ITEM 1. BUSINESS
Many of the statements in this section, including those made in "Risk Factors," below and "Item 2.
ITEM 2. PROPERTIES
We lease a 12,000 square foot facility at 670 Almanor Avenue, Sunnyvale, California. The lease on this facility expires June 30, 2005, and requires base payments on average of approximately $22,200 per month. We also lease approximately 59,000 square feet of space at 675 Almanor Avenue, Sunnyvale, California, which is across the street from 670 Almanor. Approximately 20,000 square feet remains available to accommodate expected increases in operations and additional full-time employees. We began leasing approximately one-half of the space (approximately 29,000 square feet) in December 1997 and leased the remaining space (approximately 30,000 square feet) in July 1998. This lease expires on June 30, 2005, and has a five-year renewal option which, if exercised, would extend the lease to June 30, 2010. It requires base payments of approximately $92,000 per month. Although we have in-house capabilities for the production and purification of proteins for use in our research activities, we do not have manufacturing facilities capable of supplying materials suitable for clinical trials or for commercial sale. We expect to rely on a third party for the production of proteins for use in our early clinical work.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On March 3, 1997, the Company brought suit against Affymetrix, Inc. in the U.S. District Court for the Northern District of California, San Jose Division, alleging infringement by Affymetrix of the Company's U.S. Patent Nos. 5,202,231 and 5,525,464 (Hyseq, Inc. v. Affymetrix, Inc., Case No. C 97-20188 RMW (PVT)) ("Hyseq I"). On May 5, 1997, the Company filed an Amended Complaint. On December 9, 1997, the Company filed a second lawsuit against Affymetrix alleging infringement by Affymetrix of the Company's U.S. Patent No. 5,695,940 (Hyseq, Inc. v. Affymetrix, Inc., Case No. C-97 4469 THE) ("Hyseq II"). On April 22, 1998 the two cases were consolidated before Judge Ronald M. Whyte.
The consolidated suits allege that Affymetrix willfully infringed, and continues to infringe, the Company's patents covering SBH technology. Through the lawsuit, the Company seeks both to enjoin Affymetrix from infringing its patents covering SBH technology and an award of monetary damages for Affymetrix' past infringement. On May 19, 1997, Affymetrix filed an Answer and Affirmative Defenses to the First Amended Complaint in Hyseq I and also filed a counterclaim against the Company. The counterclaim seeks a declaratory judgment of invalidity and non-infringement with respect to the two patents asserted in Hyseq I. On September 9, 1997, the Company filed a reply to the counterclaim in which it denied the allegations of invalidity and non-infringement. A similar answer and counterclaim was filed by Affymetrix in Hyseq II on December 28, 1997, and a similar reply to the counterclaim was filed by the Company on January 29, 1998. On August 1, 1997 (Hyseq I), and on March 28, 1998 (Hyseq II), initial case management conferences were held in each case in which the Court entered a pre-trial schedule. The Court held a claims construction hearing on November 17 and 18, 1998 in Hyseq I and II. On July 12, 1999, Affymetrix filed an amended answer and counterclaim alleging the additional defense that the patents were obtained through inequitable conduct. On October 27, 1999, the Court issued an order construing terms in the claims of the patents-in-suit and inviting the parties to submit briefs setting forth any perceived errors or inconsistencies in the Order. The Company and Affymetrix submitted their briefs on December 17 and 27, 1999, respectively. On January 7, 2000, the Court held a further Case Management Conference. On February 22, 2000, the Court received oral argument from the parties regarding the Claims Construction Order. The Company and Affymetrix are
currently engaged in pretrial discovery during which documents and other written discovery are being exchanged and depositions are being taken. While the Company believes it has asserted valid claims and has meritorious defenses to the counterclaims, this litigation is at an early stage and there can be no assurance that the Company will prevail in these actions.
On August 18, 1998, Affymetrix filed suit against the Company in the U.S. District Court for the Northern District of California, San Francisco Division, alleging that the Company infringed two of Affymetrix' U.S. patents, No. 5,795,716 and 5,744,305 (Affymetrix, Inc. v. Hyseq, Inc., Case No. C 98-13192). Affymetrix filed an amended complaint on September 1, 1998 alleging infringement of its U.S. Patent No. 5,800,992. The case has been was reassigned to Judge Jeremy Fogel in the San Jose Division. At the time of the assignment to Judge Fogel, the case was also renumbered as Case No. C 99-21163 JF (MEJ). A Case Management Conference before Judge Fogel is scheduled for April 17, 2000. The Company believes that Affymetrix' allegations are without merit and intends to vigorously defend the action. However, the litigation is at a very early stage and it is impossible to predict the ultimate outcome of this matter.
On October 26, 1999, the Company filed a third lawsuit against Affymetrix in the U.S. District Court for the Northern District of California, San Francisco Division (Hyseq, Inc. v. Affymetrix, Inc., Case No. C-99 4735 MJJ) ("Hyseq III"), alleging infringement by Affymetrix of the Company's recently-issued U.S. Patent No. 5,972,619 (the "'619 Patent"). Hyseq also alleges that Affymetrix' U.S. Patent No. 5,795,716 is invalid because the subject matter was first invented by Hyseq scientists and is claimed and covered by Hyseq's '619 Patent. Affymetrix filed an answer and counterclaim on November 15, 1999. The counterclaim seeks a declaratory judgment of invalidity, unenforceability and non-infringement with respect to Hyseq's '619 Patent. On December 9, 1999, the Company filed a reply to the counterclaim in which it denied the allegations of invalidity, unenforceability, and non-infringement. Subsequently, Hyseq III was reassigned to Judge Fogel and was given Case No. C-00-20050 JF/PVT. Hyseq III is presently scheduled for a Case Management Conference on April 17, 2000 along with Affymetrix, Inc. v. Hyseq, Inc.
On February 28, 2000, Judge Whyte issued an order directing each of the parties involved in each of the above cases to submit statements regarding the appropriateness of relating the cases before Judge Fogel with the Hyseq I and II cases currently before Judge Whyte. The Company and Affymetrix submitted their respective statements on March 10, 2000, as directed by the Court.
The Company has incurred substantial costs and expended substantial personnel time in asserting the Company's patent rights and defending its technology against Affymetrix and may continue to incur such costs in asserting its patent rights and defending its technology against Affymetrix or others. There can be no assurance that the Company will be successful in these efforts. Failure to successfully enforce its patent rights or the loss of these patent rights covering SBH technology also could remove a legal obstacle to competitors in designing platforms with similar competitive advantages.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to the vote of stockholders through the solicitation of proxies or otherwise during the fourth quarter of the year ended December 31, 1999.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's common stock began trading on the Nasdaq Stock Market on August 8, 1997 under the symbol "HYSQ." Prior to that date, there was no established trading market for the common stock. The following table sets forth, for the periods indicated, the high and low sales prices for the common stock, as reported by the Nasdaq Stock Market, since the common stock commenced public trading:
As of March 10, 2000, there were approximately 203 stockholders of record of the common stock. The Company has not paid dividends to its stockholders' since its inception and does not plan to pay cash dividends in the foreseeable future. The Company currently intends to retain earnings, if any, to finance the growth of the Company.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
- --------------- (1) The 1997, 1998 and 1999 balances include $2.1 million of cash on deposit, which is restricted and cannot be withdrawn. The cash on deposit has been made in connection with a letter of credit. 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
This Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements may be identified by words including "anticipate," "believe," "intends," "estimates," "expect," "should," "may," "potential" and similar expressions. Such statements are based on our management's current expectations and involve risks and uncertainties. Actual results and performance could differ materially from those projected in the forward-looking statements as a result of many factors discussed herein. Actual results and performance could also differ materially from time to time from those projected in our filings with the Securities and Exchange Commission. The factors causing such differences may include, but are not limited to, the following:
- the amount of research and development we engage in with respect to our biopharmaceutical product candidates;
- the ability to obtain additional collaborative arrangements;
- the nature, size, timing or termination of our collaborative arrangements;
- the costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims;
- others may have or obtain patent rights that are superior to ours;
- ability to find space for expansion of our operations;
- changes in government regulation; and
- competitors' release of successful products into the market.
RESULTS OF OPERATIONS
Contract Revenues
Comparison of Years Ended December 31, 1999 and 1998. Our contract revenues were $6.4 million for 1999, not including $5.0 million in deferred revenue from American Cyanamid Company, a subsidiary of American Home Products Corporation, received and recorded in December 1999, compared to $9.6 million for 1998. The decrease of $3.2 million was due primarily to lower revenues earned from our collaboration with Chiron Corporation during 1999. The primary reason that revenues were higher in 1998 was that minimum production requirements were higher under the Chiron agreement in 1998, and additionally some of the scheduled requirements for the first half of 1999 were accelerated into 1998. Decreased production requirements under the Chiron agreement during the first half of 1999 allowed us to undertake a facilities expansion to increase our production capacity in anticipation of a new collaboration.
Our contract and other revenues earned during 1999 included $4.9 million received from Chiron, $1.2 million received from the Pharmaceutical Division of Kirin Brewery Co., Ltd. and $0.3 million received from PE Corporation. As of December 31, 1999, $2.3 million remained to be earned over the term of the Chiron agreement which ends May 31, 2000. Chiron has the right to extend the agreement for up to two additional periods of two years each. As of December 31, 1999, we had received and recognized as revenue $2.7 million of the $3.0 million contract amount under our collaboration agreement with Kirin. The balance is expected to be earned during 2000. Revenues recognized from PE Corporation represent a combination of reimbursement for HyChip system development costs and initial fees earned under a new agreement that expanded our relationship with PE Corporation. Under the terms of this expanded relationship, we may earn up to an additional $1.2 million in revenue during 2000.
In December 1999, we received an upfront payment of $5.0 million in our collaboration with American Cyanamid which was classified as deferred revenue. Subject to compliance with the terms of the contract, we expect to recognize revenue from this collaboration over the term of the agreement. A certain portion of the deferred revenue will be accounted for as reimbursement of set-up costs related to initial deliverables.
Our revenues typically vary from quarter to quarter and may result in significant fluctuations in our operating results from year to year. In the future, we may not be able to maintain existing collaborations, obtain additional collaboration partners or obtain revenue from other sources. The failure to maintain existing collaborations, the inability to enter into additional collaborative arrangements or obtain revenue from other sources could have a material adverse effect on our revenues and operating results.
Comparison of Years Ended December 31, 1998 and 1997. Our contract and other revenues increased by $3.4 million to $9.6 million in 1998 compared to $6.2 million for 1997. Contract and other revenues recognized in 1998 included $8.1 million from Chiron and $1.5 million from Kirin. Contract and other revenues we earned during 1997 included $5.3 million from Chiron and $0.9 million we received in conjunction with our National Institute of Standards and Technology ("NIST") grant. As of December 31, 1997, we had received all of the funding under our NIST grant and we have not applied for any additional NIST grants or other government sponsored programs. Although we may apply for other grants in the future, we may not receive such grants or such grants, if received, may not provide us with significant funds.
Operating Expenses
Comparison of Years Ended December 31, 1999 and 1998. Our total operating expenses, consisting of research and development expenses and general and administrative expenses, decreased by $2.4 million to $26.3 million for 1999 compared to $28.7 million for 1998.
For 1999, our research and development expenses decreased by $1.0 million to $18.2 million compared to $19.2 million for 1998. Our lower 1999 research and development expenses reflect primarily lower material consumption costs resulting from decreased production during our facilities expansion in 1999 and the capitalization of internally-developed software costs, partially offset by:
- higher salary expenses;
- increased depreciation and rental expenses associated with the expansion of our facilities; and
- increased expenditures related to prosecuting and enforcing our intellectual property rights.
For 1999, our general and administrative expenses decreased by $1.4 million to $8.1 million compared to $9.5 million in 1998. The decrease in general and administrative expenses during 1999 resulted primarily from lower legal expenses during this period. Legal expenses decreased, in part, due to delayed activity in our litigation with Affymetrix, Inc. while awaiting the results of the November 1998 claims construction hearing that the Court released in October 1999. The decrease in general and administrative expenses was partially offset by increased staffing costs and other costs associated with business development.
We expect operating expenses during 2000 to increase as we plan to significantly expand:
- research and development of our biopharmaceutical product candidates;
- complete gene sequencing programs;
- development and production of our HyChip biochip; and
- efforts related to prosecuting and enforcing our intellectual property rights, including increasing expenses as our patent litigation with Affymetrix nears the trial stage.
The magnitude of the increases in our operating expenses will be significantly affected by our ability to secure adequate sources of external financing or additional sources of revenue. If we do not obtain adequate financing or revenue in a timely manner, we may be required to delay or eliminate one or more of our research or development programs. Any such action could significantly harm our business, financial condition and results of operations.
Comparison of Years Ended December 31, 1998 and 1997. Our total operating expenses, consisting of research and development expenses and general and administrative expenses, increased by $14.4 million to $28.7 million in 1998 compared to $14.3 million for 1997. Increases in our total operating expenses in 1998 as compared to 1997 resulted primarily from:
- further expansion of our scientific and management personnel;
- ongoing software and database development;
- costs associated with our collaboration arrangements, including the associated scale-up of our gene discovery capacity;
- increased depreciation and rental expenses associated with expansion of our facilities; and
- increased expenditures related to prosecuting and enforcing our intellectual property rights.
Research and development expenses increased by $9.8 million to $19.2 million for 1998 compared to $9.4 million for 1997. Increases in 1998 as compared to 1997 resulted primarily from the addition of scientific personnel. The remaining portion of the increase was due to:
- increased sequencing production in connection with gene discovery;
- expression of gene-based product candidates;
- the research discovery collaboration with Chiron Corporation;
- expenses associated with the University of California, San Francisco collaboration; and
- further development of the HyChip system, including related costs associated with expansion of our facilities.
General and administrative expenses increased by $4.6 million to $9.5 million in 1998 compared to $4.9 million in 1997. This increase was due, in significant part, to:
- an increase in legal expenses resulting primarily from costs associated with our lawsuits against Affymetrix and the Affymetrix lawsuit filed against us;
- the addition of management personnel and administrative staff to support the continued expansion of our sequencing production and data analysis capabilities; and
- costs associated with being a public company.
Interest Income, Net
Comparison of Years Ended December 31, 1999 and 1998. Our net interest income decreased by $1.4 million to $1.3 million for 1999 compared to $2.7 million for 1998. This decrease in net interest income during 1999 resulted from lower cash and investment balances held by us and higher interest expense from our increased financing activities.
Comparison of Years Ended December 31, 1998 and 1997. Our net interest income increased by $1.2 million to $2.7 million in 1998 compared to $1.5 million in 1997. The increase in net interest income in 1998 as compared to 1997 resulted from our larger cash and investment balances derived from the $17.5 million net proceeds from our private placements in May and August 1997 and the $44.0 million net proceeds from our initial public offering in August 1997. This increase in interest income was partially offset by increased interest expense related to our various capital financings.
Net Loss
Since our inception, we have incurred operating losses, and as of December 31, 1999, we had an accumulated deficit of $49.7 million. During 1999, we incurred a net loss of $18.5 million as compared to a $16.4 million net loss in 1998 and a net loss of $6.5 million in 1997. We expect to continue to incur significant operating losses, which may increase substantially as we pursue research and development of our biopharmaceutical product candidates and other operations, and as we prosecute and enforce our intellectual property rights.
As of December 31, 1999, we had a net operating loss carryover for federal income tax purposes of approximately $47.0 million. If we do not utilize this loss carryover, portions of it will expire on various dates from 2008 through 2019. Utilization of the net operating loss carryover may be subject to an annual limitation imposed by "change in ownership" provisions of the Internal Revenue Code of 1986, as amended. The annual limitation may result in the expiration of net operating losses before utilization. See Note 8 of Notes to Consolidated Financial Statements.
LIQUIDITY AND CAPITAL RESOURCES.
Cash, Cash Equivalents, Short-Term Investments, and Cash on Deposit
Comparison of Years Ended December 31, 1999 and 1998. As of December 31, 1999, we had $32.7 million in cash and investments, including $30.6 million in cash, cash equivalents and short-term investments and $2.1 million in a restricted cash on deposit account. These amounts reflect a net decrease of $15.8 million from the $48.5 million in cash and investments we had as of December 31, 1998. This decrease resulted primarily from $13.0 million of net cash used in operating activities.
All of our investments in marketable securities are considered available-for-sale and as such are classified as short-term investments. We currently hold our cash equivalents and investments in investment-grade commercial paper, bank certificates of deposit and other interest-bearing securities. We make our investments in accordance with our investment policy. The primary objectives of our investment policy are liquidity, safety of principal and diversity of investments.
In addition, we have $2.1 million in restricted cash on deposit as security for a $2.0 million letter of credit in conjunction with a facility lease. Provided that no event of default under the lease has occurred, the letter of credit and the cash collateralizing it will be reduced by $0.5 million per year commencing in 2001. The cash on deposit at any time in conjunction with this letter of credit is restricted and cannot be withdrawn. We control the investment of the cash and receive the interest earned thereon.
Cash Used in Operating Activities
Comparison of Years Ended December 31, 1999 and 1998. The amount of net cash used in operating activities increased by $1.3 million to $13.0 million during 1999 from $11.7 million in 1998. The increase in cash used for operations for 1999 compared to 1998 was due primarily to:
- a significant increase in our accounts receivables balance;
- our complete gene sequencing programs;
- expansion of our functional genomics and protein purification efforts to support research and development of our biopharmaceutical product candidates; and
- efforts related to prosecuting our intellectual property rights.
This increase in cash used in operations for 1999 was partially offset by lower spending related to enforcing our intellectual property rights.
Comparison of Years Ended December 31, 1998 and 1997. In 1998, the total amount of net cash used in operating activities increased by $3.6 million to $11.7 million from $8.1 million in 1997. The increase in cash used in 1998 resulted primarily from:
- increases in our personnel to support gene discovery, database development programs, functional genomics, corporate development and marketing;
- general corporate matters;
- efforts related to prosecuting and enforcing our intellectual property rights; and
- costs related to our new facility.
Cash Provided by Investing Activities.
Our investing activities, other than purchases and sales of short-term investments, have consisted primarily of capital expenditures.
Comparison of Years Ended December 31, 1999 and 1998. Net cash provided by investing activities decreased by $1.0 million to $3.5 million for 1999 compared to $4.5 million for 1998. Our capital expenditures slightly decreased in 1999 primarily due to lower expenditures related to the facilities expansion compared to 1998. In addition, our net redemptions of short-term investments were lower in 1999 than in 1998.
Comparison of Years Ended December 31, 1998 and 1997. For 1998, net cash provided by investing activities decreased by $32.6 million to $4.5 million compared to $37.1 million used in investing activities for 1997. The difference was due primarily to an infusion of cash to purchase short-term investments following our IPO in 1997.
Cash Provided by Financing Activities
Comparison of Years Ended December 31, 1999 and 1998. Net cash provided by financing activities decreased by $4.0 million to $1.6 million for 1999 compared to $5.6 million for 1998. The net cash provided in 1999 was primarily derived from $3.0 million of proceeds we received from asset-backed financing. The financing was partially offset by higher payments on loan obligations. In 1998, the net cash provided by financing activities resulted primarily from our $5.0 million asset-backed financing, as well as receipts of payments on notes held by certain of our stockholders and issuance of common stock related to the exercise of options and warrants.
During 1999, we obtained a $5.0 million asset-backed financing commitment. As of December 31, 1999, we had borrowed $3.0 million. This commitment has been extended through June 30, 2000. We are currently evaluating our future needs for equipment financing and may seek to obtain additional equipment financing. There is no assurance that in the future we will be able to secure new equipment financing on favorable terms, if at all.
Comparison of Years Ended December 31, 1998 and 1997. Net cash generated by financing activities in 1998 decreased by $56.0 million to $5.6 million compared to $61.6 million for 1997. The total amount of net cash provided by financing activities in 1998 reflects asset-backed financing, as well as payments received on notes held by certain of our stockholders and the issuance of common stock related to the exercise of options and warrants. Net cash provided by financing activities in 1997 reflects primarily the $44.0 million in net proceeds we received from our initial public offering and $17.5 million from our private placements with Chiron Corporation and PE Corporation.
We have financed our operations since inception through private and public sales of our stock, revenue from research and development collaborations, grants, asset-backed financings and investment income. We anticipate that existing capital resources, anticipated cash from existing collaborative partners and funds we receive under our capital financing commitment will be sufficient to support our biopharmaceutical research and development and other operations through the first half of 2001. Our estimate of the time period for which existing and anticipated cash funds will be adequate to fund our operations is a forward-looking estimate subject to risks and uncertainty. Actual results may differ substantially. Our future capital requirements and the adequacy of our available funds will depend on many factors, including, but not limited to:
- continued scientific progress in our research and development programs;
- our ability to attract additional financing on favorable terms;
- the magnitude and scope of our research and development programs, including our development of biopharmaceutical product candidates and our complete gene sequencing programs;
- our ability to maintain existing and establish additional collaborative and licensing arrangements, and the financial commitments involved in such collaborative and licensing arrangements;
- the cost of prosecution and enforcement of our intellectual property rights;
- expansion of our facilities to support research and development of our biopharmaceutical candidates;
- progress with preclinical studies and clinical trials;
- the time and cost involved in obtaining regulatory approvals;
- competing technological and market developments;
- our need to develop, acquire or license new technologies or products; and
- other factors not within our control.
Year 2000 Compliance
In late 1999, we completed Year 2000 ("Y2K") testing of third party software and hardware used in our production line. We did not experience any significant disruptions in our information technology and other systems related to Y2K and we are not aware of any vendors or collaborators who experienced Y2K problems that have or are likely to materially affect us. For the year ended December 31, 1999, we incurred less than $50,000 in costs related to preparing for Y2K contingencies.
ITEM 7A.
ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
Market Rate Risk
The Company's exposure to market rate risk for changes in interest rates relates primarily to the Company's investment portfolio. The Company does not use derivative financial instruments in its investment portfolio. The Company places its investments with high quality issuers and, by policy, limits the amount of credit exposure to any one issuee. The Company is averse to principal loss and ensures the safety and preservation of its invested funds by limiting default, market and reinvestment risk. The Company classifies its cash equivalents and marketable securities as fixed-rate if the rate of return on such instruments remains fixed over their term. These fixed-rate investments include U.S. government securities, commercial paper, corporate bonds, certificates of deposit, and all such investments held in the Company's portfolio as of December 31, 1999 mature in 2000. The Company classifies its cash equivalents and marketable securities as variable-rate if the rate of return on such investments varies based on the change in a predetermined index or set of indices during their term. These variable-rate investments primarily include money market accounts. The table below presents the amounts and related weighted-average interest rates of the Company's investment portfolio as of December 31, 1999:
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders Hyseq, Inc.
We have audited the accompanying consolidated balance sheets of Hyseq, Inc. as of December 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Hyseq, Inc. at December 31, 1999 and 1998, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States.
/s/ ERNST & YOUNG LLP
Palo Alto, California February 2, 2000
HYSEQ, INC. CONSOLIDATED BALANCE SHEETS (In thousands, except share and per share information)
See accompanying Notes to Consolidated Financial Statements.
HYSEQ, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data)
See accompanying Notes to Consolidated Financial Statements.
HYSEQ, INC. CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY For the Years Ended December 31, 1999, 1998 and 1997 (In thousands)
See accompanying Notes to Consolidated Financial Statements.
HYSEQ, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)
See accompanying Notes to Consolidated Financial Statements.
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization and Basis of Presentation
Hyseq, Inc. (the "Company" or "Hyseq") was established in August 1992 as an Illinois corporation and subsequently reincorporated as a Nevada corporation on November 12, 1993. The Company's wholly-owned subsidiary, Hyseq Diagnostics, Inc. ("HDI"), was formed as a Nevada corporation on July 18, 1995. The Company's wholly-owned subsidiary, GeneSolutions Inc., was formed as a Nevada corporation on July 23, 1999.
Hyseq researches and develops biopharmaceuticals. Hyseq uses its proprietary technology with its partners for therapeutic and diagnostic target discovery, in pharmacogenomics and polymorphism analysis, and with its DNA analysis tools such as the HyChip system.
Principles of Consolidation and Basis of Presentation
The consolidated financial statements include the accounts of the Company's wholly-owned subsidiaries. All significant intercompany transactions and accounts have been eliminated.
Use of Estimates
The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Cash, Cash Equivalents and Short-Term Investments
The Company considers all highly liquid investments with original maturities of less than 90 days and insignificant interest rate risk to be cash equivalents. Investments with maturities of less than one year from the balance sheet date and with original maturities greater than 90 days are considered short-term investments. Investments consist primarily of money market accounts, commercial paper, certificates of deposit and other short-term instruments. These investments typically bear minimal risk. This minimization of risk is consistent with the Company's policy to maintain high liquidity and ensure safety of principal.
The Company's short-term investments are classified as available-for-sale. Available-for-sale securities are carried at fair value based on quoted market prices, with the unrealized gains and losses, net of tax, included in accumulated other comprehensive loss of stockholders' equity. The amortized cost of debt securities in this category is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in interest income. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in interest income or expense. Interest and dividends on securities classified as available-for-sale are included in interest income. The cost of securities sold is based on the specific identification method.
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following is a summary of available-for-sale securities as of December 31, 1999 (in thousands):
All of the Company's short-term investments mature within one year.
Equipment and Leasehold Improvements
Equipment and leasehold improvements are stated at cost. Depreciation and amortization are computed using the straight-line method over the estimated useful lives ranging from three to five years, except that leasehold improvements are amortized over the remaining life of the lease or the life of the improvement, whichever is less.
Effective January 1, 1999, the Company adopted Statement of Position 98-1 ("SOP 98-1"), "Accounting for the Costs of Computer Software Developed for or Obtained for Internal Use". SOP 98-1 requires the capitalization of costs incurred in developing or acquiring software for internal use once feasibility studies are complete. The Company previously expensed such costs as incurred. The adoption of SOP 98-1 resulted in the capitalization of approximately $1.5 million in 1999. The Company generally amortizes software capitalized under SOP 98-1 on a straight-line basis over a three-year period. In 1999, the Company recorded an amortization expense of $0.2 million.
Revenue Recognition
Revenues are recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed and determinable and collectibility is reasonably assured. Revenues related to collaborative research agreements and government grants are generally recognized over the related funding periods for each contract as the reimbursable services are performed. Nonrefundable up-front payments received in connection with collaborative research agreements are deferred and recognized over the relevant periods specified in the agreement, generally the research term.
In December 1999, we received an upfront payment of $5.0 million in our collaboration with American Cyanamid which was classified as deferred revenue. Subject to compliance with the terms of the contract, we expect to recognize revenue from this collaboration over the term of the agreement. A certain portion of the deferred revenue will be accounted for as reimbursement of set-up costs related to initial deliverables.
The Company received research payments under its collaborative agreements with Chiron and Kirin, which were recognized as revenue as earned.
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Revenues from collaborative agreements representing 10% or more of total revenue are as follows:
Stock-Based Compensation
In accordance with the provisions of Statement of Financial Accounting Standards No. 123 ("SFAS No. 123"), "Accounting for Stock-Based Compensation" the Company has elected to account for stock-based compensation under the provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25"), and to adopt the "disclosure only" alternative described in SFAS No. 123.
Research and Development
Research and development costs are expensed to operations as incurred and include costs related to the Company's NIST grant in 1997. In 1999, 1998 and 1997, research and development costs also included costs related to the Company's collaborations. Contract and grant related costs of approximately $7.0 million, $10.7 million, and $4.7 million were recorded in 1999, 1998 and 1997, respectively.
Net Loss Per Share
Basic and diluted net loss per share are presented in conformity with the Statement of Financial Accounting Standards No. 128 ("SFAS No. 128"), "Earnings Per Share" for all periods presented. In accordance with SFAS No. 128, basic and diluted net loss per share has been computed using the weighted average number of shares of common stock outstanding during the period.
Had the Company been in a net income position, shares used in calculating diluted earnings per share for 1999, 1998, and 1997 would have included the effect of an additional 369,000, 728,000 and 963,000 shares, respectively, related to outstanding options and warrants (as determined using the treasury method).
Accumulated Other Comprehensive Loss
Accumulated other comprehensive loss consists entirely of unrealized losses on short-term investments at December 31, 1999.
Recent Accounting Pronouncements
In June 1999, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 137 ("SFAS 137"), "Accounting for Derivative Instruments and Hedging Activities -- Deferral of the Effective Date of FASB Statement No. 133." SFAS 133 establishes new standards of accounting and reporting for derivative instruments and hedging activities, and SFAS 137 defers its effective date to the first quarter of the first fiscal year after June 15, 2000. The Company will adopt SFAS 133 effective January 1, 2001. Because the Company does not use derivative financial instruments or engage in hedging activities, management does not anticipate that the adoption of SFAS 133 will have a significant effect on the Company's consolidated results of operations or financial position.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
2. EQUIPMENT, LEASEHOLD IMPROVEMENTS AND CAPITALIZED SOFTWARE
Equipment, leasehold improvements and capitalized software, net consist of the following (in thousands):
Depreciation expense amounted to $2.8 million, $1.6 million and $0.8 million for the years ended December 31, 1999, 1998 and 1997, respectively. Equipment and leasehold improvements at December 31, 1999 and 1998 include items under capitalized leases in the amount of $0.6 million and $0.7 million, respectively, and related accumulated amortization of $0.4 million and $0.3 million at December 31, 1999 and 1998, respectively. These leases are secured by the equipment leased thereunder.
3. PATENTS, LICENSES AND OTHER ASSETS
Patents
Patent costs are incurred in connection with obtaining certain patents and filing of related patent applications. Patent amortization expense, which amounted to approximately $28,000 in each of 1999, 1998 and 1997, is recorded on a straight-line basis over the patent's estimated useful life which approximates 17 years.
Patent License Agreement
In 1994, the Company entered into a patent agreement with an affiliate of the University of Chicago for an exclusive license to use certain proprietary technology developed by the Company's Chief Scientific Officer and to develop, use, and sell licensed products or processes under the license patent rights. The Company issued 15,244 shares of Series A preferred stock (which converted to common stock in connection with the Company's initial public offering) and must pay minimum royalties of $25,000 per annum beginning in 1997 and increasing to $100,000 per annum over the term of the license which terminates at expiration of the related patent.
4. CAPITAL LEASE AND LOAN OBLIGATIONS
The Company has financed equipment purchases through capital lease and loan agreements. The capital lease and loan obligations are to be repaid over terms of 48 to 60 months at interest rates ranging from 11.32% to 14.98% and are secured by related equipment. At December 31, 1999, the Company has approximately $2.0 million available for borrowings under an existing loan agreement.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Future minimum payments under the capital lease and loan agreements are as follows (in thousands):
5. OPERATING LEASE COMMITMENTS AND CONTINGENCIES
Operating Lease Commitments
The Company leases two facilities under operating lease agreements that expire in June 2005. One of the leases has a five-year renewal option, which if exercised, would extend the lease to 2010. Rental expense was approximately $1.4 million in 1999, $1.1 million in 1998, $0.2 million in 1997. The leases provide for scheduled rent increases annually over the terms of the leases. The rent is being recognized as expense on a straight-line basis and the actual cash flow is included in the minimum lease payment schedule below. Minimum non-cancelable future rental commitments under operating leases at December 31, 1999 are as follows (in thousands):
Cash on Deposit
In accordance with the terms of a facility lease agreement signed in the fourth quarter of 1997, the Company was required to obtain an irrevocable standby letter of credit in the amount of $2.0 million as partial security for the Company's lease obligations. In connection with obtaining the letter of credit, the Company was required to place $2.1 million restricted cash on deposit with the Company's primary bank as security for the letter of credit. Provided that no event of default under the lease has occurred, the letter of credit and the cash collateralizing it will be reduced by $0.5 million commencing in 2001 and will be further reduced by $0.5 million each year thereafter. The cash on deposit at any time in conjunction with this letter of credit is restricted and cannot be withdrawn. The Company controls the investment of the cash and receives interest earned thereon.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Contingencies
On March 3, 1997, the Company brought suit against Affymetrix, Inc. in the U.S. District Court for the Northern District of California, San Jose Division, alleging infringement by Affymetrix of the Company's U.S. Patent Nos. 5,202,231 and 5,525,464 (Hyseq, Inc. v. Affymetrix, Inc., Case No. C 97-20188 RMW (PVT)) ("Hyseq I"). On May 5, 1997, the Company filed an Amended Complaint. On December 9, 1997, the Company filed a second lawsuit against Affymetrix alleging infringement by Affymetrix of the Company's U.S. Patent No. 5,695,940 (Hyseq, Inc. v. Affymetrix, Inc., Case No. C-97 4469 THE) ("Hyseq II"). On April 22, 1998 the two cases were consolidated before Judge Ronald M. Whyte.
The consolidated suits allege that Affymetrix willfully infringed, and continues to infringe, the Company's patents covering sequencing by hybridization ("SBH") technology. Through the lawsuit, the Company seeks both to enjoin Affymetrix from infringing its patents covering SBH technology and an award of monetary damages for Affymetrix' past infringement. On May 19, 1997, Affymetrix filed an Answer and Affirmative Defenses to the First Amended Complaint in Hyseq I and also filed a counterclaim against the Company. The counterclaim seeks a declaratory judgment of invalidity and non-infringement with respect to the two patents asserted in Hyseq I. On September 9, 1997, the Company filed a reply to the counterclaim in which it denied the allegations of invalidity and non-infringement. A similar answer and counterclaim was filed by Affymetrix in Hyseq II on December 28, 1997, and a similar reply to the counterclaim was filed by the Company on January 29, 1998. On August 1, 1997 (Hyseq I), and on March 28, 1998 (Hyseq II), initial case management conferences were held in each case in which the Court entered a pre-trial schedule. The Court held a claims construction hearing on November 17 and 18, 1998 in Hyseq I and II. On July 12, 1999, Affymetrix filed an amended answer and counterclaim alleging the additional defense that the patents were obtained through inequitable conduct. On October 27, 1999, the Court issued an order construing terms in the claims of the patents-in-suit and inviting the parties to submit briefs setting forth any perceived errors or inconsistencies in the Order. The Company and Affymetrix submitted their briefs on December 17 and 27, 1999, respectively. On January 7, 2000, the Court held a further Case Management Conference. On February 22, 2000, the Court received oral argument from the parties regarding the Claims Construction Order. The Company and Affymetrix are currently engaged in pretrial discovery during which documents and other written discovery are being exchanged and depositions are being taken. While the Company believes it has asserted valid claims and has meritorious defenses to the counterclaims, this litigation is at an early stage and there can be no assurance that the Company will prevail in these actions.
On August 18, 1998, Affymetrix filed suit against the Company in the U.S. District Court for the Northern District of California, San Francisco Division, alleging that the Company infringed two of Affymetrix' U.S. patents, No. 5,795,716 and 5,744,305 (Affymetrix, Inc. v. Hyseq, Inc., Case No. C 98-13192). Affymetrix filed an amended complaint on September 1, 1998 alleging infringement of its U.S. Patent No. 5,800,992. The case has been reassigned to Judge Jeremy Fogel in the San Jose Division. At the time of the assignment to Judge Fogel, the case was also renumbered as Case No. C 99-21163 JF (MEJ). A Case Management Conferences before Judge Fogel is scheduled for April 17, 2000. The Company believes that Affymetrix' allegations are without merit and intends to vigorously defend the action. However, the litigation is at a very early stage and it is impossible to predict the ultimate outcome of this matter.
On October 26, 1999, the Company filed a third lawsuit against Affymetrix in the U.S. District Court for the Northern District of California, San Francisco Division (Hyseq, Inc. v. Affymetrix, Inc., Case No. C-99 4735 MJJ) ("Hyseq III"), alleging infringement by Affymetrix of the Company's recently-issued U.S. Patent No. 5,972,619 (the "'619 Patent"). Hyseq also alleges that Affymetrix' U.S. Patent No. 5,795,716 is invalid because the subject matter was first invented by Hyseq scientists and is claimed and covered by Hyseq's '619 Patent. Affymetrix filed an answer and counterclaim on November 15, 1999. The counterclaim seeks a declaratory judgment of invalidity, unenforceability and non-infringement with respect to Hyseq's '619 Patent. On December 9, 1999, the Company filed a reply to the counterclaim in which it denied
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
the allegations of invalidity, enforceability, and non-infringement. Subsequently, Hyseq III was reassigned to Judge Fogel and was given Case No. C-00-20050 JF/PVT. Hyseq III is presently scheduled for a Case Management Conference on April 17, 2000 along with Affymetrix, Inc. v. Hyseq, Inc.
On February 28, 2000, Judge Whyte issued an order directing each of the parties involved in each of the above cases to submit statements regarding the appropriateness of relating the cases before Judge Fogel with the Hyseq I and II cases currently before Judge Whyte. The Company and Affymetrix submitted their respective statements on March 10, 2000, as directed by the Court.
The Company has incurred substantial costs and expended substantial personnel time in asserting the Company's patent rights and defending its technology against Affymetrix and may continue to incur such costs in asserting its patent rights and defending its technology against Affymetrix or others. There can be no assurance that the Company will be successful in these efforts. Failure to successfully enforce its patent rights or the loss of these patent rights covering SBH technology also could remove a legal obstacle to competitors in designing platforms with similar competitive advantages.
6. COLLABORATIVE AGREEMENTS
In December 1999, the Company entered into an exclusive collaboration with American Cyanamid Company, a subsidiary of American Home Products Corporation, under which it may earn up to $60.0 million. Pursuant to the collaboration agreement, the Company is working with American Cyanamid Company primarily to develop agricultural products. The collaboration has an initial term of three and one half years and can be extended by mutual agreement for up to four additional one-year terms. In December 1999, the Company received an upfront payment of $5.0 million from American Cyanamid which was classified as deferred revenue. Subject to compliance with the terms of the contract, the Company expects to recognize revenue from this collaboration over the term of the agreement. A certain portion of the deferred revenue will be accounted for as reimbursement of set-up costs related to initial deliverables. American Cyanamid has the exclusive right to commercialize any agricultural products resulting from the collaboration. The Company will receive royalties on any such products. The agreement requires the Company to generate data at a specified level per year that, if not met, could result in its breach of the agreement.
In May 1997, the Company entered into an exclusive collaboration with Chiron Corporation. Pursuant to the terms of the collaboration agreement, the Company and Chiron are collaborating to develop solid tumor therapeutics, diagnostic molecules and vaccines. The collaboration has an initial term of three years and can be extended by Chiron for two additional two-year periods. Chiron paid a nonrefundable $1.0 million up-front licensing fee upon signing the agreement and guaranteed payment of a minimum of $8.5 million in the first year and $5.5 million in each of the two years thereafter in connection with the Company's research on Chiron tissue sample libraries. The agreement requires the Company to generate data at a specified level, which if not met, could result in the Company's breach of the collaboration. Chiron has the exclusive right to commercialize solid tumor therapeutics, diagnostic molecules and vaccines resulting from the collaboration. The Company will receive royalties on any such products. Concurrently with execution of the collaboration agreement, Chiron made an equity investment of $5.0 million in return for shares of the Company's preferred stock, which subsequently converted into common stock. Chiron also purchased shares of common stock directly from the Company in a private placement concurrent with the initial public offering for an aggregate purchase price of $2.5 million. Total revenue recognized in 1999, 1998 and 1997 under the agreement with Chiron was $4.9 million, $8.1 million and $5.3 million, respectively. The Company has no future performance obligations related to the revenue recognized in 1999, 1998 and 1997 and no portions of such revenues are refundable.
In October 1998, the Company entered into a collaboration with Kirin Brewery Co. Ltd., in which the Company used its proprietary gene discovery technologies to target novel genes relating to a specific growth factor activity from certain cell lines provided by Kirin. The Company retains exclusive rights to develop and HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
market pharmaceutical products resulting from the collaboration in North America, subject to milestone and royalty payments to Kirin. Kirin retains equivalent rights and obligations in Asia and Oceania. The Company and Kirin share such rights equally in Europe and the rest of the world. Under the terms of the agreement, Kirin will pay the Company $3.0 million for the initial phase of the collaboration. As of December 31, 1999, the Company had recognized $2.7 million in revenue from Kirin.
In May 1997, the Company entered into an agreement with PE Corporation to combine certain of the Company's chip technology and PE Corporation's life science system capabilities to commercialize HyChip products (collectively, the "HyChip System"). Pursuant to the terms of the agreement, the Company committed $5.0 million to further development of the Company's "chip" component of the HyChip System. The Company spent approximately $2.0 million for the development of the chip component of the HyChip System from June 1997 through December 1997. Of this amount, $0.5 million was reimbursed to the Company under its NIST grant. As of December 31, 1998, the Company satisfied the $5.0 million obligation under its agreement with PE Corporation. The collaboration has an initial term of five years and will be extended automatically thereafter unless the parties mutually agree to terminate the collaboration. Pursuant to the agreement, the design, development and manufacture of the HyChip "chip" is under the direction of the Company, while design, development and manufacture of the system is under the direction of PE Corporation. HyChip products will be distributed through PE Corporation's Applied Biosystems Division. In June 1997, PE Corporation made an equity investment of $5.0 million in return for shares of the Company's preferred stock, which subsequently converted into common stock. PE Corporation also purchased shares of common stock directly from the Company in a private placement concurrent with the initial public offering for an aggregate purchase price of $5.0 million. In 1999, the Company recognized approximately $0.3 million in revenue, resulting from both research funding reimbursement under the collaboration and as a result of an expansion of the existing relationship. No revenue was recorded in conjunction with the PE Corporation collaboration in 1998 and 1997.
In February 1998, the Company entered into a collaborative agreement with the University of California, San Francisco ("UCSF") to conduct research on genes that may have important roles in the development of cardiovascular and related diseases. Under the terms of the five-year agreement, the Company makes quarterly payments of approximately $0.1 million to UCSF in connection with the agreement to reimburse UCSF for direct and indirect expenses incurred in clinical sample collection and for research conducted. The Company has the exclusive rights from UCSF to commercialize the proprietary databases derived from this collaboration.
7. STOCKHOLDERS' EQUITY
Preferred Stock
The Company is authorized to issue 8,000,000 shares of preferred stock. The Company's Board of Directors may set the rights and privileges of any preferred stock issued.
In May and June 1997, Chiron and PE acquired Series B preferred stock in a private placement that generated net proceeds to the Company of $10.0 million. All shares of the Company's outstanding preferred stock automatically converted to common stock in connection with the Company's initial public offering.
As of December 31, 1999 and 1998, there were no issued and outstanding shares of preferred stock. On June 5, 1998, Hyseq's Board of Directors adopted a rights plan and declared a dividend with respect to each share of common stock then outstanding. This dividend took the form of a right that entitles the holders to purchase one one-thousandth of a share of our Series B Junior Participating Preferred Stock at a purchase price of $175, subject to adjustment from time to time. These rights have also been issued in connection with each share of common stock issued after June 5, 1998. The rights are exercisable only if a person or entity or affiliated group of persons or entities acquires, or has announced its intention to acquire, 15% (27.5% in the
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
case of certain approved stockholders) or more of the Company's outstanding common stock. The adoption of the rights plan makes it more difficult for a third party to acquire control of the Company without the approval of the Board of Directors.
Common Stock
The Company's initial public offering of 3,000,000 shares of common stock, which generated net proceeds of approximately $38.0 million, was effective August 7, 1997. In September 1997, the Company's underwriters exercised their option to purchase 450,000 additional shares at $14.00 per share to cover over- allotments, for additional net proceeds to the Company of $5.9 million. Concurrently with the initial public offering, the Company completed a private placement of shares of its common stock to Chiron and PE Corporation for net proceeds of $2.5 million and $5.0 million, respectively.
In December 1996, a former officer of the Company purchased 161,280 shares of common stock at $4.17 per share for a total purchase price of approximately $0.7 million. Simultaneously with the purchase of such stock, the officer borrowed from the Company approximately $0.7 million as evidenced by a promissory note that bore interest at 3% per annum, matures in December 2001, and is secured by and with recourse only to the 161,280 shares. In March 1997, the Company sold a total of 179,712 shares of common stock for $6.51 per share to this officer in exchange for a second promissory note with terms similar to the one previously described.
Also in December 1996, another officer of the Company exercised options to purchase 48,000 shares of common stock at an exercise price of $1.56 per share and exercised warrants to purchase 144,000 shares of common stock at $2.90 per share. Simultaneously with the exercises, the officer borrowed from the Company approximately $0.5 million, as evidenced by a promissory note that bears interest at 3% per annum, matures in December 2001, and is secured by and with recourse only to 118,080 shares. In March 1997, the Company sold a total of 179,712 shares of common stock for $6.51 per share to this officer of the Company in exchange for a second promissory note with terms similar to those described above.
Deferred Compensation
The Company has recorded deferred compensation of $695,000 representing the difference between the issuance and exercise prices related to stock awards and options and the deemed fair value for financial reporting purposes of the Company's common stock. The deferred compensation is being amortized to expense over the vesting period of the options and over the two-year repurchase period for the stock awards. The deferred compensation expense was $89,000, $319,000, and $250,000 in 1999, 1998 and 1997, respectively. At December 31, 1999, the deferred compensation balance was approximately $37,000.
Warrants
As of December 31, 1999, warrants to purchase 475,184 shares of common stock were outstanding at exercise prices ranging from $3.42 to $5.21 ($4.07 weighted average exercise price) per share. These warrants are held by certain investors, executive officers and the private placement agent for a 1996 preferred stock financing.
Stock Option Plans
In 1995, the Company's stockholders adopted the 1995 Employee Stock Option Plan (the "1995 Plan"). The Company initially reserved a total of 1,152,000 common shares for issuance under the 1995 Plan. At the 1998 annual meeting, the Company's stockholders approved a proposal to increase the number of shares authorized for issuance under the Plan to 2,152,000. Options granted under the 1995 Plan may be either incentive stock options or nonstatutory stock options. Incentive stock options may be granted to employees
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
with exercise prices of not less than fair value and nonstatutory options may be granted to employees at exercise prices of not less than par value of the common stock on the date of grant as determined by the board of directors. Options vest as determined by the board of directors and expire 10 years from the date of grant. At December 31, 1999, 1,217,786 shares were outstanding under the 1995 Plan.
The Company granted options to purchase common stock to several key employees, directors, scientific advisory board members and scientists prior to adoption of the 1995 Plan. Each option gives the holder the right to purchase common stock at prices between $0.78 and $1.82 per share. In 1998, the Company granted options outside of any of the Company's stock option plans to purchase a total of 9,500 shares of common stock to three non-employee directors and a scientific advisory board member at prices between $4.75 and $10.06 per share. The options vest over periods up to four years. As of December 31, 1999, 468,418 options issued outside of any of the Company's stock option plans were outstanding.
In 1997, the Company's stockholders adopted the Non-Employee Director Stock Option Plan (the "Directors Plan") providing for periodic stock option grants to non-employee directors of the Company. Under the Directors Plan, each new, non-employee director receives a one-time grant of options to purchase 23,040 shares of common stock, of which options to purchase 11,520 shares vest immediately, with the balance vesting in two equal allotments on the first and second anniversaries of joining the Board. All non-employee directors automatically receive options to purchase up to 5,760 shares each year (such that the amount received under the Directors' Plan when added to all prior options granted to a director which vest in that year total 5,760) on the date of the annual meeting of the stockholders commencing in 1997. Options under the Directors Plan are granted at the fair market value of the Company's common stock on the date of the grant. A total of 138,240 shares of common stock have been reserved for issuance under the Directors Plan, of which options to purchase 93,120 shares were issued and outstanding at December 31, 1999.
In 1999, the Company adopted a Scientific Advisory Board/Consultants Stock Option Plan ("SAB Plan"), which provides for periodic grants of non-qualified stock options to members of the Company's scientific advisory board and allows the Board of Directors to approve grants of stock options to consultants. A total of 30,000 shares of common stock have been reserved for issuance under the SAB Plan, of which no shares were issued and outstanding at December 31, 1999.
The Company values employee stock options using the intrinsic method of APB 25, rather than the fair value method of SFAS 123. Nevertheless, the Company is required for purposes of comparison to present net loss and loss per share on a pro forma basis as if the fair value method had been used. The fair value for employee stock options was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions:
The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. Because SFAS 123 is applicable only to options granted subsequent to December 15, 1994, the pro forma adjustment to net income was not fully reflected until fiscal 1999.
The Company's pro forma information follows (in thousands, except for per share information):
A summary of the Company's stock options activity, and related information follows:
The following table summarizes information about stock options outstanding and exercisable at December 31, 1999:
The weighted-average grant-date fair value of options granted during the years ended December 31, 1999, 1998 and 1997 was $3.52, $3.71 and $8.37, respectively.
Employee Stock Purchase Plan
In 1998, the Company's stockholders approved an Employee Stock Purchase Plan (the "ESPP"), covering an aggregate of 50,000 shares of the Company's common stock. Each quarter, an eligible employee may elect to purchase shares of the Company's stock through payroll deductions at a price equal to the lower of 85% of the fair value of the stock as of the first business day of the quarter or the last business day. In the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
year ended December 31, 1999, 43,773 shares of the Company's stock were sold under the ESPP at a weighted-average price of $2.84 per share.
In 1999, the Company adopted a Non-Qualified Stock Purchase Plan covering an aggregate of 50,000 shares of the Company's common stock, of which no shares were sold as of December 31, 1999.
8. INCOME TAXES
As of December 31, 1999, the Company had federal and state net operating loss carryforwards of approximately $47.0 million and $6.6 million, respectively. The Company also had federal and California research and development tax credit carryforwards of approximately $1.7 million and $1.4 million, respectively. The federal net operating loss and credit carryforwards will expire at various dates beginning in the year 2008 through 2019, if not utilized. The state of California net operating losses will expire at various dates beginning in 2000 through 2004, if not utilized.
Utilization of the Company's net operating loss carryforwards and credits may be subject to an annual limitation due to the "change in ownership" provisions of the Internal Revenue Code of 1986 and similar state provisions. The annual limitation may result in the expiration of net operating losses and credits before utilization.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets for financial reporting and the amount used for income tax purposes. Significant components of the Company's deferred tax assets for federal and state income taxes are as follows (in thousands):
The net valuation allowance increased by $8.3 million, $8.5 million and $2.4 million for the fiscal years ended December 31, 1999, 1998 and 1997, respectively.
9. TRANSACTIONS WITH RELATED PARTIES
As of December 31, 1999, 1998 and 1997, the Company had outstanding accounts payable balances of $86,180, $100,237 and $152,113, respectively, for professional services rendered by a law firm of which the spouse of the Company's President and Chief Executive Officer was a member during these periods. The Company incurred legal fees and costs to this law firm of approximately $441,000, $979,000 and $1,020,000 for the years ended December 31, 1999, 1998 and 1997, respectively.
In January 1997, this firm purchased 76,800 shares of the Company's common stock at $6.51 per share. This firm paid $102,415 in cash and delivered a promissory note to the Company for the balance in the amount of $397,585 secured by 61,069 shares of common stock. The note required payment of interest at 8.25% per annum. As of December 31, 1998, the principal balance and interest had been paid in full.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
10. SEGMENT INFORMATION
The Company adopted Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131") effective January 1, 1998. SFAS 131 establishes standards for reporting information regarding operating segments in annual financial statements and requires selected information for those segments to be presented in interim financial reports issued to stockholders. SFAS 131 also establishes standards for related disclosures about products, services and geographic areas. Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision maker in making decisions how to allocate resources and assess performance. The Company's chief operating decision maker is the Chief Executive Officer. To date, the Company has viewed its operations as principally one segment. As a result, the financial information disclosed herein materially represents all of the financial information related to the Company's principal operating segment.
11. SUBSEQUENT EVENTS (UNAUDITED)
In January 2000, a former officer of the Company repaid two promissory notes plus accrued interest totaling $2,003,624 due to the Company related to stock purchase agreements entered into in December 1996 and March 1997. The notes were repaid by surrendering to the Company approximately 56,000 shares of common stock.
In February 2000, an officer and director of the Company repaid two promissory notes plus accrued interest totaling $1,811,208 due to the Company related to stock purchase agreements entered into in December 1996 and March 1997. The notes were repaid by surrendering to the Company approximately 15,000 shares of common stock.
In February 2000, an officer and director of the Company was granted an option to purchase 1,000,000 shares of common stock at $31.69 per share, the closing price on the day prior to the grant, as an inducement to become an employee of the Company. This option becomes exercisable one-third upon the date of grant, one-third on the one-year anniversary and one third on the two-year anniversary of the date of grant.
PART III
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The response to this item is incorporated by reference from the discussion responsive thereto under the captions "Management" and "Compliance with Section 16(a) of the Securities Exchange Act of 1934" in the Company's Proxy Statement for its 2000 Annual Meeting of Stockholders.
ITEM 11.
ITEM 11. EXECUTION COMPENSATION
The response to this item is incorporated by reference from the discussion responsive thereto under the caption "Executive Compensation" in the Company's Proxy Statement for its 2000 Annual Meeting of Stockholders.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The response to this item is incorporated by reference from the discussion responsive thereto under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Company's Proxy Statement for its 2000 Annual Meeting of Stockholders.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The response to this item is incorporated by reference from the discussion responsive thereto under the caption "Certain Transactions" in the Company's Proxy Statement for its 2000 Annual Meeting of Stockholders.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) The Financial Statements and notes thereto included in Item 8 to this Form 10-K Report are incorporated herein by reference.
(a)(2) The schedules have been omitted because they are not applicable or are not required or the information required to be set forth therein is included in the Financial Statements or notes thereto.
(a)(3) Exhibits.
The following documents are filed as part of this annual report on Form 10-K. The Company will furnish a copy of any exhibit listed to requesting stockholders upon payment of the Company's reasonable expenses in furnishing those materials.
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One report on Form 8-K was filed on behalf of the Company during the last quarter of the year ended December 31, 1999 (Form 8-K filed on December 16, 1999).
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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, in the City of Sunnyvale, State of California, on the 17th day of March, 2000.
HYSEQ, INC.
By: /s/ LEWIS S. GRUBER ------------------------------------ Lewis S. Gruber President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities indicated on the 17th day of March, 2000.
EXHIBIT INDEX
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