variety of applications of the Isolagen Therapy, upon its successful development of markets for its products and upon the development of profitable scaleable manufacturing processes. The Company will be required to obtain additional capital in the future to continue and expand its operations. No assurance can be given that the Company will be able to obtain such regulatory approvals, successfully develop the markets for its products or develop profitable manufacturing methods. There is no assurance that the Company will be able to obtain any such additional capital as it needs to finance these efforts, through asset sales, equity or debt financing, or any combination thereof, or on satisfactory terms or at all. Additionally, no assurance can be given that any such financing, if obtained, will be adequate to meet the Company’s ultimate capital needs and to support the Company’s growth. If adequate capital cannot be obtained on a timely basis and on satisfactory terms, the Company’s operations would be materially negatively impacted.
If the Company achieves growth in its operations in the next few years, such growth could place a strain on its management, administrative, operational and financial infrastructure. The Company may find it necessary to hire additional management, financial and sales and marketing personnel to manage the Company’s expanding operations. In addition, the Company’s ability to manage its current operations and future growth requires the continued improvement of operational, financial and management controls, reporting systems and procedures. If the Company is unable to manage this growth effectively and successfully, the Company’s business, operating results and financial condition may be materially adversely affected.
Acquisition and merger and basis of presentation
On August 10, 2001, Isolagen Technologies consummated a merger with American Financial Holdings, Inc. (“AFH”) and Gemini IX, Inc. (“Gemini”). Pursuant to an Agreement and Plan of Merger, dated August 1, 2001, by and among AFH, ISO Acquisition Corp, a Delaware corporation and wholly-owned subsidiary of AFH (“Merger Sub”), Isolagen Technologies, Gemini, a Delaware corporation, and William J. Boss, Jr., Olga Marko and Dennis McGill, stockholders of Isolagen Technologies (the “Merger Agreement”), AFH (i) issued 5,453,977 shares of its common stock, par value $0.001 to acquire, in a privately negotiated transaction, 100% of the issued and outstanding common stock (195,707 shares, par value $0.01, including the shares issued immediately prior to the Merger for the conversion of certain liabilities, as discussed below) of Isolagen Technologies, and (ii) issued 3,942,400 shares of its common stock to acquire 100% of the issued and outstanding common stock of Gemini. Pursuant to the terms of the Merger Agreement, Merger Sub, together with Gemini, merged with and into Isolagen Technologies (the “Merger”), and AFH was the surviving corporation. AFH subsequently changed its name to Isolagen, Inc. on November 13, 2001. Prior to the Merger, Isolagen Technologies had no active business and was seeking funding to begin FDA trials of the Isolagen Therapy. AFH was a non-operating, public shell company with limited assets. Gemini was a non-operating private company with limited assets and was unaffiliated with AFH.
The consolidated financial statements presented include Isolagen, Inc., its wholly-owned subsidiaries and its majority-owned subsidiary. All significant intercompany transactions and balances have been eliminated. Isolagen Technologies was, for accounting purposes, the surviving entity of the Merger, and accordingly for the periods prior to the Merger, the financial statements reflect the financial position, results of operations and cash flows of Isolagen Technologies. The assets, liabilities, operations and cash flows of AFH and Gemini are included in the consolidated financial statements from August 10, 2001 onward.
Unless the context requires otherwise, the “Company” refers to Isolagen, Inc. and all of its consolidated subsidiaries, “Isolagen” refers to Isolagen, Isolagen Technologies, Isolagen Europe, Isolagen Australia and Isolagen Switzerland, and “Agera” refers to Agera Laboratories, Inc.
Note 2-Going Concern
At December 31, 2007, the Company had cash, cash equivalents and restricted cash of $17.0 million and working capital of $13.8 million (including our cash, cash equivalents and restricted cash). The Company believes that its existing capital resources are adequate to finance its operations through at least September 1, 2008. The Company estimates that it will require additional cash resources during the third quarter of 2008 based upon its current operating plan and condition. This estimate excludes any proceeds that would be realized upon the sale of the Swiss campus (see further discussion below and at Note 3).
Through December 31, 2007, the Company has been primarily engaged in developing its initial product technology and recruiting personnel. In the course of its development activities, the Company has sustained losses and expects such losses to continue through at least 2008. The Company expects to finance its operations primarily through its existing cash and any future financing, including the sale of assets. However, there exists substantial doubt about the Company’s ability to continue as a going concern. The Company will be required to obtain additional capital in the future to continue its operations. There is no assurance that the Company will be able to obtain any such additional capital as it needs to finance these efforts, through asset sales, equity or debt financing, or any combination thereof, or on satisfactory terms or at all. Additionally, no assurance can be given that any such financing, if obtained, will be adequate to meet the Company’s ultimate capital needs and to support the Company’s growth. If adequate capital cannot be obtained on a timely basis and on satisfactory terms, the Company’s operations would be materially negatively impacted. Further, if the Company does not obtain additional funding prior to or during the third quarter of 2008, it may enter into bankruptcy during 2008 and possibly cease operations thereafter.
The Company filed a shelf registration statement on Form S-3 during June 2007, which was subsequently declared effective by the SEC. The shelf registration allows the Company the flexibility to offer and sell, from time to time, up to an original amount of $50 million of common stock, preferred stock, debt securities, warrants or any combination of the foregoing in one or more future public offerings. In August 2007, the Company sold under this shelf registration statement 6,746,647 shares of common stock to institutional investors, raising proceeds of $13.8 million, net of offering costs. The Company may offer and sell up to an additional $36.2 million of common stock pursuant to this shelf registration.
The Company’s ability to complete additional offerings, including any additional offerings under its shelf registration statement, is dependent on the state of the debt and/or equity markets at the time of any proposed offering, and such market’s reception of the Company and the offering terms. In addition, the Company’s ability to complete an offering may be dependent on the status of its clinical trials, and in particular, the status of its Phase III clinical trial for the treatment of wrinkles, which cannot be predicted. The Company is also continuing its efforts to sell its Swiss campus (see Note 3). The Company will add any proceeds from the sale of the Swiss campus to its working capital, which would partially alleviate the Company’s need to obtain financing from other sources. There is no assurance that capital in any form would be available to the Company, and if available, on terms and conditions that are acceptable.
As a result of the above discussed conditions, and in accordance with generally accepted accounting principles in the United States, there exists substantial doubt about the Company’s ability to continue as a going concern, and the Company’s ability to continue as a going concern is contingent upon its ability to secure additional adequate financing or capital prior to or during the third quarter of 2008. If the Company is unable to obtain additional sufficient funds during this time, the Company will be required to terminate or delay its efforts to obtain regulatory approval of one, more than one, or all of its product candidates, curtail or delay the implementation of manufacturing process improvements and/or delay the expansion of its sales and marketing capabilities. Any of these actions would have an adverse effect on the Company’s operations, the realization of its assets and the timely satisfaction of its liabilities. The Company’s financial statements are presented on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The financial statements do not include any adjustments relating to the recoverability of the recorded assets or the classification of liabilities that may be necessary should it be determined that the Company is unable to continue as a going concern.
Note 3-Summary of Significant Accounting Policies
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Examples include provisions for bad debts and inventory obsolescence, useful lives of property and equipment and intangible assets, impairment of property and equipment and intangible assets, deferred taxes, the provision for and disclosure of litigation and loss contingencies (see Note 11) and estimates and assumptions related to equity-based compensation expense (see Note 13). Actual results may differ materially from those estimates.
Foreign Currency Translation
The financial position and results of operations of the Company’s foreign subsidiaries are determined using the local currency as the functional currency. Assets and liabilities of these subsidiaries are translated at the exchange rate in effect at each period-end. Income statement accounts are translated at the average rate of exchange prevailing during the period. Adjustments arising from the use of differing exchange rates from period to period are included in accumulated other comprehensive income in shareholders’ equity. Gains and losses resulting from foreign currency transactions are included in earnings and have not been material in any one period.
Balances of related after-tax components comprising accumulated other comprehensive income (loss) included in shareholders’ equity at December 31, 2007 and December 31, 2006 are as follows:
Upon sale or upon complete or substantially complete liquidation of an investment in a foreign entity, the amount attributable to that entity and accumulated in the translation adjustment component of equity is removed from the separate component of equity and is reported as gain or loss for the period during which the sale or liquidation occurs. During December 2005, the Company substantially completed the liquidation of the Company’s Australian entity. As such, the accumulated translation adjustment component was removed from equity by recording $0.1 million as other income in the 2005 consolidated statement of operations.
Statement of cash flows
For purposes of the statements of cash flows, the Company considers all highly liquid investments (i.e., investments which, when purchased, have original maturities of three months or less) to be cash equivalents. At December 31, 2007 and December 31, 2006, the Company had $0.5 million and $1.5 million of cash restricted for the payment of the non-cancelable portion of the Exton, Pennsylvania facility lease, due monthly through March 2008.
Concentration of credit risk
The Company maintains its cash primarily with major U.S. domestic banks. The amounts held in these banks generally exceed the insured limit of $100,000. The terms of these deposits are on demand to minimize risk. The Company has not incurred losses related to these deposits. Cash equivalents are maintained in two financial institutions. The Company invests these funds primarily in government securities.
Allowance for Doubtful Accounts
The Company maintains an allowance for doubtful accounts related to its accounts receivable that have been deemed to have a high risk of collectibility. Management reviews its accounts receivable on a monthly basis to determine if any receivables will potentially be uncollectible. Management analyzes historical collection trends and changes in its customer payment patterns, customer concentration, and creditworthiness when evaluating the adequacy of its allowance for doubtful accounts. In its overall allowance for doubtful accounts, the Company includes any receivable balances that are determined to be uncollectible. Based on the information available, management believes the allowance for doubtful accounts is adequate; however, actual write-offs might exceed the recorded allowance.
The following is a rollforward of the allowance for doubtful accounts, which includes that related to both continuing operations and discontinued operations, for the years ended December 31, 2007 and 2006.
The allowance for doubtful accounts related to continuing operations was $18,112 and $0 at December 31, 2007 and 2006, respectively. The allowance for doubtful accounts related to discontinued operations was $70,840 and $75,809 at December 31, 2007 and 2006, respectively.
Inventory
Agera purchases the large majority of its inventory from one contract manufacturer. Agera accounts for its inventory on the first-in-first-out method. At December 31, 2007, Agera’s inventory of $0.7 million consisted of $0.1 million of raw materials and $0.6 million of finished goods. At December 31, 2006, Agera’s inventory included $0.2 million of finished goods.
Asset of discontinued operations held for sale
In April 2005, the Company acquired land and a two-building, 100,000 square foot campus in Bevaix, Canton of Neuchâtel, Switzerland for $10 million. The Company subsequently spent approximately $1.8 million on the first phase of a renovation. In April 2006, management decided to place the Swiss campus on the market for sale in order to conserve capital. The Company commenced its selling efforts during June of 2006. As of December 31, 2007, the net book value of the Swiss campus was $11.2 million, reflecting the fair value of the corporate campus. Fair value is defined as the price at which an asset would change hands in a transaction between a willing buyer and willing seller in an unforced transaction. However, if the Company were to sell the Swiss campus in a forced transaction or a distress sale, it is likely that the price it would receive would be less, and the Company would recognize a loss, which may be significant, upon such sale. As the result of the cash position of the Company at December 31, 2007 and its need for funding, it is possible that the Company will choose or be required to sell the Swiss campus under such conditions. The corporate campus is included in assets of discontinued operations held for sale on the consolidated balance sheets for all periods presented.
Although the corporate campus was not being actively marketed for sale as of March 31, 2006, at that date management assessed whether the book value of the corporate campus was impaired based on its estimate of the realizable value of the corporate campus, and made a determination to write down the corporate campus by $0.7 million. The Company subsequently recorded a further impairment charge of $0.4 million during the fourth quarter of 2006 to reflect management’s estimate of the realizable value of the corporate campus at December 31, 2006. Accordingly, total impairment charges of $1.1 million have been recorded related to the Switzerland corporate campus, which charges are reflected in the loss from discontinuing operations in the consolidated statement of operations.
In March 2007, the Company completed the closing of its United Kingdom manufacturing facility. As described in Note 5, the Company recorded a fixed asset impairment charge related to its United Kingdom operation of $1.4 million during the fourth quarter of 2006, which is included in loss from discontinued operations in the consolidated statement of operations. The carrying value of the impaired United Kingdom fixed assets was $0.2 million at December 31, 2006, reflecting management’s estimate of realizable value. The United Kingdom fixed assets are included in assets of discontinued operations held for sale on the accompanying consolidated balance sheets for all periods presented (see Note 5 for further discussion of the Company’s discontinued operations).
Property and equipment
Property and equipment is carried at cost less accumulated depreciation and amortization. Generally, depreciation and amortization for financial reporting purposes is provided by the straight-line method over the estimated useful life of three years, except for leasehold improvements which are amortized using the straight-line method over the remaining lease term or the life of the asset, whichever is shorter. The cost of repairs and maintenance is charged as an expense as incurred.
Intangible assets
Intangible assets primarily include proprietary formulations and trademarks, which were acquired in connection with the acquisition of Agera (see Note 4), as well as certain in-process patents. Proprietary formulations and trademarks are amortized on a straight-line basis over their estimated useful lives, generally for periods ranging from 13 to 18 years. Amortization of intangible assets is expected to be approximately $0.3 million each year over the next five fiscal years. The Company continually evaluates the reasonableness of the useful lives of these assets. Intangibles are tested for recoverability whenever events or changes in circumstances indicate the carrying amount may not be recoverable. An impairment loss, if any, would be measured as the excess of the carrying value over the fair value determined by discounted cash flows.
Intangible assets are comprised as follows:
Debt Issue Costs
The costs incurred in issuing the Company’s 3.5% Convertible Subordinated Notes, including placement agent fees, legal and accounting costs and other direct costs are included in other assets and are being amortized to expense using the effective interest method over five years, through November 2009. Debt issuance costs, net of amortization, were approximately $1.4 million at December 31, 2007 and approximately $2.1 million at December 31, 2006 and were included in other assets, net, in the accompanying consolidated balance sheets.
The Company filed registration statements on Form S-3 and Form S-4 (the “Combined Registration Statements”) during July 2007. The Combined Registration Statements related to (1) a proposed exchange offer of new 3.5% convertible senior notes due 2024 to the holders of the currently outstanding $90 million, in principal amount, 3.5% convertible subordinated notes due 2024 and (2) a proposed offer to the public of an additional $30 million, in principal amount, of new 3.5% convertible senior notes due 2024. In August, 2007 the Company decided not to proceed with the offerings covered by the Combined Registration Statements, and the Combined Registration Statements were subsequently withdrawn by the Company in August 2007 prior to being declared effective by the SEC. During the year ended December 31, 2007, the Company incurred $0.8 million of costs related to the Combined Registration Statements. As a result of the Company’s withdrawal of the Combined Registration Statements in August 2007, such $0.8 million of costs were expensed and are included in selling, general and administrative expenses in the consolidated statement of operations for the year ended December 31, 2007.
Treasury Stock
The Company utilizes the cost method for accounting for its treasury stock acquisitions and dispositions.
Revenue recognition
The Company recognizes revenue over the period the service is performed in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements” (“SAB 104”). In general, SAB 104 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services rendered, (3) the fee is fixed and determinable and (4) collectibility is reasonably assured.
Continuing operations: Revenue from the sale of Agera’s products is recognized upon transfer of title, which is upon shipment of the product to the customer. The Company believes that the requirements of SAB 104 are met when the ordered product is shipped, as the risk of loss transfers to our customer at that time, the fee is fixed and determinable and collection is reasonably assured. Any advanced payments are deferred until shipment.
Discontinued operations: The Isolagen Therapy was administered, in the United Kingdom, to each patient using a recommended regimen of injections. Due to the short shelf life, each injection is cultured on an as needed basis and shipped prior to the individual injection being administered by the physician. The Company believes each injection had stand alone value to the patient. The Company invoiced the attending physician when the physician sent his or her patient’s tissue sample to the Company which created a contractual arrangement between the Company and the medical professional. The amount invoiced varied directly with the dose and number of injections requested. Generally, orders were paid in advance by the physician prior to the first injection. There was no performance provision under any arrangement with any physician, and there is no right to refund or returns for unused injections.
As a result, the Company believes that the requirements of SAB 104 were met as each injection was shipped, as the risk of loss transferred to our physician customer at that time, the fee was fixed and determinable and collection was reasonably assured. Advance payments were deferred until shipment of the injection(s). The amount of the revenue deferred represented the fair value of the remaining undelivered injections measured in accordance with Emerging Issues Task Force Issue (“EITF”) 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables,” which addresses the issue of accounting for arrangements that involve the delivery of multiple products or services. Should the physician discontinue the regimen prematurely all remaining deferred revenue is recognized.
Shipping and handling costs
Agera charges its customers for shipping and handling costs. Such charges to customers are presented net of the costs of shipping and handling, as selling, general and administrative expense, and are not significant to the consolidated statements of operations.
Advertising cost
Agera advertising costs are expensed as incurred and include the costs of public relations and certain marketing related activities. These costs are included in selling, general and administrative expenses in the accompanying consolidated statements of operations.
Research and development expenses
Research and development costs are expensed as incurred and include salaries and benefits, costs paid to third-party contractors to perform research, conduct clinical trials, develop and manufacture drug materials and delivery devices, and a portion of facilities cost. Research and development costs also include costs to develop manufacturing, cell collection and logistical process improvements.
Clinical trial costs are a significant component of research and development expenses and include costs associated with third-party contractors. Invoicing from third-party contractors for services performed can lag several months. The Company accrues the costs of services rendered in connection with third-party contractor activities based on its estimate of management fees, site management and monitoring costs and data management costs. Actual clinical trial costs may differ from estimated clinical trial costs and are adjusted for in the period in which they become known.
Stock-based compensation
Effective January 1, 2006 the Company adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”). SFAS No. 123(R) replaces SFAS No. 123, “Accounting for Stock-Based Compensation”, supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and amends SFAS No. 95, “Statement of Cash Flows.” SFAS No. 123(R) requires entities to recognize compensation expense for all share-based payments to employees and directors, including grants of employee stock options, based on the grant-date fair value of those share-based payments, adjusted for expected forfeitures. The Company adopted SFAS No. 123(R) using the modified prospective application method. Under the modified prospective application method, the fair value measurement requirements of SFAS No. 123(R) is applied to new awards and to awards modified, repurchased, or cancelled after January 1, 2006. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered that were outstanding as of January 1, 2006 is recognized as the requisite service is rendered on or after January 1, 2006. The compensation cost for that portion of awards is based on the grant-date fair value of those awards as calculated for pro forma disclosures under SFAS No. 123. Changes to the grant-date fair value of equity awards granted before January 1, 2006 are precluded.
Prior to the adoption of SFAS No. 123(R), the Company followed the intrinsic value method in accordance with APB No. 25 to account for its employee stock options. Historically, substantially all stock options have been granted with an exercise price equal to the fair market value of the common stock on the date of grant. Accordingly, no compensation expense was recognized from substantially all option grants to employees and directors. Compensation expense was recognized in connection with the issuance of stock options to non-employee consultants in accordance with EITF 96-18, “Accounting for Equity Instruments That are Issued to Other than Employees for Acquiring, or in Conjunction with Selling Goods and Services.” SFAS No. 123(R) did not change the accounting for stock-based compensation related to non-employees in connection with equity based incentive arrangements.
Income taxes
An asset and liability approach is used for financial accounting and reporting for income taxes. Deferred income taxes arise from temporary differences between income tax and financial reporting and principally relate to recognition of revenue and expenses in different periods for financial and tax accounting purposes and are measured using currently enacted tax rates and laws. In addition, a deferred tax asset can be generated by net operating loss carryforwards (“NOLs”). If it is more likely than not that some portion or all of a deferred tax asset will not be realized, a valuation allowance is recognized.
In the event the Company is charged interest or penalties related to income tax matters, the Company would record such interest as interest expense and would record such penalties as other expense in the consolidated statement of operations. No such charges have been incurred by the Company. As of December 31, 2007, the Company has no accrued interest related to uncertain tax positions.
The Company adopted the provisions of Financial Standards Accounting Board Interpretation No. 48 Accounting for Uncertainty in Income Taxes (“FIN 48”) an interpretation of FASB Statement No. 109 (“SFAS 109”) on January 1, 2007. No material adjustment in the liability for unrecognized income tax benefits was recognized as a result of the adoption of FIN 48. At the adoption date of January 1, 2007, we had $40.4 million of unrecognized tax benefits, all of which would affect the Company’s effective tax rate if recognized. At December 31, 2007, the Company has $54.8 million of unrecognized tax benefits, the large majority of which relates to loss carryforwards for which we have provided a full valuation allowance. The tax years 2004 through 2007 remain open to examination by the major taxing jurisdictions to which we are subject. Refer to Note 10 for further discussion of income tax related matters.
Loss per share data
Basic loss per share is calculated based on the weighted average common shares outstanding during the period, after giving effect to the manner in which the merger was accounted for as described in Note 1. Diluted earnings per share also gives effect to the dilutive effect of stock options, warrants (calculated based on the treasury stock method) and convertible notes and convertible preferred stock. The Company does not present diluted earnings per share for years in which it incurred net losses as the effect is antidilutive.
At December 31, 2007, options and warrants to purchase 7.9 million shares of common stock at exercise prices ranging from $1.50 to $9.81 per share were outstanding, but were not included in the computation of diluted earnings per share as their effect would be antidilutive. Also, 9.8 million shares issuable upon the conversion of the Company’s convertible notes, at a conversion price of approximately $9.16, were not included as their effect would be antidilutive.
At December 31, 2006, options and warrants to purchase 11.2 million shares of common stock at exercise prices ranging from $1.50 to $11.38 per share were outstanding, but were not included in the computation of diluted earnings per share as their effect would be antidilutive. Also, 9.8 million shares issuable upon the conversion of the Company’s convertible notes, at a conversion price of approximately $9.16, were not included as their effect would be antidilutive.
Fair Value of Financial Instruments
The Company’s financial instruments consist of accounts receivable, marketable debt securities, accounts payable and convertible subordinated debentures. The fair values of the Company’s accounts receivable and accounts payable approximate, in the Company’s opinion, their respective carrying amounts. The Company’s marketable debt security investments are carried at fair value. The Company’s convertible subordinated debentures were quoted at approximately 74% and 73% of par value at December 31, 2007 and 2006, respectively. Accordingly, the fair value of our convertible subordinated debentures was approximately $66.6 million and $65.7 million at December 31, 2007 and 2006, respectively.
Recently Issued Accounting Standards Not Yet Effective
In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, “Fair Value Measurement,” effective for the Company’s fiscal year beginning January 1, 2008. SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. This Statement does not require any new fair value measurements, but simplifies and codifies related guidance within GAAP. This Statement applies under other accounting pronouncements that require or permit fair value measurements. In November 2007, FASB agreed to a one-year deferral of the effective date for nonfinancial assets and liabilities that are recognized or disclosed at fair value on a nonrecurring basis. The Company is currently assessing the impact the adoption of this pronouncement will have on the financial statements.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”. SFAS No. 159 allows entities the option to measure eligible financial instruments at fair value as of specified dates. Such election, which may be applied on an instrument by instrument basis, is typically irrevocable once elected. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007, and early application is allowed under certain circumstances. The Company is currently assessing the impact the adoption of this pronouncement will have on the financial statements.
In December 2007, the Financial Accounting Standards Board released SFAS No. 141-R, “Business Combinations.” This Statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008, which is business combinations in the year ending December 31, 2009 for the Company. SFAS No. 141-R makes changes to the manner in which purchase business combinations, and in particular partial and step acquisitions, and minority interests, are measured and recorded. The objective of this Statement is to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects. The Company is currently assessing the impact the adoption of this pronouncement will have on the financial statements.
In December 2007, the Financial Accounting Standards Board released SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements - an amendment of ARB No. 51”. This Statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008, which for the Company is the year ending December 31, 2009 and the interim periods within that fiscal year. SFAS No. 160 changes the manner in which minority interests are classified in consolidated financial statements, and the accounting for changes in minority interests. The objective of this pronouncement is to improve the relevance, comparability and transparency of the financial information that a reporting entity provides in its consolidated financial statements. This pronouncement currently does not impact the Company as it has full controlling interest of all of its subsidiaries.
Note 4-Acquisition of Agera Laboratories, Inc.
On August 10, 2006, the Company acquired 57% of the outstanding common shares of Agera Laboratories, Inc. (“Agera”). Agera is a skincare company that has proprietary rights to a scientifically-based advanced line of skincare products. Agera markets its product in both the United States and Europe. The Company believes that the acquisition of Agera will complement the Company’s Isolagen Therapy and will broaden the Company’s position in the skincare market as Agera has a comprehensive range of technologically advanced skincare products that can be packaged to offer anti-aging, anti-pigmentary and acne treatment systems.
The acquisition has been accounted for as a purchase. Accordingly, the bases in Agera’s assets and liabilities have been adjusted to reflect the allocation of the purchase price to the 57% interest the Company acquired (with the remaining 43% interest, and the minority interest in Agera’ net assets, recorded at Agera’s historical book values), and the results of Agera’s operations and cash flows have been included in the consolidated financial statements from the date of the acquisition.
The Company paid $2.7 million in cash to acquire the 57% interest in Agera and in connection with the acquisition contributed $0.3 million to the working capital of Agera. Included in the purchase price was an option to acquire an additional 8% of Agera’s outstanding common shares for an exercise price of $0.5 million in cash. This option expired unexercised in February 2007. In addition, the acquisition agreement includes future contingent payments up to a maximum of $8.0 million. Such additional purchase price is based upon certain percentages of Agera’s cost of sales incurred after June 30, 2007. Accordingly, based upon the financial performance of Agera, up to an additional $8.0 million of purchase price may be due the selling shareholder in future periods. No amounts have yet been paid with respect to the additional purchase price.
The following table summarizes the allocation of the purchase price to the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition. These assets and liabilities were included in the consolidated balance sheet as of the acquisition date.
Of the $4.5 million, net, of acquired intangible assets, $4.4 million, net, was assigned to product formulations and trademarks, which have a weighted average useful life of approximately 16 years. No amount of the purchase price was assigned to goodwill.
The unaudited pro forma financial information below assumes that the Agera acquisition occurred on January 1 of the periods presented and includes the effect of amortization of intangibles from that date. The unaudited pro forma results of operations are being furnished solely for informational purposes and are not intended to represent or be indicative of the consolidated results of operations that would have been reported had these transactions been completed as of the dates and for the periods presented, nor are they necessarily indicative of future results.
Note 5-Discontinued Operations and Exit Costs
As part of the Company’s continuing efforts to evaluate the best uses of its resources, in the fourth quarter of 2006 the Company’s Board of Directors approved the proposed closing of the Company’s United Kingdom operation. On March 31, 2007, the Company completed the closure of its United Kingdom manufacturing facility. The United Kingdom operation was located in London, England with two locations; a manufacturing site and an administrative site. Both sites are under operating leases. The manufacturing site lease expires February 2010 and, as of December 31, 2007, the remaining lease obligation approximated $0.5 million. The administrative site lease expired in April 2007. The Company believes that substantially all costs related to the closure of the United Kingdom operation have been incurred by December 31, 2007, excluding the remaining lease obligation discussed above and any potential claims or contingencies unknown or which cannot be estimated at this time (see Note 11).
As a result of the closure of the Company’s United Kingdom operation, the operations that the Company previously conducted in Switzerland and Australia, which when closed had been absorbed into the United Kingdom operation, were also classified as discontinued operations as of March 31, 2007.
The Company recorded a fixed asset impairment charge related to its United Kingdom operation of $1.4 million during 2006, which is included in loss from discontinued operations in the consolidated statement of operations. All assets, liabilities and results of operations of the United Kingdom, Switzerland and Australian operations are reflected as discontinued operations in the accompanying consolidated financial statements. All prior period information has been restated to reflect the presentation of discontinued operations.
The following sets forth the components of assets and liabilities of discontinued operations as of December 31, 2007 and December 31, 2006:
The following sets forth the results of operations of discontinued operations for the years ended December 31, 2007, December 31, 2006 and December 31, 2005:
The following sets forth information about the major components of the United Kingdom operation exit costs incurred during 2007 and 2006:
The following sets forth information about the changes in the United Kingdom accrued exit costs for the year ended December 31, 2006:
The following sets forth information about the changes in the United Kingdom accrued exit costs for the year ended December 31, 2007:
Houston, Texas. On March 28, 2006, the Company’s board of directors approved the shut-down of the Houston, Texas facility. The Houston, Texas facility was used primarily for research and development purposes and is maintained under an operating lease which ends on April 30, 2008. The research and development activities conducted in Houston were transferred to the Company’s facilities located in Exton, Pennsylvania. An exit plan was communicated to the affected employees during the three months ended June 30, 2006. There were approximately 15 employees at the Houston, Texas facility at March 31, 2006 and the large majority of these employees had been terminated by June 30, 2006 at a severance cost of less than $0.1 million. The Company currently subleases approximately 50% of the facility to an unrelated third party. As of December 31, 2007, the remaining lease payments and common operating expenses due under the Houston, Texas lease agreement were less than $0.1 million.
Note 6-Available-for-Sale Investments
The Company had no available-for-sale investments at December 31, 2007 or 2006. Proceeds from the sale of available-for-sale marketable debt securities were $0.0 million, $25.7 million and $106.8 million for the years ended December 31, 2007, 2006 and 2005, respectively, and no realized gains and losses based on specific identification, were included in the results of operations upon those sales.
Note 7-Property and Equipment
Property and equipment is comprised of:
The amounts of depreciation and amortization expense for the above property and equipment included in the statement of operations are as follows:
During the third quarter of 2005, the Company determined that a certain third-party developed software system (the “MES” system) was impaired and, accordingly, recorded a charge of $1.3 million to selling, general and administrative expense in order to remove the related cost of the asset and associated depreciation. Previous to this charge, certain components of the MES system had been placed in use and certain components were still in development. The gross balance and accumulated depreciation related to the MES system components placed in use were $0.6 million and $0.1 million, respectively, at the time of the impairment charge and was being depreciated over five years. The balance related to the MES system components still in development, for which amortization had not commenced at the time of the impairment charge, was $0.9 million.
Note 8-Accrued Expenses
Accrued expenses are comprised of the following:
Note 9-Convertible Subordinated Notes
On November 3, 2004, the Company completed the private placement of $75.0 million aggregate principal amount of 3.5% Convertible Subordinated Notes Due 2024 (the “3.5% Subordinated Notes”). The 3.5% Subordinated Notes could be due sooner than 2024, as discussed below. The Company received net proceeds of approximately $71.7 million after the deduction of commissions and offering expenses. The Company also granted the purchasers of the 3.5% Subordinated Notes the option to purchase up to $15.0 million of additional 3.5% Subordinated Notes through December 2, 2004. On November 5, 2004, the Company completed the private placement of the additional $15.0 million aggregate principal amount of 3.5% Subordinated Notes. The Company received net proceeds of approximately $14.5 million after the deduction of discounts, commissions and offering expenses. The total net proceeds to the Company were approximately $86.2 million after the deduction of commissions and offering expenses.
The Company used approximately $26 million of the net proceeds to repurchase 4,000,000 shares of its common stock, of which 2,000,000 shares were repurchased from Frank DeLape, who was then the Chairman of the Board of Directors, Michael Macaluso, a former director and the former President and Chief Executive Officer, Olga Marko, the former Senior Vice President and Director of Research, Michael Avignon, the former Manager of International Operations, and Timothy J. Till, a shareholder. The purchase price from the insiders, affiliates and founders of the Company listed above was $6.33 per share which represented a 5% discount from the closing price of the Company’s common stock on the American Stock Exchange on October 28, 2004, the date the offering of the 3.5% Subordinated Notes was priced. The purchase of the shares from the insiders was approved by a special committee of independent directors in partial reliance on a fairness opinion issued by an investment bank. The remaining 2,000,000 shares were repurchased in private transactions at a price of $6.66 per share. The remaining net proceeds of approximately $60.2 million were added to the Company’s general working capital.
The 3.5% Subordinated Notes are unsecured obligations and are subordinated in right of payment to all of the Company’s existing and future senior indebtedness. The 3.5% Subordinated Notes are also effectively subordinated to all indebtedness and other liabilities of the Company’s subsidiaries.
The 3.5% Subordinated Notes require the semi-annual payment of interest, on May 1 and November 1 of each year beginning May 1, 2005, at 3.5% interest per annum on the principal amount outstanding. The 3.5% Subordinated Notes will mature on November 1, 2024. Prior to maturity the holders may convert their 3.5% Subordinated Notes into shares of the Company’s common stock. The initial conversion rate is 109.2001 shares per $1,000 principal amount of 3.5% Subordinated Notes, which is equivalent to an initial conversion price of approximately $9.16 per share.
On or after November 1, 2009, the Company may at its option redeem the 3.5% Subordinated Notes, in whole or in part, for cash, at a redemption price equal to 100% of the principal amount of the 3.5% Subordinated Notes to be redeemed plus accrued and unpaid interest.
On each of November 1, 2009, November 1, 2014 and November 1, 2019, the holders may require the Company to purchase all or a portion of their 3.5% Subordinated Notes at a purchase price in cash equal to 100% of the principal amount of 3.5% Subordinated Notes to be purchased plus accrued and unpaid interest. The holders of the 3.5% Subordinated Notes may also require the Company to repurchase their 3.5% Subordinated Notes in the event its common stock (or other common stock into which the 3.5% Convertible Subordinated Notes are then convertible) ceases to be listed for trading on a U.S. national securities exchange or approved for trading on an established automated over-the-counter market in the United States.
In the event a change in control occurs on or before November 9, 2009, the holders of the 3.5% Subordinated Notes may require the Company to purchase all or a portion of their notes at a purchase price equal to 100% of the principal amount of the 3.5% Subordinated Notes to be purchased plus accrued and unpaid interest and the payment of a “make-whole” payment which is based on the date on which the change in control occurs and the price per share paid for the Company’s common stock in such change in control transaction. The Company will be allowed to pay for the repurchase of the 3.5% Subordinated Notes and accrued and unpaid interest in cash or, at its option, shares of its common stock, and the Company will be allowed to make the make-whole payment in cash or, at its option, such other form of consideration as is paid to its common stockholders in the change in control transaction. In addition, in the event a change in control occurs on or before November 9, 2009, the holders of the 3.5% Subordinated Notes that convert their 3.5% Subordinated Notes into shares of the Company’s common stock in connection with such change in control transaction will also be entitled to receive the make-whole payment.
The 3.5% Subordinated Notes were issued in an offering not registered under the Securities Act of 1933, as amended (“the Securities Act”). However, the Company was obligated to file with the SEC a shelf registration statement covering resales of the 3.5% Subordinated Notes and the shares of the Company’s common stock issuable upon the conversion of the 3.5% Subordinated Notes. The shelf registration statement was subsequently declared effective on May 2, 2005. As of December 31, 2007, the Company has recorded $90.0 million of long-term debt as a long-term liability on the accompanying consolidated balance sheet.
Note 10-Income Taxes
Isolagen, Inc. and Isolagen Technologies, Inc. file a consolidated U.S. Federal income tax return. During the third quarter of 2006, the Company acquired a 57% interest in Agera (see Note 4). Agera files a separate U.S. Federal income tax return. The Company’s foreign subsidiaries, which comprise loss from discontinued operations, file income tax returns in their respective jurisdictions. The geographic source of loss from continuing operations is the United States.
The components of the income tax benefit below, which relate solely to continuing operations, are as follows:
The reconciliation between income tax expense (benefit) at the U.S. federal statutory rate and the amount recorded in the accompanying consolidated financial statements is as follows:
As discussed in Note 4, the purchase accounting for the acquisition of Agera’s resulted in the recording of a deferred tax liability of $0.2 million related to the difference between the tax and financial reporting bases (after the allocation of the purchase price) of Agera’s assets and liabilities. Agera recorded a deferred tax benefit during the three months ended December 31, 2006 related to its net operating losses during that period. Such deferred tax benefit was limited to the initial deferred tax liability recorded upon acquisition.
The components of the Company’s deferred tax assets (liabilities) at December 31, 2007 and 2006 are as follows:
As of December 31, 2007, the Company had generated U.S. net operating loss carryforwards of approximately $108.4 million which expire from 2011 to 2026 and net loss carryforwards in certain non-US jurisdictions of approximately $29.9 million. These net operating loss carryforwards are available to reduce future taxable income. However, a, change in ownership, as defined by federal income tax regulations, could significantly limit the Company’s ability to utilize its U.S. net operating loss carryforwards. Additionally, because federal tax laws limit the time during which the net operating loss carryforwards may be applied against future taxes, if the Company fails to generate taxable income prior to the expiration dates it may not be able to fully utilize the net operating loss carryforwards to reduce future income taxes. As the Company has had cumulative losses and there is no assurance of future taxable income, valuation allowances have been recorded to fully offset the deferred tax asset at December 31, 2007 and 2006. The valuation allowance increased $14.4 million, $13.4 million and $12.7 million during 2007, 2006 and 2005, respectively, due primarily to the Company’s 2007, 2006 and 2005 net losses, respectively.
Note 11-Commitments and Contingencies
Federal Securities Litigation
The Company and certain of its current and former officers and directors are defendants in class action cases pending in the United States District Court for the Eastern District of Pennsylvania.
In August 2005 and September 2005, various lawsuits were filed alleging securities fraud and asserting claims on behalf of a putative class of purchasers of publicly traded Isolagen securities between March 3, 2004 and August 1, 2005. These lawsuits were Elliot Liff v. Isolagen, Inc. et al., C.A. No. H-05-2887, filed in the United States District Court for the Southern District of Texas; Michael Cummiskey v. Isolagen, Inc. et al., C.A. No. 05-cv-03105, filed in the United States District Court for the Southern District of Texas; Ronald A. Gargiulo v. Isolagen, Inc. et al., C.A. No. 05-cv-4983, filed in the United States District Court for the Eastern District of Pennsylvania, and Gregory J. Newman v. Frank M. DeLape, et al., C.A. No. 05-cv-5090, filed in the United States District Court for the Eastern District of Pennsylvania.
The Liff and Cummiskey actions were consolidated on October 7, 2005. The Gargiolo and Newman actions were consolidated on November 29, 2005. On November 18, 2005, the Company filed a motion with the Judicial Panel on Multidistrict Litigation (the “MDL Motion”) to transfer the Federal Securities Actions and the Keene derivative case (described below) to the United States District Court for the Eastern District of Pennsylvania. The Liff and Cummiskey actions were stayed on November 23, 2005 pending resolution of the MDL Motion. The Gargiulo and Newman actions were stayed on December 7, 2005 pending resolution of the MDL Motion. On February 23, 2006, the MDL Motion was granted and the actions pending in the Southern District of Texas were transferred to the Eastern District of Pennsylvania, where they have been captioned In re Isolagen, Inc. Securities & Derivative Litigation, MDL No. 1741 (the “Federal Securities Litigation”).
On April 4, 2006, the United States District Court for the Eastern District of Pennsylvania appointed Silverback Asset Management, LLC, Silverback Master, Ltd., Silverback Life Sciences Master Fund, Ltd., Context Capital Management, LLC and Michael F. McNulty as Lead Plaintiffs, and the law firms of Bernstein Litowitz Berger & Grossman LLP and Kirby McInerney & Squire LLP as Lead Counsel in the Federal Securities Litigation.
On July 14, 2006, Lead Plaintiffs filed a Consolidated Class Action Complaint in the Federal Securities Litigation on behalf of a putative class of persons or entities who purchased or otherwise acquired Isolagen common stock or convertible debt securities between March 3, 2004 and August 9, 2005. The complaint purports to assert claims for securities fraud in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against Isolagen and certain of its former officers and directors. The complaint also purports to assert claims for violations of Section 11 and 12 of the Securities Act of 1933 against the Company and certain of its current and former directors and officers in connection with the registration and sale of certain shares of Isolagen common stock and certain convertible debt securities. The complaint also purports to assert claims against CIBC World Markets Corp., Legg Mason Wood Walker, Inc., Canaccord Adams, Inc. and UBS Securities LLC as underwriters in connection with an April 2004 public offering of Isolagen common stock and a 2005 sale of convertible notes. On November 1, 2006, the defendants moved to dismiss the complaint. On September 26, 2007, the court denied the Company’s motions to dismiss the complaint. On November 6, 2007, the court entered a scheduling order that provides for discovery to be complete by June 8, 2009.
The Company intends to defend these lawsuits vigorously. However, the Company cannot currently estimate the amount of loss, if any, that may result from the resolution of these actions, and no provision has been recorded in the consolidated financial statements. The Company will expense its legal costs as they are incurred and will record any insurance recoveries on such legal costs in the period the recoveries are received.
Derivative Actions
The Company is the nominal defendant in derivative actions (the “Derivative Actions”) pending in State District Court in Harris County, Texas, the United States District Court for the Eastern District of Pennsylvania, and the Court of Common Pleas of Chester County, Pennsylvania.
On September 28, 2005, Carmine Vitale filed an action styled, Case No. 2005-61840, Carmine Vitale v. Frank DeLape, et al. in the 55th Judicial District Court of Harris County, Texas and in February 2006 Mr. Vitale filed an amended petition. In this action, the plaintiff purports to bring a shareholder derivative action on behalf of the Company against certain of the Company’s current and former officers and directors. The Plaintiff alleges that the individual defendants breached their fiduciary duties to the Company and engaged in other wrongful conduct. Jeffrey Tomz, who formerly served as Isolagen’s Chief Financial Officer, was accused of engaging in insider trading of Isolagen stock through a proxy. The plaintiff did not make a demand on the Board of Isolagen prior to bringing the action and plaintiff alleges that a demand was excused under the law as futile.
On December 2, 2005, the Company filed its answer and special exceptions pursuant to Rule 91 of the Texas Rules of Civil Procedure based on pleading defects inherent in the Vitale petition. The plaintiff filed an amended petition on February 15, 2006, to which the defendants renewed their special exceptions. On September 6, 2006, the Court granted the special exceptions and permitted the plaintiff thirty days to attempt to replead. Thereafter the plaintiff moved the Court for an order compelling discovery, which the Court denied on October 2, 2006. On October 18, 2006, the Court entered an order explaining its grounds for granting the special exceptions. On November 3, 2006, the plaintiff filed a second amended petition. On February 8, 2007, the Company filed its answer and special exceptions to the second amended petition. On August 9, 2007, the Court granted the special exceptions and dismissed the second amended petition with prejudice. On September 4, 2007, the plaintiff moved for reconsideration of the dismissal with prejudice of the second amended petition, for a new trial, and for leave to further amend the petition, and the defendants opposed that motion on September 20, 2007. On October 23, 2007, that motion was deemed denied by operation of law because the court had not acted on it by that date.
On October 8, 2005, Richard Keene filed an action styled, C.A. No. H-05-3441, Richard Keene v. Frank M. DeLape et al., in the United States District Court for the Southern District of Texas. This action makes substantially similar allegations as the original complaint in the Vitale action. The plaintiff also alleges that his failure to make a demand on the Board prior to filing the action is excused as futile.
The Company sought to transfer the Keene action to the United States District Court for the Eastern District of Pennsylvania as part of the MDL Motion. On January 21, 2006, the court stayed the Keene action pending resolution of the MDL Motion. On February 23, 2006, the Keene action was transferred with the Federal Securities Actions from the Southern District of Texas to the Eastern District of Pennsylvania. Thereafter, on May 15, 2006, the plaintiff filed an amended complaint, and on June 5, 2006, the defendants moved to dismiss the amended complaint. On August 21, 2006, the plaintiff moved for leave to file a second amended complaint, and on September 15, 2006, defendants filed an opposition to that motion. On January 24, 2007, the court denied the plaintiff’s motion to file a second amended complaint, and on April 10, 2007 the court granted the defendants’ motion to dismiss and dismissed the amended complaint without prejudice. On May 9, 2007, plaintiff filed a notice of appeal from the January 24, 2007 order denying plaintiff’s motion to file a second amended complaint, and from the April 10, 2007 order dismissing plaintiff’s amended complaint without prejudice. The appeal is fully briefed.
On October 31, 2005, William Thomas Fordyce filed an action styled, C.A. No. GD-05-08432, William Thomas Fordyce v. Frank M. DeLape, et al., in the Court of Common Pleas of Chester County, Pennsylvania. This action makes substantially similar allegations as the original complaint in the Vitale action. The plaintiff also alleges that his failure to make a demand on the Board prior to filing the action is excused as futile.
On January 20, 2006, the Company filed its preliminary objections to the complaint. On August 31, 2006, the Court of Common Pleas entered an opinion and order sustaining the preliminary objections and dismissing the complaint with prejudice. On September 19, 2006, Fordyce filed a motion for reconsideration, which the Court of Common Pleas denied. On September 28, 2006, Fordyce filed a notice of appeal to the Superior Court of Pennsylvania. On July 27, 2007, the Superior Court affirmed the decision of the Court of Common Pleas.
On February 14, 2008, Ronald Beattie filed an action styled C.A. No. 08-724, Ronald Beattie v. Michael Macaluso, et al., in the United States District Court for the Eastern District of Pennsylvania. This action makes substantially similar allegations as the original complaint in the Vitale action. The complaint has not yet been served on the Company.
The Derivative Actions are purportedly being prosecuted on behalf of the Company and any recovery obtained, less any attorneys’ fees awarded, will go to the Company. The Company is advancing legal expenses to certain current and former directors and officers of the Company who are named as defendants in the Derivative Actions and expects to receive reimbursement for those advances from its insurance carriers. The Company will expense its legal costs as they are incurred and will record any insurance recoveries on such legal costs in the period the recoveries are received. The Company cannot currently estimate the amount of loss, if any, that may result from the resolution of these actions, and no provision has been recorded in the consolidated financial statements.
Indemnity Demands
Mr. Jeffrey Tomz
After the above referenced litigations were commenced, Mr. Jeffrey Tomz, who formerly served as Isolagen’s Chief Financial Officer, demanded reimbursement of his costs of defense, and reimbursement for the costs of responding to a Securities and Exchange Commission investigation of his alleged insider trading in Isolagen stock. It is understood that Tomz’s defense costs to date amount to approximately $0.3 million.
As the Vitale matter has now been resolved in favor of all defendants, including Mr. Tomz, the Company is presently obligated to reimburse him for the reasonable and necessary costs of defending all claims asserted therein other than the insider trading allegations. Although decided on jurisdictional grounds, it is likely the Company is also obligated to reimburse Mr. Tomz for the reasonable and necessary costs incurred in defending the Fordyce matter given that it has also been resolved in favor of all defendants. The Company would be liable to reimburse Mr. Tomz for the reasonable and necessary costs of defense in the Keene case if it is affirmed on appeal and in the putative securities cases should he prevail in that action. The Company has refused to pay the amount of fees and expenses for which Mr. Tomz has sought reimbursement because it believes they are excessive, duplicative and have not been properly segregated between reimbursable and non-reimbursable claims. The Company has negotiated an acceptable compromise for the amounts billed by Mr. Tomz’s local Pennsylvania counsel for an amount less than $0.1 million.
Prior to the resolution of the various derivative actions, Mr. Tomz filed a demand for arbitration seeking advancement of his defense costs. He subsequently agreed to stay those proceedings. At present, Mr. Tomz has not sought to lift this stay and it is uncertain whether he will attempt to do so in the future.
The Company has accrued less than $0.1 million in the accompanying Consolidated Financial Statements as of December 31, 2007 with respect to Mr. Tomz’s existing defense costs in dispute. The Company intends to seek reimbursement under its directors and officers liability policy for any amounts paid to reimburse Mr. Tomz for his defense costs, which includes less than $0.1 million paid to date.
Underwriters
The Underwriters have each demanded that the Company indemnify, hold harmless and defend them with respect to the claims asserted in the putative securities actions. The total amount demanded to date is less than $0.3 million, however, we believe that cumulative future amounts of these defense costs are likely to be significant, although these cumulative future amounts cannot be estimated at this time.
Isolagen has denied this demand on numerous grounds, including that: (i) as to the November 2004 convertible notes offering, it only agreed to indemnify the Underwriters for any losses resulting from any untrue statement, or alleged untrue statement, of material fact in the offering documents provided by the Company to a holder or prospective purchaser of securities, and plaintiffs’ claims in the securities action are not based upon alleged untrue statements in any such documents; (ii) as to the June 2004 secondary offering, it only agreed to indemnify the Underwriters for untrue statements, or alleged untrue statements, of material fact, in the preliminary prospectus, registration statement, prospectus or any amendment thereof, and there were no such untrue statements in any such document; (iii) Isolagen assumed no duty to defend or advance defense costs; and (iv) Isolagen satisfied whatever duty to defend it may have to the Underwriters by offering to assume the Underwriters’ defense. Accordingly, the Company has have not accrued any amounts related to the Underwriters’ defense costs in our Consolidated Financial Statements.
Dispute with Former President and Member of the Board of Directors
On March 16, 2007, the Company disclosed in its Form 10-K for the year ended December 31, 2006 (the “Form 10-K”), that the Company and Susan Ciallella had reached an understanding pursuant to which Ms. Ciallella would resign from the Company in all capacities. The understanding, which was described in the Form 10-K, was subject to the negotiation and execution of a definitive agreement. On May 10, 2007, the Company disclosed in its Form 10-Q for the quarter ended March 31, 2007, that no such definitive agreement had been concluded with Ms. Ciallella, and that Ms. Ciallella was asserting claims against the Company in connection with her separation from the Company. On June 8, 2007, the Company and Ms. Ciallella participated in a voluntary mediation before a former federal judge. Upon conclusion of the mediation, the Company and Ms. Ciallella entered into a Settlement Agreement and Release (the “Settlement Agreement”) pursuant to which the parties agreed to settle and resolve all claims that Ms. Ciallella may have against the Company as well as all aspects of Ms. Ciallella’s separation from the Company. The Settlement Agreement provided Ms. Ciallella the following:
(i) severance payments as follows: (a) $450,000, which was paid by June 2007; (b) $240,000 paid on September 17, 2007; and (c) $40,000 per month to be paid each month beginning October 17, 2007 through July 15, 2008 with a $20,000 payment to be made on July 30, 2008;
(ii) $1,745,000, which was paid during June 2007 in satisfaction and settlement of Ms. Ciallella’s legal claims relating to her termination;
(iii) $5,000 paid during June 2007 in connection with Ms. Ciallella’s release of claims under the Age Discrimination in Employment Act;
(iv) $159,245 paid during June 2007 for the reimbursement of Ms. Ciallella’s legal fees in connection with the negotiation and execution of the Settlement Agreement;
(v) $198,950 related to Ms. Ciallella’s legal support services to be provided to the Company, of which approximately $158,000 had been paid as of December 31, 2007;
(vi) Ms. Ciallella retained 300,000 of the 400,000 performance options issued to her in June 2006, which expire in June 2016; Ms. Ciallella retained 160,000 of the options issued to her in April 2006, which expire in April 2016 and which were fully vested; and Ms. Ciallella retained her vested 300,000 options, which were issued to her in April 2005 and expire in April 2015 (see Note 13).
Each of the Company and Ms. Ciallella released the other party from any and all claims that it/she may have; and Ms. Ciallella agreed to resign from all officer and director positions she held with the Company or any of its subsidiaries.
During the three months ended March 31, 2007, the Company recorded termination costs aggregating $2.6 million to reflect the March 16, 2007 understanding between the parties, which were included in selling, general, and administrative expenses. As a result of the June 2007 Settlement Agreement, during the three months ended June 30, 2007 the Company recorded an additional $2.0 million of termination costs, which are also included in selling, general, and administrative expenses. No such expenses were incurred during the three months ended September 30, 2007. Accordingly, during the year ended December 31, 2007, the Company recorded total termination costs of approximately $4.6 million, as follows:
Of the $0.3 million of Company legal fees discussed above, approximately $133,000 related to the Board of Directors’ Special Committee legal counsel retained in connection with the Ciallella matter and was paid directly by the Company. Less than $10,000 related to the legal fees of one the Company’s Board members in connection with the Ciallella matter was paid directly by the Company. Also, less than $10,000 related to the legal fees of our Chief Executive Officer in connection with the Ciallella matter was paid directly by the Company. The Company is pursuing reimbursement of the amounts paid in excess of Ms. Ciallella’s contractual severance, plus defense costs, from its insurance carriers. There can be, however, no assurance that there will be a recovery or if there is, of the amount thereof. As of December 31, 2007, $0.3 million remains due to Ms. Ciallella and is recorded in accrued expenses on the consolidated balance sheet.
United Kingdom Customer Settlement
During 2005, the Company began an informal study and surveyed a number of patients who had previously received the Isolagen treatment to assess patient satisfaction. Some patients surveyed reported sub-optimal results from treatment. One hundred forty-nine patients who claimed to have received sub-optimal results were retreated for the purpose of determining the reasons for sub-optimal results. Only those patients who completed the survey, provided adequate medical records including before and after photographs and who were deemed both to have received a sub-optimal result from a first treatment administered according to the Isolagen protocol and who were considered to be appropriate patients for treatment with the Isolagen Therapy received re-treatment. No one completing the survey was offered re-treatment unless they agreed to these conditions. Following re-treatment, a number of patients reported better results than first obtained through the initial treatment by their initial treating physician.
During the first quarter of 2006, the Company received a number of complaints from certain patients who had learned of the limited re-treatment program and also learned that a number of physicians with dissatisfied patients were generating public ill-will as a result of the Company’s decision to limit the number of patients offered re-treatment and were encouraging dissatisfied patients to seek recourse against the Company. In response, in March 2006 the Company decided that it was in its best interest to address these complaints to foster goodwill in the marketplace and avoid the cost of any potential patient claims. Accordingly, the Company agreed to resolve any properly documented and substantiated patient complaints by offering to retreat the patient pursuant to the same criteria stated above or pay £1,000 (approximately US$1,750) to the patients identified to the Company as having received a sub-optimal result. In order to qualify for re-treatment and in addition to the criteria set forth above, the patient will be treated by a physician identified by the Company who will treat these patients pursuant to a protocol. In addition, these patients must have agreed to follow-up visits and assessments of their response to treatment. No patient unlikely to benefit from Isolagen Therapy has been or will be retreated.
The Company made this offer to approximately 290 patients during late March 2006. Accordingly, the Company believed its range of liability was between £290,000 (or approximately $0.5 million), assuming all 290 patients were to choose the £1,000 payment, and approximately £580,000 (or approximately $1.0 million), assuming all 290 patients elected to be retreated. The estimated costs for retreatment include the cost of treatment, physician fees and other ancillary costs. The Company estimated that 60% of the patients would elect the £1,000 offer and 40% would elect to be retreated. Accordingly, the Company recorded a charge reflected under loss from discontinued operations for the three months ended March 31, 2006 of $0.7 million. During the three months ended June 30, 2006, an additional 31 patients were entered into the settlement program, resulting in an additional charge reflected under loss from discontinued operations of $0.1 million.
During the year ended December 31, 2006, payments to patients and retreatments reduced the accrual by $0.6 million. During the three months ended March 31, 2007 and June 30, 2007, payments and retreatments to patients reduced the accrual by approximately $0.1 million and $0.0 million, respectively. As of December 31, 2007, the accrual, which is included in current liabilities of discontinued operations in the consolidated balance sheet, was $0.1 million. The estimates related to this liability may change in future periods and the effects of any changes will be accounted for in the period in which the estimate changes.
Subsequent to the Company’s public announcement regarding the closure of the United Kingdom operation, the Company received negative publicity and negative correspondence from former patients in the United Kingdom that previously received our treatment. More recently, the Company received a written demand by an attorney representing approximately 82 former patients each claiming negligent misstatements were made and each claiming, on average, £3,500 (or approximately $7,000), plus unquantified interest and incidental expenses. The Company is in the process of evaluating the merits of the claims made in the demand. To date, no formal legal action has been brought by the attorney against the Company, and no provision has been recorded in the consolidated financial statements related to this matter.
Other Litigation
The Company is involved in various other legal matters that are being defended and handled in the ordinary course of business. Although it is not possible to predict the outcome of these other matters, management currently believes that the results will not have a material impact on the Company’s financial statements.
Leases
The Company has entered into leases for office, warehouse and laboratory facilities in Exton, Pennsylvania, Houston, Texas, Santa Barbara, California and London, England under third party non-cancelable operating leases through 2010. Future minimum lease commitments at December 31, 2007 are as follows:
For the years ended December 31, 2007, 2006 and 2005, rental expense totaled $1.7 million, $1.8 million and $1.8 million, respectively (which includes rent expense related to discontinued operations of $0.4 million, $0.7 million and $0.7 million for the years ended December 31, 2007, 2006 and 2005, respectively).
In August 2006, the Company entered into a non-cancelable two year operating lease for approximately 2,200 square feet in Santa Barbara, California. This office space houses certain members of our senior management team.
In April 2005, the Company entered into a non-cancelable three year operating lease for approximately 86,500 square feet in Exton, Pennsylvania. This facility houses members of our senior management team, quality and manufacturing personnel, and the corporate finance department. The Company began constructing a production line in a portion of this facility in anticipation of eventual FDA approval. The facility was completed during September 2005. This production line is expected to be utilized for the production of clinical supplies. The non-cancelable portion of the lease expires on March 31, 2008, provided however that if the lease is not cancelled by the Company prior to March 31, 2007, at least one year prior to the end of the non-cancelable portion of the lease, then the lease shall end on March 31, 2013. The Company would then have the option to extend the term of the lease for five years, beginning on April 1, 2013. During 2007, the Company extended the lease through March 31, 2013, and accordingly, the Company amortizes its leasehold improvements related to this facility through March 31, 2013. Lease expense is recognized on a straight-line basis through March 31, 2013. The Exton, Pennsylvania minimum lease payments have been included in the future minimum lease commitments table above through March 31, 2013.
Certain former officers of the Company had previously provided office space and laboratory facilities in Houston, Texas at no charge until August 2003. Beginning September 2003, the lease rate was approximately $1.80 per month per square foot. During the first quarter of 2005, this lease with certain former officers of the Company was terminated. Commencing March 2005, the Company entered into a new lease with a third-party for approximately 14,850 square feet lease of office and laboratory space in Houston, Texas. The lease term is through April 2008. The Company no longer leases or occupies office space or laboratory facilities from related parties.
As discussed in Note 5, in September 2004 the Company adopted a plan to close its Australia facility. The lease related to the Company’s Australia facility was originally due to expire on December, 31, 2004. The Company terminated this lease in October 2005.
As discussed in Note 3, in April 2005 the Company acquired a two-building corporate campus in Bevaix, Canton of Neuchâtel, Switzerland, which is reflected as assets of discontinued operations held for sale on the accompanying consolidated balance sheets. The Company leases one of these buildings to a third party for approximately $0.3 million per year. This lease began April 15, 2005 and concludes on December 31, 2010.
Distribution agreement
In April 2003, the Company entered into a distribution agreement with Equipmed Pty. Ltd (“Equipmed”). Equipmed had the exclusive right as the Company’s distributor in Australia and New Zealand of services utilizing the Company’s technology for its autologous cellular system for soft tissue regeneration and other therapies in the cosmetic dermatological surgery markets (i.e., exclusively for wrinkle and acne reduction) within Australia and New Zealand. The Company terminated this agreement in exchange for a payment to Equipmed of approximately $0.4 million during 2005. Approximately $0.1 million of this payment was charged to loss from discontinued operations in the consolidated statement of operations during the year ended December 31, 2005.
Departure of Former Chief Executive Officers
Effective October 27, 2005 Mr. Frank DeLape also resigned as Chairman of the Board and member of the Board of Directors. In connection with Mr. DeLape’s resignation, Mr. DeLape and the Company entered into a Separation and Release Agreement (the “Agreement”). Pursuant to the Agreement, Mr. DeLape agreed, among other things, to (a) resign all positions with the Company and all of its subsidiaries and to terminate his employment with the Company, (b) certain lock-up and standstill restrictions in respect of shares of the Company’s common stock he and his affiliates own through July 2006, and (c) execute a release for the benefit of the Company and its subsidiaries. The Company agreed, among other things, to pay a separation payment in the amount of $210,000, beginning on Mr. DeLape’s resignation date through March 15, 2006. Mr. DeLape also retained options to purchase (a) 650,000 shares of the Company’s common stock granted on September 1, 2001 at an exercise price of $6.00, which were fully vested as of his resignation date and will be exercisable for a period of two years following his resignation date, (b) 400,000 shares of the Company’s common stock granted on February 25, 2003 at an exercise price of $4.50, which were fully vested as of his resignation date and will be exercisable for a period of five years following his resignation date and (c) 150,000 shares of the Company’s common stock granted on September 5, 2003 at an exercise price of $9.81, which were fully vested as of his resignation date and will be exercisable for a period of three years following his resignation date. All other unexercised options granted to Mr. DeLape to purchase shares of the Company’s common stock were cancelled as of Mr. DeLape’s resignation date. The Amended and Restated Employment Agreement of June 2005 between Mr. DeLape and the Company was terminated. Any options to purchase stock under the 2005 Agreement were cancelled. The separation payment pursuant to the Separation and Release Agreement reflects the amount that would otherwise be owed under Mr. DeLape’s 2003 Employment Agreement reduced by the amount of certain office expense reimbursements paid to him pursuant to the 2005 Agreement.
Mr. Michael Macaluso, former Chief Executive Officer and former Director, entered into an employment agreement dated September 5, 2003, with an initial term ending July 31, 2006 and providing for a base salary of $300,000, subject to the right of the Board of Directors to increase his salary from time to time. Mr. Macaluso resigned from Chief Executive Officer and President effective September 1, 2004. Mr. Macaluso was paid his base salary until July 2006, which was fully accrued at the time of his resignation.
Note 12-Equity
Significant Common Stock Transactions
In August 2003, the Company sold in a private offering 3,359,331 shares of Common Stock, par value $0.001 per share, at an offering price of $6 per share. After deducting the costs and expenses associated with the sale, the Company received net cash totaling $18.5 million.
In June 2004, the Company issued a) 7,200,000 shares of common stock, at $8.50 per share, for cash totaling net $56.8 million in connection with the secondary offering completed in June 2004; and b) 51,828 shares of common stock in exchange for cashless exercise of warrants.
In June 2007, the Company filed a shelf registration statement on Form S-3, which was subsequently declared effective by the SEC. The shelf registration allowed the Company the flexibility to offer and sell, from time to time, up to an original amount of $50 million of common stock, preferred stock, debt securities, warrants or any combination of the foregoing in one or more future public offerings. In August 2007, the Company sold under this shelf registration statement 6,767,647 shares of common stock to institutional investors, raising proceeds of $13.8 million, net of offering costs. The Company may offer and sell up to an additional $36.2 million of common stock pursuant to this shelf registration.
Refer to the consolidated statement of shareholders’ equity (deficit) and comprehensive loss for common stock transactions from the period December 28, 1995 through December 31, 2007.
Treasury Stock
In November 2004, the Company repurchased 4,000,000 shares of its common stock for an aggregate of approximately $26.0 million, of which 2,000,000 shares were repurchased from Frank DeLape, who was then the Chairman of the Board of Directors, Michael Macaluso, a former director and the former President and Chief Executive Officer, Olga Marko, the former Senior Vice President and Director of Research, Michael Avignon, the former Manager of International Operations, and Timothy J. Till, a shareholder. The purchase price from the insiders, affiliates and founders of the Company listed above was $6.33 per share which represented a 5% discount from the closing price of the Company’s common stock on the American Stock Exchange on October 28, 2004, the date the offering of the 3.5% Subordinated Notes was priced. The purchase of the shares from the insiders was approved by a special committee of independent directors in partial reliance on a fairness opinion issued by an investment bank.
2003 Conversion of Series A Convertible Preferred Stock and Series B Convertible Preferred Stock
In July 2002, the Company completed a private offering of 2,895,000 shares of Series A Convertible Preferred Stock, par value $0.001 per share, at an offering price of $3.50 per share. Each share of Series A Preferred Stock was convertible into two shares of common stock at any time after issuance and accrued dividends at 8% per annum payable in cash or additional shares of Series A Preferred Stock. In conjunction with this private offering, the Company issued to the placement agent warrants to purchase 1,158,000 shares of common stock with an exercise price of $1.93 per share. The warrants were exercisable immediately after grant and expire five years thereafter. The fair market of the warrants granted to the placement agent, based on the Black-Scholes valuation model, is estimated to be $1.57 per warrant. The value of the warrants granted were offset against the proceeds received from the sale of the Series A Preferred Stock. During the year ended December 31, 2002, the Company issued an additional 143,507 shares of Series A Preferred Stock in lieu of cash for payment of dividends on the Series A Preferred Stock totaling approximately $0.5 million.
The price of the preferred stock sold was $3.50 per share. The market value of the Company’s common stock sold on the dates that the preferred stock sold or was issued as a dividend had a range of $2.30 - $5.40 per common share. In accordance with EITF 00-27 this created a beneficial conversion to the holders of the preferred stock and a deemed dividend to the preferred stockholders totaling $10.2 million was recorded by the Company with a corresponding amount recorded as additional paid-in capital. The deemed dividend associated with the beneficial conversion is calculated as the difference between the fair value of the underlying common stock less the proceeds that have been received for the Series A Preferred Stock limited to the value of the proceeds received.
In May 2003, the Company sold in a private offering 155,750 shares of Series B Convertible Preferred Stock, par value $0.001 per share, at an offering price of $28 per share. Each share of Series B preferred stock is convertible into 8 shares of common stock at any time after issuance and accrues dividends at 6% per annum payable in cash or additional shares of Series B Preferred Stock. After deducting the costs and expenses associated with the sale, the Company received cash totaling $3.9 million. In conjunction with the private offering, the Company issued to the placement agent warrants to purchase 124,600 shares of common stock with an exercise price of $3.50 per share. The warrants are exercisable immediately after grant and expire five years thereafter. The fair value of the warrants granted to the placement agent, based on the Black-Scholes valuation model is estimated to be $2.77 per warrant. The value of the warrants granted has been offset from the proceeds received from the sale of the Series B Preferred Stock and recorded as additional paid in capital.
The price of the preferred stock sold was $28 per share. The market value of the Company’s common stock sold on the dates that the preferred stock was sold had a range of $4.40 - $4.54 per common share. In accordance with EITF 00-27 this created a beneficial conversion to the holders of the preferred stock and a deemed dividend to the preferred stockholders totaling approximately $1.2 million was recorded by the Company with a corresponding amount recorded as additional paid-in capital. The deemed dividend associated with the beneficial conversion is calculated as the difference between the fair value of the underlying common stock less the proceeds that have been received for the Series B Preferred Stock limited to the value of the proceeds received.
In 2003, all outstanding shares of Series A and Series B Convertible Preferred Stock were converted into 7.3 million shares of common stock.
Stockholder Rights Plan
In May 2006, the Board of Directors of the Company adopted a Stockholder Rights Plan, as set forth in the Rights Agreement, dated as of May 12, 2006, by and between the Company and American Stock Transfer & Trust Company, a trust company organized under the laws of the State of New York (the “Rights Agent”). Pursuant to the Rights Agreement, stockholders of record at the close of business on May 22, 2006 received one right (“Right”) for each share of Isolagen common stock held on that date. The Rights, which will initially trade with the common stock and represent the right to purchase one ten-thousandth of a share of the Company’s newly created Series C Preferred Stock at $35 per Right, become exercisable when a person or group acquires 15% or more of the Company’s common stock (20% in the case of certain institutional stockholders) or announces a tender offer for 15% or more of the common stock. In that event, in lieu of purchasing the Series C Preferred Stock, the Rights permit the Company’s stockholders, other than the acquiror, to purchase Isolagen common stock having a market value of twice the exercise price of the Rights. In addition, in the event of certain business combinations, the Rights permit holders to purchase the common stock of the acquiror at a 50% discount. Rights held by the acquiror will become null and void in each case.
The Rights have certain anti-takeover effects, in that they would cause substantial dilution to a person or group that attempts to acquire a significant interest in the Company on terms not approved by the Board of Directors. In the event that the Board of Directors determines a transaction to be in the best interests of the Company and its stockholders, the Board of Directors will be entitled to redeem the Rights for $.001 per Right at any time before the tenth business day after the Company’s announcement that a person or group has acquired ownership of 15% or the tenth business day after commencement of a tender or exchange offer for more than 15% of the outstanding common stock. The Rights expire on May 12, 2016.
Note 13-Equity-based Compensation
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”). SFAS No. 123(R) replaces SFAS No. 123, “Accounting for Stock-Based Compensation”, supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and amends SFAS No. 95, “Statement of Cash Flows.” SFAS No. 123(R) requires entities to recognize compensation expense for all share-based payments to employees and directors, including grants of employee stock options, based on the grant-date fair value of those share-based payments, adjusted for expected forfeitures. The Company adopted SFAS No. 123(R) as of January 1, 2006 using the modified prospective application method. Under the modified prospective application method, the fair value measurement requirements of SFAS No. 123(R) is applied to new awards and to awards modified, repurchased, or cancelled after January 1, 2006. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered that were outstanding as of January 1, 2006 is recognized as the requisite service is rendered on or after January 1, 2006. The compensation cost for that portion of awards is based on the grant-date fair value of those awards as calculated for pro forma disclosures under SFAS No. 123. Changes to the grant-date fair value of equity awards granted before January 1, 2006 are precluded.
Prior to the adoption of SFAS No. 123(R), the Company followed the intrinsic value method in accordance with APB No. 25 to account for its employee stock options. Historically, substantially all stock options have been granted with an exercise price equal to the fair market value of the common stock on the date of grant. Accordingly, no compensation expense was recognized from substantially all option grants to employees and directors. Compensation expense was recognized in connection with the issuance of stock options to non-employee consultants in accordance with EITF 96-18, “Accounting for Equity Instruments That are Issued to Other than Employees for Acquiring, or in Conjunction with Selling Goods and Services.” SFAS No. 123(R) did not change the accounting for stock-based compensation related to non-employees in connection with equity based incentive arrangements.
The Company utilizes the straight-line attribution method for recognizing stock-based compensation expense under SFAS No. 123(R). The Company recorded $1.8 million and $1.1 million of compensation expense, net of tax, during the years ended December 31, 2007 and 2006, respectively, for stock option awards to employees and directors based on the estimated fair values, at the grant dates, of the awards. Further, in connection with the separation agreement with the Company’s former President and related modification of the former President’s stock options (see Note 11), the Company recorded $1.1 million in stock option modification expense during the three months ended March 31, 2007, as discussed further below.
Results for the years ended December 31, 2005 have not been restated. Had compensation expense for employee and director stock options been determined based on fair value at the grant date consistent with SFAS No. 123(R), with stock options expensed using the straight-line attribution method, the Company’s net loss and loss per share would have been increased to the pro forma amounts indicated below:
The weighted average fair market value using the Black-Scholes option-pricing model of the options granted was $1.91, $1.42 and $2.90 for the years ended December 31, 2007, 2006 and 2005, respectively. The fair market value of the stock options at the date of grant was estimated using the Black-Scholes option-pricing model with the following weighted average assumptions:
The risk-free interest rate is based on U.S. Treasury interest rates at the time of the grant whose term is consistent with the expected life of the stock options. Expected volatility is based on the Company’s historical experience. Expected life represents the period of time that options are expected to be outstanding and is based on the Company’s historical experience or the simplified method, as permitted by SEC Staff Accounting Bulletin No. 107 where appropriate. Expected dividend yield was not considered in the option pricing formula since the Company does not pay dividends and has no current plans to do so in the future. The forfeiture rate used was based upon historical experience. As required by SFAS No. 123(R), the Company will adjust the estimated forfeiture rate based upon actual experience.
During December 2005, the Company’s Board of Directors approved the full vesting of all unvested, outstanding stock options issued to current employees and directors. The Board decided to take this action (“the acceleration event”) in anticipation of the adoption of SFAS No. 123(R). As a result of this acceleration event, approximately 1.4 million stock options were vested that would have otherwise vested during 2006 and later periods. At the time of the acceleration event, the unamortized grant date fair value of the affected options was approximately $3.6 million (for SFAS No. 123 and SFAS No. 148 pro forma disclosure purposes), which was charged to pro forma expense in the fourth quarter of 2005. As the Company accelerated the vesting of outstanding employee and director stock options during December 2005, there was no remaining expense related to such options to be recognized in the Company’s statements of operations in future periods.
There were 16,666 stock options exercised during the year ended December 31, 2007, resulting in cash proceeds to the Company of less than $0.1 million. There were 86,000 stock options exercised during the year ended December 31, 2006, resulting in cash proceeds to the Company of $0.2 million. There were 25,000 stock options exercised during the year ended December 31, 2005, resulting in cash proceeds to the Company of $0.1 million. These exercised options in 2007, 2006 and 2005, respectively, had an intrinsic value of less than $0.1 million, $0.2 million and less than $0.1 million. A summary of option activity for the year ended December 31, 2007 is as follows:
The following table summarizes the status of the Company’s non-vested stock options since January 1, 2007:
The total fair value of shares vested during the years ended December 31, 2007, 2006 and 2005 was $2.1 million, $1.2 million and $10.6 million, respectively. As discussed above, in December 2005 the Company’s Board of Directors approved the full vesting of all unvested, outstanding stock options issued to current employees and directors. As of December 31, 2007, there was $1.8 million of total unrecognized compensation cost related to non-vested director and employee stock options which vest over time. That cost is expected to be recognized over a weighted-average period of 1.6 years. As of December 31, 2007, there was $0.8 million of total unrecognized compensation cost related to performance-based, non-vested employee stock options. That cost will begin to be recognized when the performance criteria within the respective performance-base option grants become probable of achievement.
2001 Stock Option and Stock Appreciation Rights Plan
Effective August 10, 2001, the Company adopted the Isolagen, Inc. 2001 Stock Option and Stock Appreciation Rights Plan (the “2001 Stock Plan”). The 2001 Stock Plan is discretionary and allows for an aggregate of up to 5,000,000 shares of the Company’s common stock to be awarded through incentive and non-qualified stock options and stock appreciation rights. The 2001 Stock Plan is administered by the Company’s Board of Directors, who has exclusive discretion to select participants who will receive the awards and to determine the type, size and terms of each award granted. As of December 31, 2007, there were 1,984,000 options outstanding under the Stock Plan and 2,390,334 options are available to be issued under the Stock Plan.
During the three months ended March 31, 2007, the Company issued, under the 2001 Stock Plan, 395,000 options to employees and Board of Director members, with exercise prices ranging from $2.37 to $3.10 and with contractual lives of 5 years for employees and 10 years for Board members.
During the three months ended June 30, 2007, the Company issued, under the 2001 Stock Plan, 140,000 options to three employees, with exercise prices ranging from $4.20 to $4.55 and with contractual lives of 5 years.
During the three months ended September 30, 2007, the Company issued, under the 2001 Stock Plan, (1) a total of 102,500 options to four employees with an exercise price of $3.38 per share, which have a five year maximum contractual life and which vest annually over a three year period from the date of grant and (2) a total of 50,000 performance-based options to one employee with an exercise price of $3.38 per share and which have a maximum contractual life of five years. With respect to these 50,000 performance-based stock options, no compensation expense will be recorded until the performance-based vesting event is probable of occurrence. The grant date fair value of this award was less than $0.1 million.
During the three months ended December 31, 2007, the Company issued, under the 2001 Stock Plan, 30,000 options to one newly appointed board member, with exercise price of $3.14, with a contractual life of 10 years and a cliff-vesting period of one year.
2003 Stock Option and Stock Appreciation Rights Plan
On January 29, 2003, the Company’s Board of Directors approved the 2003 Stock Option and Appreciation Rights Plan (the “2003 Stock Plan”). The 2003 Stock Plan is discretionary and allows for an aggregate of up to 2,250,000 shares of the Company’s common stock to be awarded through incentive and non-qualified stock options and stock appreciation rights. The 2003 Stock Plan is administered by the Company’s Board of Directors, who has exclusive discretion to select participants who will receive the awards and to determine the type, size and terms of each award granted. As of December 31, 2007, there were 1,866,666 options outstanding under the 2003 Stock Plan and 383,334 shares were available for issuance under the 2003 Stock Plan. No options were granted under the 2003 Stock Plan during the year ended December 31, 2007.
2005 Equity Incentive Plan
On April 26, 2005, the Company’s Board of Directors approved the 2005 Equity Incentive Plan (the “2005 Stock Plan”). The 2005 Stock Plan is discretionary and allows for an aggregate of up to 2,100,000 shares of the Company’s common stock to be awarded through incentive and non-qualified stock options, stock units, stock awards, stock appreciation rights and other stock-based awards. The 2005 Stock Plan is administered by the Compensation Committee of the Company’s Board of Directors, who has exclusive discretion to select participants who will receive the awards and to determine the type, size and terms of each award granted. As of December 31, 2007, there were 305,000 options outstanding and 1,712,652 shares were available for issuance under the 2005 Stock Plan.
During the three months ended March 31, 2007, the Company modified a 400,000 share performance option grant, as discussed below under Modification of Stock Options. This 400,000 share performance option grant was issued during the three months ended June 30, 2006 to purchase common stock with an exercise price of $1.88 per share to the Company’s President. These options had a ten year maximum contractual life and the options were to vest, and no longer be subject to forfeiture, upon the occurrence of any of the following events: (i) upon the closing of the sale of substantially all of the assets of the Company or the reorganization, consolidation or the merger of the Company; provided that the event results in the payment or distribution of consideration valued in good faith by the Board of Directors at $25 per share or more; or (ii) upon the closing of a tender offer or exchange offer to purchase 50% or more of the issued and outstanding shares of common stock of the Company at a price per share valued in good faith by the Board of Directors at $25 or more; or (iii) immediately following a “Stock Acquisition Date,” as that term is defined in the Rights Plan adopted by the Company on May 12, 2006 (provided that said rights are not subsequently redeemed by the Company or that the Rights Plan is not subsequently amended to preclude exercise of the rights issued thereunder, prior to the Distribution Date, as that term is defined in the Rights Pan), or (iv) at such other time as the Board of Directors, in its sole discretion, deems appropriate; provided in each case that the President is employed by the Company at the time of said event. The 400,000 share option grant was considered a grant of a performance stock option. No compensation cost was recorded during 2006 for this grant as the Company did not believe that the vesting events were probable of occurrence. The 2006 grant date fair value of the award was approximately $0.6 million. Subsequently, this 400,000 share option grant was modified during the three months ended March 31, 2007, as discussed below under Modification of Stock Options.
Modification of Stock Options
In connection with the separation of the Company’s President (see Note 11), the Company agreed on March 16, 2007 to modify certain of the President’s stock options such that (1) 120,000 unvested, time-based stock options would vest immediately and (2) of 400,000 performance based stock options, 100,000 would be cancelled and the remaining 300,000 would be extended such that the 300,000 options would expire 10 years from the original grant date, as opposed to expiring upon termination of employment. The 300,000 performance based stock options would continue to be subject to the same performance based vesting requirements. The 120,000 modified stock options were valued using the Black-Scholes valuation model, and resulted in $0.3 million charge to selling, general and administrative expense during the months ended March 31, 2007. The 300,000 modified performance stock options were valued using the Black-Scholes valuation model, and resulted in $0.8 million charge to selling, general and administrative expense in the year ended December 31, 2007. Two other employee stock option modifications resulted in less than $0.1 million charge to selling, general and administrative expense in the year ended 2007.
During the year ended December 31, 2006, the Company modified 100,000 stock options previously granted to the former CFO of the Company during 2005, such that the options will expire five years from the date of grant, as opposed to 90 days after termination. In connection with this modification, the Company recorded a charge of $0.1 million to selling, general and administrative expenses in the consolidated statement of operations in the year ended December 31, 2006.
Also, refer to Note 17, Subsequent Event, for a discussion of the stock options modifications, which occurred in January 2008, related to our former Chief Executive Officer.
Restricted Stock
During the three months ended March 31, 2006, the Company issued 126,750 shares of restricted stock awards to various employees. The restricted common stock vested quarterly over three years, beginning on March 31, 2006 and ending on December 31, 2008. On March 31, 2006, 10,557 shares of the 126,750 shares of restricted stock vested.
During the three months ended June 30, 2006, 2,752 shares of the restricted stock were cancelled due to terminations, 94,648 shares of restricted stock were cancelled in a Board approved exchange for 206,500 stock options (which were issued under the 2001 Plan) and 3,707 shares of restricted stock vested.
During the three months ended September 30, 2006, 1,708 shares of restricted stock vested. During the three months ended December 31, 2006, 15,002 shares were cancelled due to terminations and 42 shares of restricted stock vested. Compensation expense related to the restricted stock was less than $0.1 million for the year ended December 31, 2007 and less than $0.1 million for the year ended December 31, 2006. As of December 31, 2007, 166 shares of unvested restricted stock were outstanding, which vest quarterly through March 31, 2009.
Other Stock Options
During the year ended December 31, 2007, the Company did not issue any options outside the 2001 Stock Plan, the 2003 Stock Plan or the 2005 Stock Plan. As of December 31, 2007, there were 3,568,333 nonqualified stock options outstanding outside of the shareholder approved plans discussed above.
During the year ended December 31, 2006, the Company issued (1) 2,000,000 options to purchase its common stock with an exercise price of $1.88 per share to the Company’s CEO, which have a ten year maximum contractual life and which vest each fiscal quarter end over a three year period from the date of grant, (2) 325,000 options to purchase its common stock with an exercise price of $1.87 per share to the Company’s CFO, with a five year maximum contractual life and which vest annually over a three year period from the date of grant and (3) 200,000 options to purchase its common stock with an exercise price of $1.87 per share to a separate employee, with a five year maximum contractual life and which vest annually over a three year period from the date of grant.
In addition, during the year ended December 31, 2006 the Company issued 500,000 options to purchase its common stock with an exercise price of $1.88 per share to the Company’s CEO. These options have a ten year maximum contractual life and the options have identical vesting terms to the Performance Stock Option Grant issued to the Company’s President under the 2005 Stock Plan as described above. No compensation cost has been recorded for this grant as the Company does not currently believe that the vesting events are probable of occurrence. The grant date fair value of the award was approximately $0.7 million. This fair value of $0.7 million, or any portion thereof, will not be recognized as compensation expense until the vesting of the award becomes probable.
Equity Instruments Issued for Services
As of December 31, 2007, the Company had outstanding 603,600 warrants and options issued to non-employees under consulting agreements. The following sets forth certain information concerning these warrants and options:
Expense related to these contracts was less than $0.1 million, $0.2 million and $(0.2) million for the years ended December 31, 2007, 2006 and 2005, respectively. The expense was calculated using the Black Scholes option-pricing model based on the following weighted average assumptions:
Further, there were 168,246 and 688,256 warrants outstanding as of December 31, 2007 and as of December 31, 2006, which were primarily issued in connection with past equity offerings. During the years ended December 31, 2007, 2006 and 2005, there were 520,010, 0 and 60,000 warrants exercised, respectively. Of the warrants exercised during the year ended December 31, 2007, 463,370 were exercised via cash payment of the $1.93 exercise price, and the remaining 56,640 warrants were exercised via net share exercise. In total, 492,613 shares of common stock were issued during 2007 as a result of these warrants exercised and $0.9 million of cash proceeds were received by the Company in connection with the payment of the related warrant exercise price. The intrinsic value of the warrants exercised during the years ended December 31, 2007 and 2005 were $1.1 million and $0.4 million, respectively. There were no warrants converted or forfeited during the year ended December 31, 2006.
Note 14-Certain Relationships and Related Transactions
As discussed in Notes 9 and 12, in November 2004 the Company repurchased 2,000,000 shares of its common stock from Frank DeLape, who was then the Chairman of the Board of Directors, Michael Macaluso, a former director and the former President and Chief Executive Officer, Olga Marko, the former Senior Vice President and Director of Research, Michael Avignon, the former Manager of International Operations, and Timothy J. Till, a shareholder. The purchase price from the insiders, affiliates and founders of the Company listed above was $6.33 per share which represented a 5% discount from the closing price of the Company’s common stock on the American Stock Exchange on October 28, 2004, the date the offering of the 3.5% Subordinated Notes was priced. The purchase of the shares from the insiders was approved by a special committee of independent directors in partial reliance on a fairness opinion issued by an investment bank.
Five of the Company’s current Board members and seven of the Company’s former officers and directors are named defendants in certain pending class action and derivative legal proceedings discussed in Note 11 above. During 2007, the Company advanced an aggregate of $0.8 million, or approximately $0.1 million per person, for legal expenses incurred on behalf of those five Board members and seven former officers and directors in connection with their defense in those proceedings. During 2006, the Company advanced an aggregate of $0.9 million, or approximately $0.1 million per person, for legal expenses incurred on behalf of those five Board members and seven former officers and directors in connection with their defense in those proceedings. As of December 31, 2007, $1.5 million of the advanced amounts (approximately $0.1 per person) have been reimbursed to the Company by the Company’s insurance carriers.
Since June 2005, Mr. Ralph De Martino, a member of the Company’s Board of Directors, has been a member of the law firm Cozen O’Connor in the firm’s Washington, DC office. From January 2003 until June 2005, Mr. De Martino was the managing partner of the Washington, DC office of the law firm Dilworth Paxson LLP. Fees paid by the Company to Cozen O’Connor during 2007, 2006 and 2005 were $0.7 million, $0.4 million and $0.2 million, respectively. Fees paid by the Company to Dilworth Paxson LLP during 2007, 2006 and 2005 were $0.0 million, $0.0 million and $0.4 million, respectively.
See Note 11, Dispute with Former President and Member of the Board of Directors and Departure of Former Chief Executive Officers, for discussion of severance arrangements with former senior employees. See Note 17, Subsequent Event, for discussion of the January 2008 departure of our former Chief Executive Officer.
Note 15-Segment Information and Geographical information
With the acquisition of Agera on August 10, 2006 (see Note 4), the Company now has two reportable segments: Isolagen Therapy and Agera. Prior to the acquisition of Agera, the Company reported one reportable segment. The Isolagen Therapy segment specializes in the development and commercialization of autologous cellular therapies for soft tissue regeneration. The Agera segment maintains proprietary rights to a scientifically-based advanced line of skincare products. The following table provides operating financial information for the continuing operations of the Company’s two reportable segments:
An intercompany receivable of $1.1 million, due from the Agera segment to the Isolagen Therapy segment, is eliminated in consolidation. This intercompany receivable is primarily due to the intercompany management fee charge to Agera by Isolagen, as well as Agera working capital needs provided by Isolagen, and has been excluded from total assets of the Isolagen Therapy segment in the above table. Total assets on the consolidated balance sheet at December 31, 2007 are approximately $39.5 million, which includes assets of continuing operations of $28.2 million and assets of discontinued operations of $11.3 million.
An intercompany receivable of $0.3 million, due from the Agera segment to the Isolagen Therapy segment, is eliminated during consolidation. This intercompany receivable is primarily due to the intercompany management fee charge and has been excluded from total assets of the Isolagen Therapy segment in the above table. Total assets on the consolidated balance sheet at December 31, 2006 are approximately $57.3 million, which includes assets of continuing operations of $45.9 million and assets of discontinued operations of $11.4 million.
Geographical information concerning the Company’s continuing operations and assets is as follows:
During 2007, revenue from one foreign customer and one domestic customer represented 69% and 16% of consolidated revenue, respectively.
Note 16-Summarized Quarterly Financial Data (unaudited)
Quarterly and year to date computations of per share amounts are made independently; therefore, the sum of per share amounts for the quarters may not equal per share amounts for the year.
Note 17-Subsequent Event
On January 7, 2008, the Company and Mr. Nicholas L. Teti, Jr. entered into a consulting and non-competition agreement (the “Consulting Agreement”), pursuant to which Mr. Teti agreed to continue as the Company’s non-executive Chairman of the Board and to become a consultant to the Company, and Mr. Teti resigned his position as Chief Executive Officer and President of the Company. Mr. Teti agreed to provide consulting services to the Company until June 30, 2009, subject to the prior termination of the Consulting Agreement, which may occur upon 30 days notice by either party. Mr. Teti will receive an annual consulting fee of $100,000 for his services. Pursuant to the Consulting Agreement, Mr. Teti’s original employment agreement, dated June 5, 2006, was terminated and the parties agreed that he was owed no severance payments under the original employment agreement. Mr. Teti will retain his previously issued stock options, which will continue to vest in accordance with their original terms. In connection with Mr. Teti’s service as non-executive Chairman of the Board, Mr. Teti will receive an annual retainer of $60,000.
As a result of the modifications to Mr. Teti’s stock options set forth in the Consulting Agreement, the Company will be required to record a non-cash compensation charge during the three months ended March 31, 2008 of approximately $1.3 million related to Mr. Teti’s 1,166,665 vested stock options, even though the number of shares, the vesting schedules and the exercise price of the stock options previously granted to Mr. Teti have not changed. Further, related to Mr. Teti’s 833,335 unvested stock options, the Company estimates that a non-cash charge of approximately $1.4 million will be recorded ratably over five fiscal quarters, beginning with the three months ended March 31, 2008. This estimate is based on certain stock option valuation assumptions as of January 2008. However, the ultimate charge will be based on the future valuation assumptions in effect upon the vesting dates of these currently unvested stock options.
On January 7, 2008, the Company and Mr. Declan Daly entered into an employment agreement (the “Agreement”) pursuant to which Mr. Daly agreed to serve as Chief Executive Officer of the Company until December 31, 2010, subject to the automatic renewal of the Agreement for an additional one-year term unless the Company notifies Mr. Daly 180 days prior to the expiration of the Agreement of its intention not to renew the Agreement. The Agreement supersedes the current employment agreement between the Company and Mr. Daly, effective June 5, 2006, which was terminated. In addition, Mr. Daly agreed to continue in his current role as Chief Financial Officer of the Company, but has resigned as Chief Operating Officer of the Company. The Agreement provides Mr. Daly with an annual base salary of $430,000, which will be periodically reviewed and may be increased at the Board’s discretion. Under the Agreement, Mr. Daly was granted the following ten-year option grants: (a) an option to purchase 350,000 shares of common stock at an exercise price equal to the closing of the common stock on the last trading day preceding execution of the Agreement, which vests in twelve equal quarterly installments commencing March 31, 2008; and (b) a performance stock option to purchase 100,000 shares of common stock at an exercise price equal to the closing of the common stock on the last trading day preceding execution of the Agreement that shall vest as follows: (i) 50% of performance stock option shall vest upon the Company’s accepted filing of a Biologics License Application by the FDA and (ii) the remaining 50% of the performance stock option shall vest upon the FDA’s approval of the Company’s Biologics License Application filing; provided in each case that Mr. Daly is the Company’s Chief Executive Officer at the time of said event.
EXHIBIT INDEX