ITEM 1. BUSINESS
GENERAL
Cohesion Technologies, Inc. was organized in June 1997 as a Delaware corporation and wholly owned subsidiary of Collagen Aesthetics, Inc., formerly known as Collagen Corporation. Collagen Aesthetics, Inc. is now known as McGhan Medical since Collagen was acquired by Inamed Corporation in the quarter ended September 30, 1999. In October 1997, Collagen announced that it would separate its Aesthetic Technologies Group and its Collagen Technologies Group ("CTG") into two independent, publicly-traded companies. Effective January 1, 1998, Collagen contributed its research and development programs for hemostatic devices, biosealants, orthopedics products and programs, adhesion barriers and recombinant human collagen and thrombin and other related businesses of CTG to Cohesion, including various equity investments. On August 18, 1998, Collagen distributed as a dividend to its stockholders, one share of our common stock for each share of Collagen common stock outstanding. Cohesion and Collagen entered into various intercompany agreements to provide for an orderly transition of matters and to govern certain ongoing matters between the two entities and provide a mechanism for transitioning license, supply, distribution, research and development, tax, service and other agreements in connection with the distribution.
Cohesion is focused on developing and commercializing proprietary surgical products, including bioresorbable hemostatic devices and biosealants for tissue repair and regeneration, which increase the effectiveness of, and minimize complications following, open and minimally invasive surgeries. CoStasis(R) Surgical Hemostat, our hemostatic product, is designed for use in cardiovascular, orthopedic and general surgery indications. We received European Community certification ("CE Mark") for CoStasis in fiscal 1999, and in June 2000, we received approval from the FDA to market CoStasis in the United States. We received CE Mark in February 2000 for CoSeal(TM) Surgical Sealant, our lead biosealant product candidate designed for sealing vascular grafts and other tissues, and are currently conducting clinical trials in the U.S. Our products and programs are based on a platform of proprietary technologies centered around collagen and hydrophilic polymers that quickly polymerize in vivo and bind to tissue. In addition, we have research and development programs in recombinant human collagen and thrombin.
PRODUCTS AND DEVELOPMENT PROGRAMS
Although we are currently selling CoStasis and marketing a line of collagen-based materials for research applications, which include Vitrogen, Cell Prime and other bulk collagen products (collectively "Intermediate Products"), most of our products are still under development. Most of these products under development are being designed to target the market for biosurgery, which includes at least two significant segments: hemostatic products, used to control bleeding, and surgical sealants, used to seal organs and tissues compromised by surgery or other trauma. During most surgical procedures, which entail damage to the vasculature and the compromise of normal tissue barriers, bleeding is inevitable, but the degree to which bleeding constitutes a threat to the well-
being of the patient depends on the degree of intervention and the tissues involved. The ability to control bleeding and the subsequent repair of tissues and systems containing fluids, such as the vasculature, heart, bladder and bowel, however, are essential, as the consequences of uncontrolled bleeding and fluid leakage can be catastrophic. In a typical cardiovascular surgical procedure, for example, the surgeon first attempts to control bleeding from major blood vessels, and the attendant pulsating blood loss, by tying off or cauterizing the vessels. However, it is typically more difficult to control diffuse bleeding from multiple veins and capillaries, which are too numerous to close individually. This diffuse bleeding is time-consuming to control with currently available products and limits the surgeon's ability to close the patient at the end of a procedure. Surgeons must also close wounds created by the trauma of surgery and seal the surgical site to prevent the leakage of fluids, air or waste. Effective sealing of organs and tissues during surgery is a critical factor in the ultimate success of a surgical procedure. Ineffective sealing can result in life-threatening complications such as blood loss and leakage of air or waste, higher levels of pain, prolonged hospitalization and a higher mortality rate. As a result of these considerations, surgeons have increasingly sought improved technologies for both bleeding control and tissue sealing.
COSTASIS SURGICAL HEMOSTAT
Cohesion's first surgical product is CoStasis Surgical Hemostat. CoStasis is a sprayable liquid hemostat designed for use in surgical procedures to control bleeding from capillaries and small veins. Composed of a sterile suspension of bovine fibrillar collagen and bovine thrombin in calcium chloride, CoStasis is applied to the bleeding site with the patient's plasma, incorporating the surgical advantages of collagen, fibrinogen and thrombin. The pre-mixed, ready-to-use collagen/thrombin suspension is supplied in one syringe and is mixed with the patient's own plasma from a second syringe at the time of administration to the bleeding site. The patient's plasma provides the source of fibrinogen that is cleaved by the thrombin to form a collagen-reinforced fibrin clot, which is hemostatic and adherent to the bleeding tissue.
The collagen component of CoStasis is derived from closed-herd cows, whose maintenance is overseen by McGhan and which constitute a source available to none of our competitors. The thrombin component is obtained from a biologically-licensed commercial source. The use of these components minimizes the possibility of allergic reactions associated with lower-purity bovine collagen or thrombin used in other products. In addition, both components come from manufacturing processes which reduce the potential for viral contamination, providing a further margin of safety. The pre-mixed nature of the collagen/thrombin components reduces preparation time compared to either lyophilized commercial fibrin sealants, which must be reconstituted before use, or other agents, which have complex preparation requirements.
In addition, we have developed a patented system, called the CellPaker(R) plasma collection device, which is designed to quickly and sterilely separate the patient's blood into plasma in the operating room for use in conjunction with CoStasis. The CellPaker is a single-use device, which is packaged separately from CoStasis, and which we believe makes it easy to obtain the patient's plasma upon entry into surgery. Unlike competitive products, which generally require a large amount of a patient's blood (or plasma from a pooled blood source) and have lengthy preparation times, CoStasis is designed to require a small amount of a patient's blood and has a relatively short preparation time of less than 10 minutes.
When applied to a bleeding surface, the CoStasis/plasma composite is designed to rapidly form a collagen/fibrin matrix which conforms to the tissue surface and is able to enter surface cracks and crevices. The hemostatic capacity of the collagen/fibrin gel is a combination of the effects of collagen, fibrin and thrombin in activation of the coagulation cascades and in presenting a physical barrier which exerts pressure on the site to stem blood flow. Preclinical studies have demonstrated that CoStasis acts significantly faster than traditional hemostatic sponges and commercial fibrin sealants in the control of bleeding from a variety of bleeding tissue sites. CoStasis also proved effective in controlling bleeding in animal models in which coagulation was compromised using heparin or aspirin. Controlled clinical trials demonstrated greater hemostatic performance of CoStasis versus hemostatic collagen sponges. We believe that these preclinical and clinical data indicate that CoStasis has the potential to be highly effective in the rapid control of diffuse bleeding from capillaries, venules, and arterioles under diverse conditions modeling clinical use and tissue conditions.
CoStasis has been used to control bleeding in cardiovascular, orthopedic and general surgery indications in clinical trials in the United States and Europe. In fiscal 1999, we received a CE Mark for CoStasis and began product introductions in Europe. We received approval from the FDA to market CoStasis in the United States in June 2000.
COSEAL SURGICAL SEALANT
Cohesion's second surgical product, currently under development, is CoSeal Surgical Sealant. Surgical repair necessitates the opening or puncturing of body cavities and the compromise of barriers that normally prevent fluid, solids and gas leakage in the body. This leakage ranges from a minor inconvenience to a life-threatening event and is especially burdensome in cardiothoracic, cardiovascular and abdominal surgery procedures. Currently, the surgeon is dependent on meticulous use of surgical staples and sutures to create a fluid- or gas-tight seal when repairing these tissues. In some cases, "home-brew" or commercial fibrin sealants are used to assist in achieving a dependable seal. While polymer-based hydrogels are an alternative to fibrin sealants, they are unable to covalently cross-link directly to the tissue surface at the surgical site and often require cumbersome processes, including light or energy activation, in order to seal the surgical site of application.
CoSeal Surgical Sealant uses two biocompatible liquids which polymerize in seconds at the site of application without the need for activating equipment and are absorbed by the body within weeks after the tissue has repaired. CoSeal is based on reactive derivatives of polyethylene glycol, also known as PEG, which has a history of safe use in other medical applications. These PEG-polymers are liquids of low viscosity and flow readily across the surfaces to be sealed. In seconds, they covalently cross-link with the patient's tissue over the treated surgical site to form a tightly bound matrix with excellent elasticity and strength. CoSeal is based on a completely synthetic, PEG-polymer platform technology, which avoids the need for any blood products or animal proteins, addressing concerns about transmission of infectious agents.
Some existing products and products in development use light or energy-activated polymers that require significant additional equipment in the surgical field and are difficult to use in minimally invasive surgery. CoSeal is a self-polymerizing device which does not require activating equipment. In consultation with our clinical advisers, we are also developing a variety of special delivery devices, which complement the designed flexibility in CoSeal, giving surgeons a variety of delivery tools for diverse applications. CoSeal has demonstrated ease of use and clinical effectiveness in sealing surgical sites in cardiovascular grafting procedures in animal models. Once CoSeal was applied, vascular grafts did not leak at anastomoses or puncture sites when treated. We received a CE Mark for CoSeal in February 2000 and expect to launch the product in Europe in September 2000. We are currently conducting clinical trials for CoSeal in the United States.
OTHER PRODUCT DEVELOPMENT PROGRAMS
Next Generation Surgical Sealant. We are developing a next generation sealant utilizing our proprietary PEG-polymer technology. The improved sealant is expected to be initially targeted towards skin and muscle flap procedures and eliminate the formation of seromas and hematomas at the surgical sites. As with our other products, existing and under development, this resorbable sealant will be designed to have a relatively short preparation time and to be easy to use.
Internal Adhesives. The internal adhesive program is currently focused on characterizing and developing candidate formulations for a biocompatible, self-polymerizing liquid, which would serve as the basis for an internal adhesive product having the strength to potentially replace or minimize the use of sutures and staples in surgeries.
Adhesion Prevention Barriers. We are also developing an adhesion-prevention barrier, based on our proprietary PEG-polymer technology which polymerize at the site of application and adhere to the tissue surface. Adhesion-prevention barriers are used to prevent the formation of debilitating or painful internal tissue adhesions (or scars) after surgery. The few products currently on the market suffer serious shortcomings, including low efficacy, high cost, difficult handling and ineffectiveness in the presence of blood. We believe our PEG-polymer technology will offer superior efficacy, greater ease-of-use and lower cost, relative to products on the market or known to be under development.
Recombinant Human Collagen and Thrombin. Our recombinant programs are focused on the development of recombinant human collagen and thrombin through transgenic animals and yeast. Our objective is to obtain commercially significant quantities of recombinant human type I collagen and thrombin to serve as an alternative to bovine collagen and thrombin in our products. We believe that by achieving this objective, we will be able to develop a wider range of innovative surgical products for tissue repair and regeneration. We have an equity investment in Pharming, B.V. of The Netherlands and are collaborating with them for the purpose of developing recombinant human collagen through transgenic animals.
ORTHOPEDICS
In February 1999, Cohesion formed a wholly-owned subsidiary, NeuColl, Inc., to commercialize products in the orthopedics field, which include Collagraft(R) Bone Graft Matrix ("Collagraft") and NeuVisc(TM), a collagen-based intra-articular implant for the treatment of pain related to osteoarthritis. During the quarter ended March 31, 2000, NeuColl obtained financing from a third party which reduced Cohesion's ownership to below 50%. As a result, NeuColl's operating results were no longer consolidated in Cohesion's financial results subsequent to March 31, 2000.
RESEARCH AND DEVELOPMENT
Our research and development efforts are directed at achieving continuing improvements in surgical products to achieve hemostasis, tissue sealing and adhesion prevention. We have identified opportunities in using only synthetic agents and recombinant proteins in product configurations and in achieving superior sealant properties with advanced hemostatic potential at the surgical site. In addition, future product development will utilize our proprietary technology platforms in the generation of tissue engineering products for tissue repair, regeneration and replacement. Research and development expenses for the years ended June 30, 2000, 1999 and 1998 were $12.4 million, $15.3 million, and $16.3 million, respectively.
The following table summarizes the status of our products and development programs. The column titled "Status" indicates product development status. "Preclinical" denotes formulation and efficacy studies in animal models necessary to support an application to commence human clinical testing. "Research" includes discovery, research, development of and subsequent identification of a candidate for preclinical studies. The regulatory approval process requires successful completion of many steps before a product is approved for commercialization. See " -- Government Regulation."
MANUFACTURING
We manufacture and package the final products for CoStasis and use outside contractors for other functions such as non-proprietary, high-volume processes. We anticipate that this will also be the case for CoSeal. We have approximately 6,000 square feet of manufacturing space in Palo Alto, California, which was constructed in fiscal 1999. There can be no assurance that we will be able to attract, hire, train and retain the required personnel or will be able to increase our manufacturing capability to manufacture commercial quantities of our planned products in a timely manner, or at all. Manufacturers often encounter difficulties in scaling up production of their products, including problems involving production yields, quality control and assurance, component supply and shortages of qualified personnel, and we may encounter similar problems. We can make no assurance that our manufacturing scale-up efforts will be successful or that high-volume manufacturing, if needed, can be established or maintained at commercially reasonable costs on a timely basis, if at all. Any of these factors could have a material adverse effect on our ability to develop and commercialize products, which in turn would have a material adverse effect on our business, financial condition and results of operations. See "-- Additional Factors that Might Affect Future Results."
Cohesion purchases raw materials used in its products from various suppliers. For example, we purchase all of our requirements for collagen materials from McGhan pursuant to the terms of the intercompany agreements entered into in connection with our spin-off from Collagen. These materials have generally been readily available in the marketplace and have not been the subject of shortages; however, Cohesion, its suppliers or contract manufacturers may experience material shortages in the future. The source of the collagen supplied by McGhan is bovine dermis. McGhan uses our patented viral inactivation process for its collagen-based products to promote both safety and quality. Since 1987, Collagen, now McGhan Medical, has sourced the bovine dermis from a "closed herd" of cattle in an effort to prevent diseases, such as Bovine Spongiform Encephalopathy, or BSE, a disease commonly known as mad cow disease, from contaminating its collagen-based products. Maintaining a closed herd requires the physical separation of the herd from other herds, the tracking of the lineage of each animal and the maintenance of each animal under a veterinary program. In the event of any material diminution in the size of the herd for any reason, including accident or disease, McGhan would have a limited ability to quickly increase its supply of acceptable cattle. Any such diminution would have a material adverse effect on our ability to sell bovine collagen-based products and, as a result, our results of operations would be materially and adversely affected. Cohesion may also purchase PEG from a sole supplier. The PEG material is a key raw material component used in our CoSeal product. Any future shortages of materials or components could have a material adverse effect on our business, financial condition and results of operations. In addition, there can be no assurance that materials and components can be obtained at attractive prices in the future. Pursuant to the intercompany agreements, McGhan supplies our requirements for CoStasis and Intermediate Products.
Cohesion, as well as any third-party manufacturers of its products, will be subject to inspections by the FDA for compliance with applicable good manufacturing practices ("GMP"), codified in the quality system regulation ("QSR") requirements, which include requirements relating to manufacturing conditions, extensive testing, control documentation and other quality assurance procedures. Our facilities have undergone an ISO inspection, in preparation for obtaining a CE Mark on our products, in addition to annual renewal inspections. Despite these efforts, we may not be able to obtain all necessary FDA inspections of our facility in a timely fashion, if at all. Cohesion has not yet undergone an FDA quality system regulation inspection. See "-- Government Regulation."
SALES, MARKETING AND DISTRIBUTION
In November 1999, we entered into an agreement with U.S. Surgical for the marketing and distribution of CoStasis. The U.S. Surgical territories include the United States, European Union, Eastern Europe, Latin America, Middle East, Australia, New Zealand, and India. CoStasis is also distributed in certain European countries through geographically-focused, specialty distributors with existing customer relationships and established sales infrastructures. We face significant sales and marketing challenges in Europe, which is a market that is and has been very entrenched with using a fibrin sealant product for many years. Our sales, marketing and distribution plans will be dependent in part on our ability to enter into successful strategic relationships and hire, train and retain specialized sales, marketing and distribution personnel. There can be no assurance that we will be able to secure such strategic relationships or hire, train or retain such specialized personnel on terms that are attractive and acceptable to Cohesion, if at all.
While sales of Collagraft bone graft products in fiscal years 2000, 1999 and 1998, totaled $1.2 million, $1.9 million and $1.5 million, respectively, we will no longer reflect such sales in our future financial results as our ownership in NeuColl fell below 50% in March 2000. Sales of our collagen-based materials for research applications, which include Vitrogen, Cell Prime, and other bulk collagen products, were not material in fiscal 2000, 1999 and 1998. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and " -- Government Regulation."
COMPETITION
We compete with many domestic and foreign medical device, pharmaceutical and biopharmaceutical companies and organizations across each of our product categories and areas in which we are conducting research and development activities. Many of these companies and organizations have or will have substantially greater financial, technological, research and development, regulatory and clinical, marketing, sales and personnel resources than we do. They may also have greater experience in developing products, conducting clinical trials, obtaining regulatory approvals, and manufacturing and marketing such products. They may also develop alternative technologies and products that are more effective, easier to use or more economical than those which have been or are being developed by us or that render our technology and products obsolete and non-competitive. Recently developed technologies or procedures are, or may in the future be, the basis of competitive products. There can be no assurance that our current competitors or other parties will not succeed in developing alternative technologies and products that are more effective, easier to use or more economical than those which we have been or are developing or that would render our technology and products obsolete or uncompetitive. In such an event, our business, financial condition and results of operations would be materially and adversely affected. Competitors may also obtain approval or clearance by the FDA or foreign regulatory approval organizations, achieve product commercialization or obtain patent protection earlier than we do. Additionally, there can be no assurance that any marketing or other strategic partners that we may engage will not pursue parallel development of technologies or products relating to or competitive with our planned product portfolio. Also, to the extent we commence manufacturing activities, we will also face competition with respect to manufacturing efficiency and marketing capabilities, areas in which we currently have limited experience. Failure to address the foregoing factors and circumstances could have a material adverse impact on us, our financial condition and results of operations.
Hemostatic and Biosealant Devices. In the hemostatic and biosealant areas, we believe we face strong competition in the United States from existing methodologies for controlling bleeding and sealing wounds resulting from surgery. This competition results from hemostatic powders and sponges, as well as from collagen-based hemostats and traditional sutures and staples marketed by companies such as Johnson & Johnson, Tyco Healthcare Group and American Home Products Corporation. In addition, Baxter Healthcare Corporation obtained FDA approval for a fibrin sealant product. We also face competition from more recent products and technologies, such as those developed by Fusion Medical Technologies, Inc. and Focal, Inc. Outside of the United States, other competitive products currently being marketed include fibrin sealants and cyanoacrylates, another class of sealants, which are sold in Europe and the Pacific Rim countries by Immuno AG, Centeon L.L.C and Cryolife. In the United States, there are several fibrin sealants under development, including those by the American Red Cross, Convatec, a subsidiary of Bristol-Myers Squibb Company, and Haemacure Corporation. In addition to conventional fibrin sealants, there are a number of other products in late-stage development using cyanoacrylates or either collagen or polymer technologies, made by Fusion and Focal.
We plan to develop a second-generation surgical sealant which eliminates the need to collect and process plasma at the time of surgery by utilizing our PEG polymer technology and which will offer surgeons strong, easy-to-apply sealing in sensitive open and endoscopic surgery situations. Cohesion plans to ultimately seek additional indications in general surgery, urology and neurosurgery. We believe that the second-generation biosealants we currently have under development will largely supersede fibrin sealants in adhesive applications and that patch or membrane products will likely remain niche products compared to liquid and gel formulations, because patch products are generally more difficult to handle and apply than a liquid or gel, especially in minimally invasive surgery. Most second-generation products under development are still in the preclinical stage in the United States and overseas, with the exception of those being developed by Focal, which is marketing its FocalSeal photoactivated polymer hydrogel outside of the United States with Ethicon, Inc., a Johnson & Johnson subsidiary, and in the United States with Genzyme Surgical Products, and BioGlue, which is sold by Cryolife.
INTELLECTUAL PROPERTY
Collagen and Cohesion entered into an Assignment and License Agreement, effective January 1, 1998, which, among other things, allocated Collagen's technology and intellectual property between Cohesion and Collagen. Pursuant to this agreement, substantially all of Collagen's technology and intellectual property (including patents, copyrights, trademarks, and trade secrets), other than technology relating to the breast implant technology, was assigned to Cohesion, and Cohesion has granted back to Collagen an exclusive, worldwide, perpetual, fully-paid license to such assigned technology and intellectual property that is used solely in the field of Collagen's business, which consists of the development, manufacture, use, sale and other commercialization of human aesthetics products, technologies and treatments, breast implant products and processes, urinary incontinence products and treatments and ostomy products. The Assignment and License Agreement provides that Cohesion and Collagen, now McGhan Medical, may obtain certain rights to improvements made by the other company prior to March 15, 2004, inasmuch as such improvements, if any, are in the applicable party's field of business. In addition, under the Assignment and License Agreement, Cohesion and Collagen have covenanted to not compete with each other's business until March 15, 2004.
As of September 2000, our patent portfolio includes approximately 157 U.S. and foreign issued patents and approximately 70 U.S. and non-U.S. patents pending. These patents cover novel compositions of a variety of biomaterials and uses in various fields of medicine. The patent portfolio has a strong focus on proprietary technology in the fields of collagen compositions and hydrophilic polymers used for in situ polymerization. We also hold several registered trademarks in the United States and a number of foreign countries and pursue the protection of our trademarks and service marks, whether or not such marks are registered. Notwithstanding these measures, we can make no assurance as to the effectiveness of our efforts and many of the older patents covering collagen-containing compositions have already begun to expire. However, the majority of the patent portfolio covers biomaterials that are tailored for use in a particular manner, and these patents will not expire until well into the next decade. In addition, we have a number of more recently issued patents covering various methods of treatment using specific formulations of biomaterials that will not expire for approximately 10 or more years. We have filed patent applications covering tissue adhesives, biosealants, and adhesion prevention agents; however, we can make no assurance that any such patents will issue, will provide us any competitive advantages or will not be challenged by third parties.
We also rely upon trade secret protection for certain unpatented aspects of our proprietary technology. There can be no assurance that others will not independently develop or otherwise acquire substantially equivalent proprietary information or techniques, that others will not otherwise gain access to our proprietary technology or disclose such technology, or that we can meaningfully protect our trade secrets. We require our employees and consultants to execute appropriate confidentiality and proprietary information agreements upon the commencement of an employment or consulting relationship with us. These agreements generally provide that all confidential information developed or made known to the individual by us during the course of the individual's relationship with us is to be kept confidential and not disclosed to third parties, except in specific circumstances. The agreements also generally provide that all inventions conceived by the individual in the course of rendering services to Cohesion shall be the exclusive property of Cohesion; however, certain of Cohesion's agreements with consultants, who typically are employed on a full-time basis by academic institutions or hospitals, do not contain assignment of invention provisions. There can be no assurance that these agreements will provide meaningful protection or adequate remedies for us in the event of unauthorized use, transfer or disclosure of such information or inventions.
Our success will depend on our ability to obtain patent protection for our products, preserve our trade secrets, prevent third parties from infringing upon our proprietary rights, and operate without infringing upon the proprietary rights of others, both in the United States and internationally. There can be no assurance that our pending or future patent applications will issue, or that the claims of our issued patents, or any patents that may issue in the future, will provide any competitive advantages for our products or that they will not be successfully challenged, narrowed, invalidated or circumvented in the future. Moreover, litigation and interference or opposition proceedings associated with obtaining, enforcing or defending patents or trade secrets is expensive and can divert the efforts of technical and management personnel. We have filed patent applications in certain foreign countries corresponding to certain patent applications that we have filed in the United States and may file additional patent applications inside and outside the United States. We believe that obtaining foreign patents may be more difficult than obtaining domestic patents because of differences in patent laws and believe the protection afforded by foreign patents or any other foreign intellectual property protection, if obtained, may be more limited than that provided domestically. In addition, there can be no assurance that competitors will not seek to apply for
and obtain patents that will prevent, limit or interfere with our ability to make, use, offer for sale, sell and import our products. We are aware that certain medical device, pharmaceutical and other companies, universities and research institutions have filed patent applications or have issued patents relating to compositions and methods for wound closure and adhesion prevention. In addition, the medical device and pharmaceutical industries have been characterized by litigation regarding patents and other intellectual property rights, and many companies in the medical device industry have employed intellectual property litigation to gain a competitive advantage. There can be no assurance that litigation will not be brought against us by third parties in the future challenging our patent rights or claiming infringement by us of patents held by these or other third parties.
Because of the substantial length of time and expense associated with bringing new products through the development and regulatory approval processes in order to reach the marketplace, the medical products industry places considerable importance on obtaining patent and trade secret protection for new technologies, products and processes. While we intend to seek patent protection for our proprietary technology, products and processes, there can be no assurance as to the success or timeliness in obtaining any such patents, that the breadth of claims obtained, if any, will provide adequate protection of our proprietary technologies, products and processes, or that we will be able to adequately enforce any such claims to protect its proprietary technology, products and processes. Because patent applications in the United States are confidential until the patents issue, and publication of discoveries in the scientific and patent literature tends to lag behind actual discoveries by several months, we cannot be certain that our inventors or licensors were the first to conceive of inventions covered by pending patent applications or that we were the first to file patent applications for such inventions. We may desire or may be required to obtain licenses to patents or proprietary rights of others. No assurance can be given that any licenses required under any patents or proprietary rights of third parties would be made available on terms acceptable to us or at all. If we do not obtain such licenses, we could encounter delays in product introductions while it attempts to design around or otherwise avoid such patents, or it could find that the development, manufacture or sale of products requiring such licenses is foreclosed.
Litigation may be necessary to defend against or assert claims of patent infringement or invalidity, to enforce or defend patents issued to us, to protect trade secrets or know-how owned by us, or to determine the scope and validity of the proprietary rights of others. In addition, interference proceedings in the U.S. Patent and Trademark Office, or opposition proceedings in a foreign patent office, may be necessary to determine the priority of inventions with respect to our patent applications or patent applications of our licensors. Litigation, interference or opposition proceedings could result in substantial costs to and diversion of effort by us, and adverse determinations in any such proceedings could prevent us from manufacturing, marketing or selling our products and could have a material adverse effect on our business, financial condition and results of operations.
We also rely upon unpatented trade secrets and improvements, unpatented know-how and continuing technological innovation to develop and maintain our competitive position, which we seek to protect, in part, by confidentiality agreements with collaborative partners, vendors, suppliers, employees and consultants. We also have invention or patent assignment agreements with our employees and certain, but not all, commercial partners and consultants. There can be no assurance that relevant inventions will not be developed by a person not bound by an invention assignment agreement. There can be no assurance that binding agreements will not be breached, that we would have adequate remedies for any breach, or that our trade secrets will not otherwise become known or be independently discovered by competitors.
GOVERNMENT REGULATION
Our existing and proposed products, research and development and planned commercialization activities are subject to regulation by numerous governmental authorities, principally the FDA and corresponding state and foreign regulatory agencies. The Federal Food, Drug and Cosmetic Act, as amended (the "FDC Act"), the regulations promulgated thereunder, and other federal and state statutes and regulations, govern, among other things, the preclinical and clinical testing, manufacturing conditions, device safety, efficacy, labeling and storage, record keeping, advertising and the promotion of medical devices and drugs. Product development and approval within this regulatory framework takes a number of years and involves the expenditure of substantial resources.
Additionally, in order for us to market our products in Europe and other foreign countries, we and/or our partners, if any, must obtain required regulatory approvals and comply with extensive regulations governing safety, quality and manufacturing processes. These regulations vary significantly from country to country. The
time required to obtain approval to market our products outside the United States may be longer or shorter than that required in the United States. In order to market our products being developed in the member countries of the European Union, we will be required to obtain CE Mark certification. CE Mark certification is an international symbol of adherence to quality assurance standards and compliance with applicable European medical device directives. As part of the CE Mark certification process, we completed a successful quality systems audit to the ISO 9001/EN46001 and Medical Devices Directive requirements, one of the principal steps in the CE Mark process. In addition to a quality system audit, the CE Mark process involves review by the approving body of documentation submitted by us to document each product's clinical safety and performance.
In the United States, medical devices are classified into three different classes (Class I, Class II and Class III) on the basis of controls deemed necessary to reasonably ensure the safety and effectiveness of the device. Class I devices are subject to general controls relating to labeling, premarket notification and adherence to the FDA's good manufacturing practices, as codified in the quality system regulation requirements. Class II devices are subject to general and special controls relating to performance standards, postmarket surveillance, patient registries, and FDA guidelines. Class III devices are those which must receive premarket approval by the FDA to ensure their safety and effectiveness. Class III devices are generally life-sustaining, life-supporting and implantable devices, or new devices which have been found not to be substantially equivalent to legally marketed devices. Before a new medical device can be marketed, marketing clearance must be obtained through a premarket notification under Section 510(k) of the FDC Act or a premarket approval ("PMA") application under Section 515 of the FDC Act. A 510(k) clearance will typically be granted by the FDA if it can be established that the device is substantially equivalent to a "predicate device," which is a legally marketed Class I or Class II device or a preamendment Class III device (i.e., one that has been marketed since a date prior to May 28, 1976) for which the FDA has not called for PMAs. The FDA has been requiring an increasingly rigorous demonstration of substantial equivalence and this demonstration may include a requirement to submit human clinical trial data. It generally takes four to 12 months from the date of a 510(k) submission to obtain clearance, but it may take longer. The FDA may determine that a medical device is not substantially equivalent to a predicate device, or that additional information is needed before a substantial equivalence determination can be made. A "not substantially equivalent" determination, or a request for additional information, could prevent or delay the market introduction of new products that fall into this category. For any devices that are cleared through the 510(k) process, modifications or enhancements that could significantly affect the safety or effectiveness, or that constitute a major change in the intended use of the device, will require new 510(k) submissions.
A PMA application must be filed if a proposed device is not substantially equivalent to a legally marketed Class I or Class II device, or if it is a preamendment Class III device for which the FDA has called for PMAs. A PMA application must be supported by valid scientific evidence to demonstrate the safety and effectiveness of the device, typically including the results of clinical trials, bench tests, and laboratory and animal studies. The PMA must also contain a complete description of the device and its components, and a detailed description of the methods, facilities and controls used to manufacture the device. In addition, the submission includes the proposed labeling, advertising literature and any training materials. The PMA application can be expensive, uncertain and lengthy, and a number of devices for which FDA approval has been sought by other companies have never been approved for marketing. Upon receipt of a PMA application, the FDA makes a threshold determination as to whether the application is sufficiently complete to permit a substantive review. If the FDA determines that the PMA application is sufficiently complete to permit a substantive review, the FDA will accept the application for filing. Once the submission is accepted for filing, the FDA begins an in-depth review of the PMA application. The FDA review of a PMA application generally takes one to three years from the date the PMA application is accepted for filing, but may take significantly longer. The review time is often significantly extended by the FDA asking for more information or clarification of information already provided in the submission. During the review period, an advisory committee, typically a panel of clinicians and others knowledgeable in the applicable field, may be convened to review and evaluate the application and provide a recommendation to the FDA as to whether the device should be approved. The FDA accords substantial weight to the recommendation but is not bound by it. Toward the end of the PMA application review process, the FDA generally will conduct an inspection of the manufacturer's facilities to ensure compliance with applicable QSR requirements, which include extensive requirements relating to product design, manufacturing processes, testing, control documentation and other quality assurance procedures.
If the FDA evaluations of both the PMA application and the manufacturing facilities are favorable, the FDA may issue either an approval letter or an approvable letter, which usually contains a number of conditions that must be met in order to secure final approval of the PMA application. When, and if, those conditions have been fulfilled to the satisfaction of the FDA, the FDA will issue a PMA letter, authorizing marketing of the device for certain indications. If the FDA's evaluation of the PMA application or manufacturing facilities is not favorable, the FDA will deny approval of the PMA application or issue a "non-approvable" letter. The FDA may determine that additional clinical trials are necessary, in which case the PMA application may be delayed for one or more years while additional clinical trials are conducted and submitted in an amendment to the PMA application. Modifications to a device that is the subject of an approved PMA application, its labeling or manufacturing process may require approval by the FDA of PMA supplements or new PMA applications. Supplements to a PMA application often require the submission of the same type of information required for an initial PMA application, except that the supplement is generally limited to that information needed to support the proposed change from the product covered by the original PMA application.
If human clinical trials of a device are required, either for a 510(k) premarket notification or a PMA application, and the device presents a "significant risk," the sponsor of the trial must file an investigational device exemption, or IDE, application prior to commencing human clinical trials. The IDE application must be supported by data, typically including the results of animal and laboratory testing. If the IDE application is approved by the FDA and one or more appropriate Institutional Review Boards, human clinical trials may begin at a specific number of investigational sites with a specific number of patients, as approved by the FDA. If the device presents a "nonsignificant risk" to the patient, a sponsor may begin the clinical trial after obtaining approval for the study by one or more appropriate Institutional Review Boards ("IRBs"), without the need for FDA review. Submission of an IDE provides no assurance that the FDA will approve the IDE. Even if the IDE is approved, there can be no assurance that the FDA will determine that the data derived from the studies support the safety and efficacy of the device or warrant the continuation of clinical studies. Sponsors of clinical trials are permitted to sell investigational devices distributed in the course of the study, provided such compensation does not exceed recovery of the costs of manufacture, research, development and handling. An IDE supplement must be submitted to and approved by the FDA before a sponsor or investigator may make a change to the investigational plan that may affect its scientific soundness or the rights, safety or welfare of human subjects.
We anticipate that our products currently in development will be regulated as Class III medical devices and will require PMA prior to being marketed in the United States. If this belief is true, we will need to obtain for each of our products in development an IDE in order to conduct clinical trials in the United States. There can be no assurance that we will receive Class III medical device designation for our products in development or that we will be able to obtain IDEs for each of our planned products or that data from such clinical studies if and when commenced will demonstrate the safety and effectiveness of our product or will adequately support a PMA application.
If clearance or approval for a given product is obtained, such product will be subject to pervasive and continuing regulation by the FDA. For example, we will be subject to routine inspection by the FDA and will have to comply with the host of regulatory requirements that usually apply to medical devices marketed in the United States, such as labeling regulations, applicable QSR requirements, the Medical Device Reporting regulations (which require a manufacturer to report to the FDA certain types of adverse events involving its products), and the FDA prohibitions against promoting products for unapproved or "off-label" uses. Any failure by us to comply with applicable regulatory requirements could result in the detention or seizure of products, issuance of an enjoinment of future product activities and the assessment of civil and criminal penalties against the company, its officers and its employees. Failure to comply with the regulatory requirements could have a material adverse effect on our business, financial condition and results of operations. In addition, regulations regarding the manufacture and sale of our products are subject to change. We cannot predict the effect, if any, that such changes might have on our prospects, business, financial condition or results of operations.
In November 1997, the President of the United States signed into law the FDA Modernization Act of 1997. This legislation makes changes to the device provisions of the FDC Act and other provisions in the FDC Act affecting the regulation of devices. Among other things, the changes will affect the IDE, 510(k) and PMA processes, and also will affect device standards and data requirements, procedures relating to humanitarian and breakthrough devices, tracking and postmarket surveillance, accredited third party review, and the dissemination of off-label information. Cohesion cannot predict how or when these changes will be implemented or what effect the changes will have on the regulation of the company's products.
Although we anticipate that our products in development will be classified by the FDA as medical devices, in the event that a given product is classified by the FDA as a drug, it will require FDA approval of a new drug application, or NDA, prior to commercialization in the United States. The NDA process is generally more onerous, costly and lengthy than the PMA process, often requiring more extensive preclinical and clinical testing. Many products for which NDAs have been submitted by other companies have never been approved for marketing. Before clinical studies of a new drug can begin, an investigational new drug application, or IND, must be submitted to the FDA. FDA regulations provide that human clinical trials may begin 30 days following submission of an IND application, unless the FDA advises otherwise or requests additional information, clarification or additional time to review the application. An IND application contains extensive preclinical data and information about the drug. There can be no assurance that Cohesion will develop sufficient data and information to submit an IND for its products or that such data and information if submitted, would be sufficient for the purposes of commencing clinical studies of the products. Delays in the receipt of or failure to obtain FDA authorization to begin or continue clinical trials could have a material adverse effect on our business, financial condition or results of operations.
The FDA regulates the manufacturing, product testing and marketing of both medical devices and drugs. Manufacturers of drugs are required to comply with applicable GMP and, in the case of medical devices, QSR requirements, which include requirements relating to product design, manufacturing processes, product testing, and quality assurance, as well as the corresponding maintenance of records and documentation. There is no assurance that Cohesion will be able to comply with the applicable QSR requirements. In addition, we are required to provide information to the FDA on death or serious injuries alleged to have been associated with the use of its medical devices, as well as product malfunctions that would likely cause or contribute to death or serious injury if the malfunction were to recur. Failure to comply with QSR regulations, or other FDA regulatory requirements, could have a material adverse effect on the Cohesion's business, financial condition or results of operations.
We received approval from the FDA in June 2000 to market CoStasis in the United States. With respect to CoSeal, we believe that the product will be regulated by the FDA as a medical device because similar biosealant products of other manufacturers have been classified and regulated as medical devices by the FDA. We received a CE Mark for CoSeal in February 2000 and are currently conducting clinical trials in the United States and expect to seek marketing clearance at the conclusion of those studies by filing a PMA application with the FDA. There can be no assurance that the FDA will agree that the clinical study results, once submitted, will have adequately demonstrated the safety and effectiveness of CoSeal.
The collagen used in our products is derived from the cow hides of United States cattle. Bovine Spongiform Encephalopathy, or BSE, was initially reported in cattle in the United Kingdom, characterized by degenerative lesions of the central nervous system. The source of infections in animals derives from eating infected sheep-derived feed. While the disease has been reported in European countries, we are not aware of any reports of BSE in United States cattle to date, and, currently we rely on a "closed herd" of United States cattle for our bovine collagen-based products. There can be no assurance that the various foreign or domestic regulatory authorities will not raise issues regarding BSE or other matters which may adversely affect our ability to manufacture, market or sell our bovine collagen-based products, which could have a material and adverse effect on our business, financial condition and results of operations.
THIRD PARTY REIMBURSEMENT
Reimbursement and health care payment systems in international markets vary significantly by country. In connection with international product introductions, Cohesion and any future strategic marketing partners may be required to seek international reimbursement approvals. If required, there can be no assurance that any such approvals will be obtained in a timely manner, or at all, and failure to receive such international reimbursement approvals could have an adverse effect on market acceptance of our products in the international markets in which such approvals are sought.
In the United States, health care providers, such as hospitals and physicians, which purchase medical devices such as Cohesion's products, generally rely on third-party payors, principally federal Medicare, state Medicaid and private health insurance plans, to reimburse all or part of the cost of surgical procedures. Cohesion anticipates that in a prospective payment system, such as the diagnostic-related group system utilized by Medicare, and in many managed care systems used by private health care payors, there will be no separate,
additional reimbursement for our products and therefore no assurance that reimbursement for Cohesion's products will be available. Accordingly, we believe that there will be no procedure-specific reimbursement codes for our products and therefore no assurance that reimbursement for Cohesion's products will be available in the United States or in international markets under either governmental or private reimbursement systems. Furthermore, Cohesion could be adversely affected by changes in reimbursement policies of governmental or private health care payors. Failure by physicians, hospitals and other users of Cohesion's products to obtain sufficient reimbursement from health care payors for procedures in which our products are used or adverse changes in governmental and private third party payors' policies toward reimbursement for such procedures would have a material adverse effect on our business, financial condition and results of operations. Cohesion's business may also be materially and adversely affected by the continuing efforts of government and third-party payors to contain or reduce the costs of health care through various means.
PRODUCT LIABILITY AND INSURANCE
The development, manufacture and sale of our products may expose us to product liability claims. To date, we have not been held liable for a products liability claim asserted against us. However, there can be no assurance that we will not experience losses due to product liability claims in the future. Although we currently have general liability insurance and product liability insurance, there can be no assurance that such coverage will be available to us in the future on reasonable terms, if at all. In addition, there can be no assurance that all of the activities encompassed within our business are or will be covered under our policies. We may require additional product liability coverage if we significantly expand commercialization of our products. Such additional coverage is expensive, difficult to obtain and may not be available in the future on acceptable terms, if at all. Any claims or series of claims against us, regardless of their merit or eventual outcome, could have a material adverse effect on our business, financial condition and results of operations.
ADDITIONAL FACTORS THAT MIGHT AFFECT FUTURE RESULTS
We have a history of operating losses and anticipate continued operating losses.
Prior to July 1, 1998, our historical results of operations discussed in this Annual Report, and contained in the financial statements and related notes included in this Annual Report, reflect the historical operations of the transferred businesses contributed by Collagen (now McGhan Medical) to Cohesion. The financial statements, prior to July 1, 1998, may not necessarily reflect the results of operations, financial position and cash flows of the transferred businesses had Cohesion been operated as an independent entity during the periods presented. The transferred businesses incurred operating losses in each of the past five years, including operating losses of $21.2 million, $24.9 million and $31.5 million in fiscal 2000, 1999 and 1998, respectively. Cohesion's operating losses have resulted primarily from expenses incurred in connection with research and development activities, including preclinical and clinical trials, development of manufacturing processes and general and administrative expenses, and we expect that such expenses will continue to increase for the foreseeable future. While we had sales of Collagraft bone products of $1.2 million, $1.9 million, and $1.5 million for the years ended June 30, 2000, 1999, and 1998, respectively, we will no longer reflect those product sales in future financial results as our interest in NeuColl fell below 50% in March 2000. Our ability to achieve and sustain operating profitability is highly dependent upon obtaining in a timely and efficient fashion, regulatory approval for and successfully commercializing and marketing our products in development, particularly CoSeal Surgical Sealant and developing sales and marketing capabilities for our products, both in Europe, the United States and other markets. There can be no assurance that we will obtain required regulatory approvals in a timely fashion, if at all, or successfully develop, manufacture, commercialize and market products or that we will ever record significant product revenues or achieve operating profitability.
We must develop and commercialize our products to generate revenues.
Except for CoStasis, CoSeal in Europe, and our line of Intermediate Products, all of our products are in research or preclinical or clinical development. The development and commercialization of new products is highly uncertain, as is the timing associated with these activities. Among other things, potential products that may appear to be promising may not reach the market for a number of reasons, including the possibilities that the potential products will be found to be ineffective or to cause harmful side effects during preclinical testing or
clinical trials, will fail to receive necessary regulatory approvals, will be difficult to manufacture on a commercial scale, will be uneconomical, will fail to achieve market acceptance or will be precluded from commercialization by the proprietary rights of third parties. We cannot assure you that any of our development programs will be successfully completed, that clinical trials will generate anticipated results or will commence or be completed as planned. Additionally, we cannot assure you that we will be able to obtain CE Marks in Europe, on a timely basis, if at all, or that any PMA application will be accepted or ultimately approved by the FDA on a timely basis, if at all, or that any products for which approval is obtained will be commercially successful. If any of our development programs are not successfully completed in a timely fashion, required regulatory approvals are not obtained in a timely fashion, or products for which approvals are obtained are not commercially successful, our business, financial condition and results of operations will be materially and adversely affected.
We operate in an intense competitive environment.
We compete with many domestic and foreign medical device, pharmaceutical and biopharmaceutical companies and organizations across each of our product categories and areas in which we are conducting research and development activities. In the hemostatic and biosealant areas, we believe in the United States that we will face strong competition from existing methodologies for controlling bleeding and sealing wounds resulting from surgery, such as hemostatic powders and sponges, collagen-based hemostats and traditional sutures and staples marketed by companies such as Johnson & Johnson, Tyco Healthcare Group and American Home Products Corporation. In addition, a fibrin sealant product is currently being marketed by Baxter Healthcare Corporation. Cohesion faces competition from more recent products and technologies, such as those developed by Focal, Inc. and Fusion Medical Technologies, Inc. Outside of the United States, other competitive products currently being marketed include fibrin sealants and another class of sealants, cyanoacrylates, which are sold in Europe and the Pacific Rim countries by Immuno AG, Centeon L.L.C. and Cryolife. In the United States, there are several fibrin sealants under development including those by the American Red Cross, Convatec, a subsidiary of the Bristol-Myers Squibb Company, and Haemacure Corporation. In addition to conventional fibrin sealants, there are a number of other products in late-stage development using either collagen or polymer technologies, made by Focal and Fusion, as well as cyanoacrylates. Additionally, several companies and institutions are engaged in the development of collagen-based materials, techniques, procedures and products for use in medical applications we anticipate addressing with our current and proposed products and research programs.
Many of these companies and organizations have or will have substantially greater financial, technological, research and development, regulatory and clinical, marketing and sales and personnel resources than we do. They may also have greater experience in developing products, conducting clinical trials, obtaining regulatory approvals, and manufacturing and marketing such products. They may also develop alternative technologies and products that are more effective, easier to use or more economical than those which have been or are being developed by us or that render our technology and products obsolete and non-competitive. Recently developed technologies or procedures are, or may in the future be, the basis of competitive products. There can be no assurance that our current competitors or other parties will not succeed in developing alternative technologies and products that are more effective, easier to use or more economical than those which have been or are being developed by us or that would render our technology and products obsolete and uncompetitive. In such an event, our business, financial condition and results of operations would be materially and adversely affected. Competitors may also obtain approval or clearance by the FDA or foreign regulatory approval organizations, achieve product commercialization or obtain patent protection earlier than Cohesion. Additionally, there can be no assurance that any marketing or other strategic partners that Cohesion may engage will not pursue parallel development of technologies or products relating to or competitive with our planned product portfolio. Also, to the extent Cohesion commences manufacturing activities, we will also face competition with respect to manufacturing efficiency and marketing capabilities, areas in which we currently have limited experience. Failure to successfully address these factors and circumstances could have a material adverse impact on Cohesion, its financial condition and results of operations. See "Business -- Competition;" and "Business -- Manufacturing."
The market may not accept our products.
CoStasis Surgical Hemostat is a device designed to control diffuse capillary and small vein bleeding, and CoSeal Surgical Sealant is a device designed to seal anastomoses and sites of incision, in connection with surgery. There can be no assurance that either of these products will gain commercial acceptance among physicians, patients and health care payors, even when and if necessary international and U.S. marketing approvals are obtained. We believe that recommendations and endorsements by physicians will be essential for market acceptance of our surgical products, and there can be no assurance that any such recommendations or endorsements will be obtained. We believe that surgeons will not use our products unless they determine, based on clinical data and other factors, that the products are an effective means of controlling bleeding and sealing anastomoses and sites of incision, and that the clinical benefits to the patient and cost savings achieved through use of these systems outweigh their cost. Acceptance among physicians may also depend upon our ability to train surgeons and other potential users of our products in the application of sprayable surgical products, which they typically have not used, and the willingness of such users to learn these new techniques. Additional factors in achieving market acceptance may include our ability to address competition from U.S. and international medical device, pharmaceutical and biopharmaceutical companies, to develop a marketing and sales force, to form strategic partnerships and to manufacture cost-effective products. Failure of our products to achieve significant market acceptance will have a material adverse effect on our business, financial condition and results of operations.
We have limited marketing and sales capabilities.
We currently have limited experience in marketing and selling our products, including those under development, and we do not have a significant marketing and sales staff. In order to achieve commercial success for any product approved by the FDA, we must either develop a marketing and sales force or enter into arrangements with third parties to market and sell our products. If we develop our own marketing and sales capabilities, we will be competing with other companies that currently have experienced and well-funded marketing and sales operations. To the extent that we enter into co-promotion or other marketing and sales arrangements with other companies, any revenues we receive will be dependent on the efforts of others, and there can be no assurance that such efforts will be successful. Failure to develop a sales and marketing force or enter into arrangements with other companies will reduce our ability to generate revenues.
We depend on the sale of equity investments to fund operations.
The market prices of our equity investments are highly volatile. In connection with our spin-off from Collagen, Collagen transferred to Cohesion, effective January 1, 1998, all of its equity interest in Boston Scientific and other investments. We have implemented a "hedge" strategy based on purchases of put options and sales of call options in combination, commonly known as an "equity collar," covering approximately 48% of our Boston Scientific holdings. While the strategy is designed to minimize downside risk of loss should the stock price decline below approximately $22.00 and allow for limited upside participation should the stock price rise above approximately $49.00, there can be no assurance that we will be able to sell any of the remaining unhedged shares of Boston Scientific common stock at attractive prices if, when and as needed. See "Management's Discussion and Analysis of Financial Condition and Results of Operations."
EMPLOYEES
As of September 15, 2000, we had 77 employees, 33 of whom were engaged directly in research and new product development, 8 in regulatory affairs, quality assurance and clinical activities, 15 in manufacturing, 4 in sales and marketing and 17 in finance and administration. We maintain compensation, benefits, equity participation and work environment policies intended to assist in attracting, hiring and retaining qualified personnel. We believe the success of our business will depend, in significant part, on our ability to attract, hire and retain such personnel. None of our employees are represented by a collective bargaining agreement, nor have we experienced any work stoppage. We consider relations with our employees to be good.
EXECUTIVE OFFICERS
Set forth below is certain information as of September 15, 2000 with respect to our executive officers.
David Foster, Chief Executive Officer and Director. Mr. Foster has served as Chief Executive Officer of Cohesion since January 1998. From February 1997 to December 1997 he served as Senior Vice President and General Manager of the Collagen Technologies Group, a division of Collagen Aesthetics, Inc. From May 1992 until February 1997, Mr. Foster served as Chief Financial Officer of Collagen. Mr. Foster serves on the Board of Directors of Innovasive Devices, Inc. Mr. Foster has a B.S. in mechanical engineering and an M.B.A. from the University of California at Berkeley.
Frank DeLustro, Ph.D., President, Chief Operating Officer and Director. Dr. DeLustro has served as President and Chief Operating Officer of Cohesion since January 1998. He served as President and Chief Executive Officer of Cohesion Corporation from its inception in 1996 until December 1997. Prior to joining Cohesion Corporation, Dr. DeLustro served at Collagen for 13 years in positions of increasing responsibility, most recently as Senior Vice President, Scientific Affairs. Dr. DeLustro has a B.S. in biology from Fordham University and a Ph.D. in immunology/microbiology from Upstate Medical School, SUNY (Syracuse). He is the author of over 40 scientific publications and the holder of 18 U.S. patents.
Ross Erickson, Vice President, Regulatory Affairs, Clinical Research and Quality Assurance. Mr. Erickson has served as Vice President, Regulatory Affairs, Clinical Research and Quality Assurance of Cohesion since January 1998. He was Vice President of Regulatory Affairs and Clinical Affairs at Cohesion Corporation from May 1996 to December 1997. From January 1987 to April 1996, he held various positions with Collagen and was Vice President of Regulatory Affairs and Quality Assurance from 1991. Mr. Erickson has a B.A. and an M.A. from Western Michigan University.
Russ McDaniell, Vice President, Sales. Mr. McDaniell has served as Vice President, Sales of Cohesion since March 2000. Prior to joining Cohesion, Mr. McDaniell was a co-founder of CardioVention, an early stage cardiovascular company where he served as Vice President of Marketing and Business Development. Prior to CardioVention, Mr. McDaniell was Director of Sales at Cardio Thoracic Systems. From 1986 to 1996, Mr. McDaniell was the Director of Sales for Sulzer-Carbomedics. Mr. McDaniell holds a B.S. in marketing from Fairleigh Dickinson University and an A.A.S. in Engineering from New York Technical College.
Deborah Webster, Vice President and Chief Administrative Officer. Ms. Webster has served as Vice President and Chief Administrative Officer of Cohesion since January 1998. Ms. Webster joined Collagen in 1982 and served in various human resource and management positions until 1991, when she was appointed to Vice President, Human Resources and Administrative Services. Ms. Webster has a B.A. from the University of California at Berkeley and completed the Stanford University Executive Program at the Graduate Business School.
Sharon Kokubun, Vice President, Financial Operations. Ms. Kokubun has served as Vice President, Financial Operations of Cohesion since January 1998. Ms. Kokubun joined Collagen in April 1988 as Assistant Controller and was promoted in February 1994 to Treasurer. Ms. Kokubun is a certified public accountant and has an M.B.A. in finance from the University of Hawaii.
ITEM 2.
ITEM 2. PROPERTIES
Cohesion's principal executive, research and development, marketing, and manufacturing activities presently are located in Palo Alto, California. Cohesion leases approximately 33,000 square feet of facility under a lease agreement that expires in 2004. We believe that our facilities are adequate to meet our requirements through the end of fiscal year 2002.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Two actions, Crane v. Collagen Aesthetics, Inc., et al., and Kerr, et al., v. Inamed Corp., et al., were filed in August 2000 in the U.S. District Court for the Northern District of California by the same attorneys. Both actions allege personal injury claims arising out of the development and sale of Trilucent breast implants outside the United States by an affiliate of Collagen Aesthethics. Cohesion had no role in the development or sale of these products. The Crane case is a personal injury complaint on behalf of a single plaintiff seeking monetary damages, while the Kerr case is a purported class action seeking "medical monitoring" and monetary damages.
Pursuant to the Separation and Distribution Agreement between Collagen and Cohesion, Cohesion has called upon Collagen to indemnify Cohesion with respect to these suits. Collagen has acknowledged its obligation to indemnify Cohesion, and has assumed the defense of Cohesion in these suits.
Cohesion is currently involved in other legal actions arising in the ordinary course of business. While the outcome of these other legal matters is currently not determinable, it is management's opinion that these matters will not have a material adverse effect on our consolidated financial position or results of our operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE BY SECURITY HOLDERS
There were no matters submitted to a vote of our security holders during the fourth quarter of the fiscal year ended June 30, 2000.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
MARKET FOR COMMON STOCK
Our common stock began trading on The Nasdaq Stock Market under the symbol CSON as of August 13, 1998. There was no public market for our common stock prior to that date. The following table sets forth, for the periods indicated, the high and low trading prices for our common stock as reported on The Nasdaq Stock Market by quarter in fiscal 1999 and 2000.
SALES OF UNREGISTERED SECURITIES
Cohesion has not engaged in any sale of unregistered securities in the year ending June 30, 2000.
HOLDERS OF RECORD
At September 15, 2000 there were approximately 708 holders of record of Cohesion's common stock.
DIVIDENDS
Cohesion has never paid any cash dividends and does not anticipate paying cash dividends in the foreseeable future.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
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(1) The first five months of the fiscal 1996 financial information is presented with the Target Therapeutics, Inc. investment accounted for under the equity method.
(2) Historical per share data has not been presented since no Cohesion common shares were outstanding until June 25, 1998. Pro forma share and per share data has been presented assuming the distribution of shares of Cohesion's Common Stock to Collagen's stockholders had already occurred based on the number of Collagen common shares and common equivalent shares outstanding for those periods, reflecting a one-for-one exchange ratio in the distribution.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
The following discussion should be read in conjunction with the consolidated financial statements and the related notes and the other information included elsewhere in this Annual Report. Certain statements in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" are forward-looking. The forward-looking statements contained herein are based on current expectations and entail various risks and uncertainties that could cause actual results to differ materially from those expressed in such forward-looking statements. These risks include, but are not limited to, the timing of product introductions, the success of scaling up product production, the timing and terms of sales arrangements with other companies, performance of third-party sales representatives, receipt of regulatory approvals, including approvals from the FDA, clinical efficacy of and market demand for products, results of clinical studies and potential unfavorable publicity regarding us or our products, among other matters. Such differences may be based upon factors within our control, such as strategic planning decisions by management and reallocation of internal resources, or on factors outside our control, such as scientific advances by third parties, introduction of competitive products and delays by regulatory authorities, including approvals from the FDA. For a more detailed discussion of these and other business risks, see "Business - Government Regulation," "Business - Competition," and "Business - Additional Factors that Might Affect Future Results."
Cohesion is focused on developing and commercializing proprietary surgical products, including bioresorbable hemostatic devices and biosealants for tissue repair and regeneration, to increase the effectiveness of minimally invasive surgeries. CoStasis Surgical Hemostat, our hemostatic product, is designed for use in cardiovascular, orthopedic and general surgery indications. We received a CE Mark for CoStasis in fiscal 1999 and received FDA approval in June 2000 to market the product in the United States. In November 1999, we announced an agreement with U.S. Surgical for the marketing and distribution of CoStasis. The U.S. Surgical territories include the United States, European Union, Eastern Europe, Latin America, Middle East, Australia, New Zealand and India. In February 2000, we received a CE Mark for CoSeal Surgical Sealant, our biosealant product candidate designed for sealing vascular grafts. We are currently conducting clinical trials for CoSeal in the United States. We believe that our surgical products will provide several distinct advantages over currently available technologies, including ease of preparation and use, better delivery systems, improved safety profiles and clinical effectiveness. Our products and programs are based on a platform of proprietary technologies centered around collagen and hydrophilic polymers that quickly polymerize in-vivo and bind to tissue. We also have research and development programs in recombinant human collagen and thrombin. We reported sales of Collagraft implant, an orthopedic product, through our investment in NeuColl, Inc. up through March 31, 2000. In March 2000, our interest in NeuColl fell below 50% and, as a result, we no longer reflect NeuColl product sales in our financial results.
Cohesion was organized in June 1997 as a Delaware corporation and wholly owned subsidiary of Collagen Aesthetics, Inc. formerly known as Collagen Corporation, now known as McGhan Medical since Collagen was acquired by Inamed Corporation. During fiscal 1998, Collagen proceeded to separate its Aesthetic Technologies Group and its Collagen Technologies Group ("CTG") into two independent, publicly-traded companies. Effective January 1, 1998, Collagen contributed its research and development programs for hemostatic devices, biosealants, orthopedics products and programs, adhesion barriers and recombinant human collagen and thrombin and other related businesses of CTG to Cohesion, including various equity investments. On August 18, 1998, Collagen distributed as a dividend to its stockholders, one share of Cohesion's common stock for each share of Collagen common stock outstanding. Cohesion and Collagen entered into various agreements to provide for an orderly transition of matters and to govern certain ongoing matters between the two entities and provide a mechanism for transitioning license, supply, distribution, research and development, tax, service and other agreements in connection with the distribution of Cohesion's common stock. Cohesion's historical financial position and results of operations prior to the distribution reflect the historical operations of the transferred businesses contributed by Collagen to Cohesion. In particular, this Management's Discussion and Analysis of Financial Condition and Results of Operations reflects the historical results of the CTG operating group for all years presented through January 1, 1998, as if the contribution of the transferred businesses by Collagen to Cohesion had occurred on July 1, 1992.
In February 1999, we formed a new subsidiary, NeuColl, Inc., to commercialize products in the orthopedics field, which included Collagraft and NeuVisc(TM), a collagen-based intra-articular implant for the treatment of pain related to osteoarthritis. In connection with the formation, we granted NeuColl an exclusive license to certain patents relating to collagen and polymer technology for orthopedic applications. During the quarter ended March 31, 2000, NeuColl obtained a total of $4 million in financing from a third party in two tranches, which reduced our ownership from 100% to approximately 39% as of March 31, 2000. For the quarter ended March 31, 2000, we consolidated NeuColl's operating loss in our results of operations and reported the related minority interest for a two-month period. Beginning March 31, 2000, we no longer consolidated NeuColl into our financial results and instead, reported our share of NeuColl's operating income or loss under the equity method of accounting.
RESULTS OF OPERATIONS
Fiscal Years Ended June 30, 2000, 1999, and 1998
Revenues were $2.5 million, $2.6 million, and $2.0 million for fiscal years 2000, 1999, and 1998, respectively. Fiscal 2000 revenues included $0.5 million for a milestone payment from U.S. Surgical upon receipt of FDA approval to market CoStasis. Product sales were $2.0 million in fiscal 2000, compared to product sales of $2.6 million in fiscal 1999 and $2.0 million in fiscal 1998. The decrease in product sales reflects only nine months of Collagraft sales in fiscal 2000. Other fluctuations in product sales are primarily due to the timing of shipments of Collagraft product to a distributor. As of March 31, 2000, we no longer consolidated NeuColl's operations into our financial results as our ownership fell below 50%. Currently, we expect revenues to be higher in fiscal 2001 primarily due to CoStasis sales in the U.S. A number of uncertainties exist surrounding the marketing and distribution of our products where the primary means of distribution is through a third party firm, such as U.S. Surgical. Our business and financial results could be adversely affected in the event that a third party firm is unable to market the product effectively, anticipate customer demand accurately, or effectively manage industry-wide pricing and cost containment pressures in health care.
Cost of sales as a percentage of product sales was 167%, 76%, and 57% for fiscal years 2000, 1999 and 1998, respectively. The increases in cost of sales as a percentage of sales in fiscal years 2000 and 1999 were primarily due to manufacturing startup costs for the CoStasis product. Cost of sales for fiscal 2001 is expected to continue to reflect manufacturing startup costs as we bring our CoSeal product into commercial production.
Research and development expenses were $12.4 million, $15.3 million, and $16.3 million for fiscal 2000, 1999, and 1998, respectively. The decreases in R&D spending over the three-year period were due primarily to timing of clinical trial expenses and lower spending in our recombinant programs. R&D expense for fiscal years 2000, 1999 and the last half of fiscal 1998 reflect reimbursement from Collagen for the recombinant human collagen program in accordance with the intercompany agreements entered into between Cohesion and Collagen in connection with our spin-off from Collagen. Currently, we expect R&D spending in fiscal 2001 to be at higher levels than fiscal 2000.
Selling, general and administrative expenses were $6.5 million, $6.8 million, and $5.5 million in fiscal 2000, 1999, and 1998, respectively. The slight decrease in SG&A spending in fiscal 2000 over the prior year is due to spin-off related costs incurred in fiscal 1999. The increase in SG&A expense in fiscal 1999 over fiscal 1998 is due primarily to increased marketing costs associated with the launch of CoStasis in Europe. Currently, we expect SG&A expenses to increase in fiscal 2001 due to increased spending in sales and marketing for resources required to support current and future products. Future levels of SG&A spending will depend on various factors, including the level of product sales and how future products are distributed in the U.S.
Collagen increased its ownership position in Cohesion Corporation from approximately 40% to 81% in May 1996 and from 81% to approximately 99% in December 1997. In connection with Collagen's May 1996 and December 1997 investments and purchases of Cohesion Corporation shares, substantially all of the $3.0 million and $10.6 million purchase prices, respectively, were allocated to in-process research and development, which was expensed at the time of the purchases. The $10.6 million purchase price includes cash compensation amounts of approximately $3.8 million associated with the purchase of certain vested employee stock options. Pursuant to the intercompany agreements, Collagen transferred its interest in Cohesion Corporation to Cohesion effective January 1, 1998.
We determined the amounts to be allocated to in-process technology for Cohesion Corporation based on whether technological feasibility had been achieved and whether there was any alternative future use for the technology. We concluded that the in-process technology had no alternative future use after taking into consideration the potential for both usage of the technology in different products and for resale of the technology. Except for CoStasis, the products and programs related to the in-process technology acquired are currently in the clinical trial and preclinical trial stages, respectively. This technology, which relates to surgical hemostasis and sealing products we are developing, utilizes liquid-based biomaterials and related delivery systems. We expect to benefit from the in-process technology within the next three years, provided that sufficient preclinical and clinical data has been generated, submitted to regulatory authorities, and cleared for commercial sale by those regulatory authorities; however we can make no assurance in this regard. We expect to spend approximately $5 to $6 million per year for the next three years on the in-process technology in an effort to develop commercially viable products. If this technology is not successfully developed and commercialized, our ability to generate product revenue and our business, financial condition and results of operations will be materially and adversely effected.
During fiscal years 2000 and 1999, we recorded $1.4 million and $3.4 million, respectively, of compensation expense in connection with the cancellation of the remaining stock options of Cohesion Corporation. In September 1998, our board of directors approved a program to cancel options to purchase shares of the common stock of Cohesion Corporation. In connection with this cancellation, we offered to pay each holder of canceled options a per share amount equal to the excess of $16.70 over the exercise price of the canceled option. We will make this option payment ratably over the original vesting period of the canceled option so long as the former holder thereof remains an employee or consultant of Cohesion. Currently, we expect to record an additional $0.5 million of compensation expense with respect to the cash-out of canceled options, which will be recognized during the next two fiscal years.
Realized gains on investments were $31.8 million, $36.3 million, and $19.1 million in fiscal 2000, 1999, and 1998, respectively. In fiscal 2000, 1999 and 1998, the gains were primarily from the sale of common stock of Boston Scientific Corporation. During fiscal 2000, gains also included $4.4 million resulting from a business combination between Innovasive Devices and Johnson & Johnson. The timing and number of shares of common stock sold will depend on market conditions and our anticipated cash needs.
Equity in losses of affiliates were $20,000 in fiscal 2000 and $9,000 in fiscal 1998. The fiscal 2000 loss is related to the investment in NeuColl and the equity loss in fiscal 1998 was related to Cohesion Corporation. The fiscal 1999 impairment of investments of $1,321,000 was due to a writedown of the Innovasive Devices investment.
Interest income was $987,000, $94,000 and $332,000 in fiscal 2000, 1999, and 1998, respectively. The increase in fiscal 2000 was due to higher average cash and cash equivalent balances during the fiscal year, whereas in fiscal 1999, average cash balances were lower than in fiscal 1998 which contributed to the decrease in interest income over fiscal 1998.
Interest expense was $224,000, $15,000, and $0 in fiscal 2000, 1999, and 1998, respectively. Interest expense in fiscal 2000 was related to our obligation under our capital lease whereas, in fiscal 1999, interest expenses was related to short-term borrowings secured by the Boston Scientific common stock.
Cohesion's effective tax rate for fiscal 2000 was 22% due to tax benefits related to investments and equity losses in affiliate companies. The tax rate for fiscal 1999 was 39% which primarily reflected utilization of credit for research and development expenditures. In fiscal 1998, we recorded a benefit for income taxes of 21%. The tax benefit is primarily due to the in-process research and development charges related to the increase in ownership of Cohesion Corporation which is not deductible for tax purposes.
SEGMENT INFORMATION
Historically, we have operated in two segments: 1) our surgical business and 2) our orthopedics business. Our surgical segment develops proprietary surgical products, including bioresorbable hemostatic devices and biosealants, such as CoStasis and CoSeal, for tissue repair and regeneration. In February 1999, we formed a new subsidiary, NeuColl, Inc., to commercialize products in the orthopedics field, which included Collagraft(R) and NeuVisc(TM), a collagen-based intra-articular implant for the treatment of pain related to osteoarthritis. For a discussion of Collagraft sales, see revenue discussion in "- Results of Operations." Our ownership in NeuColl decreased from 100% to below 50% as of March 31, 2000 due to financing received by NeuColl from a third party. Beginning March 31, 2000, we are no longer consolidating NeuColl into our financial results and instead, will report our share of NeuColl's income or loss under the equity method of accounting. Subsequent to March 31, 2000, we are operating in only one segment, our surgical business. Additional financial information with respect to our segments can be found in Note 11 to our financial statements contained in Part II, Item 8 of this Annual Report on Form 10-K.
LIQUIDITY AND CAPITAL RESOURCES
At June 30, 2000, cash and investments were $51.3 million compared to $59.6 million at June 30, 1999. Net cash used in operating activities was $21.5 million, $28.8 million, and $19.0 million for fiscal 2000, 1999, and 1998, respectively.
For the fiscal year ended June 30, 2000, cash provided by investing activities of $22.7 million was related to proceeds of approximately $23.1 million from the sale of equity investments and proceeds of approximately $4.9 million from the maturity of our equity collars. The investment proceeds were offset by $4.2 million for the purchase of investments and $1.1 million for capital expenditures. Currently, we anticipate that capital expenditures will not exceed $2.0 million in fiscal 2001. Net cash provided by financing activities for the fiscal year ended June 30, 2000 was $8.7 million primarily due to proceeds of $4.2 million from the sale-leaseback of our manufacturing facility improvements and equipment and $5.3 million of proceeds from stock programs (incentive stock options and employee stock purchases), which were offset by payments of approximately $0.8 million on a capital lease obligation.
Our principal sources of liquidity include our marketable equity investments, cash, and cash equivalents. We anticipate that stock sales will be made from time to time, with the objective of generating cash for, among other things, further investments in both current and new affiliate companies. We may defer sales of equity investments for tax planning purposes or other reasons, although decisions concerning prospective stock sales will also be affected by the then-current market price of the common stock. As another source of financing, we may in the future establish a credit facility, although there can be no assurance that a line of credit will be available to us on acceptable terms, if at all.
In September 1998, our Board of Directors approved a stock repurchase program to buy back up to 1.0 million shares of common stock at a price of up to $4.25 per share. As of September 15, 2000, we had repurchased 515,100 shares of our common stock under this program, none of which were repurchased in fiscal 2000.
In September 1998, our Board of Directors approved a program to cancel options to purchase shares of the common stock of Cohesion Corporation. In connection with such program, Cohesion offered to pay each holder of canceled options a per share amount equal to the excess of $16.70 over the exercise price of the canceled option. Cohesion will make this option payment ratably over the original vesting period of the canceled option so long as the holder thereof remains an employee or consultant of Cohesion. Cohesion expects to record an additional $0.5 million of compensation expense with respect to the cash-out of canceled options during the next two fiscal years.
We believe that our current sources of liquidity should be adequate to fund our anticipated capital requirements through at least the next two years. However, during this period and thereafter, we may require additional financing. Our capital requirements will depend on numerous factors, including the achievement of targeted sales levels, progress of our clinical research and product development programs, the extent to which we enter into collaborative relationships with third parties and the scope of our obligations in such relationships, the receipt of, and the time required to obtain, regulatory clearances and approvals, the resources required to protect
our intellectual property and other factors. We cannot accurately predict the timing and amount of such capital requirements. Additional financing may not be available to us on acceptable terms, if at all.
In February 1999, we formed a new subsidiary, NeuColl, Inc., in order to commercialize products in the orthopedics field, which included Collagraft and NeuVisc(TM), a collagen-based intra-articular implant. We provided the initial funding for NeuColl; however, during the quarter ended March 31, 2000, NeuColl obtained a total of $4 million in financing from a third party, reducing our ownership from 100% to below 50%. Accordingly, NeuColl's operations were no longer consolidated from that date forward and we began to report our share of NeuColl's operating results under the equity method of accounting. As of June 30, 2000, the carrying value of our investment in NeuColl was zero. We hold a warrant to purchase an additional 3.0 million shares of common stock in NeuColl, which expires in February 2006.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
Revenue Recognition
In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101 Revenue Recognition in Financial Statements ("SAB 101"), which provides guidance on the accounting for revenue recognition. The Company is currently evaluating the applicability of SAB 101 to its existing agreements. Should the Company conclude that its approach is different from the approach described in SAB 101, it will change its method of accounting. As amended, SAB 101 must be implemented no later than the quarter ending December 2000. The Company receives payments from customers for product sales and licenses. The license payments are generally non-refundable but are reported as deferred revenue until they are recognizable as revenue. The Company follows the following principles in recognizing revenue:
Product Sales: Revenue from product sales, including shipment to distributors, is recognized upon transfer of title, which is generally upon shipment, net of allowances for estimated future returns.
License Fees: Fees to license distribution rights of the Company's products are recognized over the period of the distribution agreement. Milestone payments are recognized as revenue when the milestone is achieved.
In June 1998, the Financial Accounting Standards Board issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), which provides a comprehensive and consistent standard for the recognition and measurement of derivatives and hedging activities. SFAS 133 is effective for the Company as of July 1, 2000. The adoption of SFAS 133 is estimated to result in a loss of approximately $130,000, net of tax.
EXEMPTION FROM INVESTMENT COMPANY REGULATION
Given the composition of its current assets, the Company may fall within the definition of investment company under the Investment Company Act of 1940, as amended (the "Investment Company Act") and may be required to register as such. Because of this possibility and the fact that regulation as an investment company would not permit the Company to accomplish many of its business objectives and policies, the Company has applied for and obtained an order of the Securities and Exchange Commission under Sections 6(c) and 6(e) of the Investment Company Act. The order exempts the Company from all provisions of the Investment Company Act, except Sections 9, 17(e), 17(f) and 37 through 53 of the Investment Company Act, and the rules and regulations under these sections, with certain exceptions as described in the Company's application to the Commission for an order of exemption. The Company, and certain other persons in their transactions with the Company, must comply with these provisions as if the Company were a registered investment company. The order continues in effect until the earlier of August 18, 2001 or such time as the Company may no longer be deemed to be an investment company.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Cohesion is exposed to financial market risks, including changes to interest rates and equity security prices. To mitigate these risks, Cohesion utilizes derivative financial instruments. Cohesion does not utilize derivative financial instruments for speculative or trading purposes.
INTEREST RATE RISK
The primary objective of Cohesion's debt investment portfolio is to preserve principal. Cohesion invests in debt instruments that meet high credit quality standards and limits the amount of credit exposure to any one issue, issuer, or type of instrument. Cohesion also limits the maturity of debt investments to 400 days or less. As of June 30, 2000 and 1999, Cohesion held approximately $12,509,875 and $2,526,000 of interest rate sensitive investments in debt securities, respectively. A hypothetical 1% increase in interest rates would result in a decrease in the fair value of investments in debt securities of less than $30,000 and $20,000 as of June 30, 2000 and 1999, respectively. This estimate is based on sensitivity analyses performed on Cohesion's financial positions at June 30, 2000. Actual results may differ materially.
EQUITY SECURITY PRICE RISK
Cohesion is exposed to equity security price risks on investments in Boston Scientific common stock and equity instruments of other biotechnology or biomedical device companies. To hedge against fluctuations in the market value of a portion of the Boston Scientific common stock, Cohesion entered into costless collar instruments that expire quarterly from August 1998 through May 2001 and will require settlement in cash. At June 30, 2000, 350,000 shares, out of 725,720 held by Cohesion, were hedged using these collars. The costless collar instruments are collateralized by shares of Boston Scientific common stock held by Cohesion. The collars hedge 200,000 shares at prices between $32 and $49 and 150,000 shares at prices between $22 and $29. As of June 30, 2000, the market value of Boston Scientific stock was $22. The fair values of these investments as of June 30, 2000 and 1999 are as follows (in thousands):
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL INFORMATION
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders Cohesion Technologies, Inc.
We have audited the accompanying consolidated balance sheets of Cohesion Technologies, Inc. as of June 30, 2000 and 1999, and the related consolidated statements of operations and comprehensive income (loss), stockholders' and parent company equity and cash flows for each of the three years in the period ended June 30, 2000. 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 Cohesion Technologies, Inc. at June 30, 2000 and 1999, and the consolidated results of its operations and its cash flows for each of the three years in the period ended June 30, 2000 in conformity with accounting principles generally accepted in the United States.
ERNST & YOUNG LLP
Palo Alto, California July 27, 2000
COHESION TECHNOLOGIES, INC.
CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARES AND PER SHARE AMOUNTS)
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
COHESION TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS) (IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
COHESION TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' AND PARENT COMPANY EQUITY YEARS ENDED JUNE 30, 2000, 1999 AND 1998 (IN THOUSANDS)
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
COHESION TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (IN THOUSANDS)
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
COHESION TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2000
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
Cohesion Technologies, Inc. ("Cohesion" or the "Company") was organized in June 1997 as a Delaware corporation and a wholly owned subsidiary of Collagen Aesthetics, Inc. formerly known as Collagen Corporation ("Collagen"), and now known as McGhan Medical ("McGhan") since Collagen was acquired by Inamed Corporation. In fiscal 1998, Collagen proceeded to separate its Aesthetic Technologies Group and its Collagen Technologies Group ("CTG") into two independent, publicly-traded companies. CTG's business activities focused on the design, development, manufacture and commercialization of innovative resorbable biomaterials, adhesive technologies, and delivery systems in the fields of tissue repair and regeneration. On August 18, 1998, Collagen distributed as a dividend to its stockholders, one share of the Company's Common Stock for each share of Collagen common stock outstanding (the "distribution").
The accompanying consolidated financial statements have been prepared using Collagen's historical cost basis of the assets and liabilities of the various division activities that comprised Cohesion as a component of Collagen up through August 18, 1998 and as a separate stand-alone company thereafter. The financial statements of Cohesion include the operating results of Cohesion Corporation, a subsidiary of the Company, a developer of proprietary products for hemostasis and tissue adhesion, biosealants and adhesion barriers for surgical applications, since the acquisition of Cohesion Corporation by Collagen in fiscal 1996 (see Note 7, "Acquisitions of Cohesion Corporation"). Cohesion and Collagen entered into various agreements (collectively, the "Intercompany Agreements") which (i) provided for the transfer, effective January 1, 1998, of certain assets and liabilities relating to the businesses previously conducted by Collagen's CTG to Cohesion, and (ii) established contractual arrangements between Collagen and the Company described below under Note 2. The various assets, liabilities, revenues and expenses associated with CTG were allocated to the historical financial statements of Cohesion in a manner consistent with the Intercompany Agreements. Management believes that the consolidated statements of operations include either a reasonable allocation of costs incurred by Collagen, which benefit Cohesion, or a specific identification basis where appropriate.
Principles of Consolidation
The consolidated financial statements include the accounts of Cohesion and its wholly-owned and majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Cohesion operated in two industry segments through March 2000, focusing on the development and sale of medical devices and orthopedic products. Investments in unconsolidated subsidiaries, and other equity investments in which Cohesion has a 20% to 50% interest or otherwise has the ability to exercise significant influence, are accounted for under the equity method.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Reclassification
Certain prior year amounts in the consolidated financial statements have been reclassified to conform with the current year presentation.
Cash Equivalents, Short-term Investments and Other Investments
Cohesion considers all highly liquid investments with an original maturity from date of purchase of three months or less to be cash equivalents. Short-term investments have remaining maturities less than one year.
Cohesion invests its excess cash in deposits with major banks and in money market securities of companies with strong credit ratings and from a variety of industries. These securities are typically short-term in nature and, therefore, bear minimal risk. Cohesion has not experienced any credit losses on its money market investments.
Cohesion determines the appropriate classification of marketable securities at the time of purchase and re-evaluates such designation as of each balance sheet date. All of Cohesion's debt and equity securities are classified as available-for-sale. The carrying value of available-for-sale debt securities approximates fair value because of the short-term maturity of these investments. Both realized and unrealized gains and losses on debt securities were immaterial as of June 30, 2000 and 1999 and for the years ended June 30, 2000, 1999 and 1998. Unrestricted available-for-sale equity securities are carried at fair value with the unrealized gains and losses, net of tax, included in other comprehensive income. Restricted equity securities are carried at cost or estimated realizable value, if less. The cost of securities sold is based on the specific identification method. The fair value of public equity securities held is based upon quoted closing market prices.
The amortized cost of debt securities 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. Interest and dividends on securities classified as available-for-sale are included in interest income.
Equity Collar Instruments
At June 30, 2000, Cohesion held 725,720 shares of Boston Scientific common stock. In order to manage the risk of market fluctuations in the price of this stock, Cohesion entered into certain costless collar instruments (the "Collars"), to hedge a portion (350,000 shares at June 30, 2000) of the Boston Scientific equity securities against changes in market value. A costless collar instrument is a combination of a purchased put option and a written call option on a specific equity security such that the cost of the purchased put and the proceeds of the written call offset each other. Therefore, there is no initial cost or cash outflow for these instruments. Cohesion obtained the Collars with expiration dates and numbers of shares so that the potential adverse impact of movements in market price of the stock will be at least partially offset by an associated increase in the value of the Collars.
Realized gains and losses on the Collars are recorded in other income (expense) with the related gains from the sale of the stock. Unrealized gains and losses on these instruments, net of tax, are recorded as an adjustment to other comprehensive income. Fair value of the equity collar instruments are based upon broker quote for similar instruments. Equity collar instruments that do not qualify for hedge accounting or early termination of these instruments would be recognized in other income (expense).
Inventories
Inventories are valued at the lower of cost, determined on a standard cost basis which approximates average cost, or market.
Inventories comprise the following at June 30, 2000 and 1999, respectively (in thousands):
Property and Equipment
Depreciation and amortization of property and equipment, which is stated at cost, are provided on the straight-line method over estimated useful lives as follows:
Intangible Assets
Intangible assets are amortized using the straight-line method. Patents acquired prior to October 1996 are amortized over a seventeen year period beginning with the effective date or over the remainder of such period from the date acquired and patents purchased thereafter are expensed when acquired. As of June 30, 2000 and 1999, gross intangible assets were $2,265,000 net of accumulated amortization of $2,016,000 and $1,538,000, respectively. Intangible assets are recorded in other assets in the consolidated balance sheet.
Loans to Officers and Employees
Principal plus accrued interest due from officers and employees totaled $27,323 and $38,000 at June 30, 2000 and 1999, respectively.
Revenue Recognition
In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101 Revenue Recognition in Financial Statements ("SAB 101"), which provides guidance on the accounting for revenue recognition. The Company is currently evaluating the applicability of SAB 101 to its existing agreements. Should the Company conclude that its approach is different from the approach described in SAB 101, it will change its method of accounting. As amended, SAB 101 must be implemented no later than the quarter ending December 2000. The Company receives payments from customers for product sales and licenses. The license payments are generally non-refundable but are reported as deferred revenue until they are recognizable as revenue. The Company follows the following principles in recognizing revenue:
Product Sales: Revenue from product sales, including shipment to distributors, is recognized upon transfer of title, which is generally upon shipment, net of allowances for estimated future returns.
License Fees: Fees to license distribution rights of the Company's products are recognized over the period of the distribution agreement. Milestone payments are recognized as revenue when the milestone is achieved.
Earnings Per Share
Historical per share data for the year ended June 30, 1998 has not been presented as no common shares were outstanding until June 25, 1998.
Pro forma share and per share data has been presented below for the year ended June 30, 1998 assuming the distribution of shares of the Company's Common Stock to Collagen's stockholders had already occurred based on the number of Collagen common shares and common equivalent shares outstanding for those periods, reflecting a one-for-one exchange ratio in the distribution.
Basic earnings per share ("EPS") is calculated using the weighted average number of common shares outstanding for the period. The computation of diluted EPS includes the effects of stock options, warrants and convertible preferred stock, if such effect is dilutive. Options that had an exercise price greater than their market price during the years ended June 30, 2000, 1999 and 1998 were excluded, as their inclusion would have been anti-dilutive. Below is a reconciliation between the basic and diluted weighted average common and common-equivalent shares for 2000, 1999 and 1998:
Concentration of Credit Risk
Cohesion sells its intermediate products (Vitrogen, Cell Prime, and Zygen) to various universities and institutions. CoStasis(TM) is sold to U.S. Surgical ("USS") and certain specialty distributors in Europe. Cohesion performs ongoing credit evaluations of its customers and generally does not require collateral. Cohesion maintains reserves for potential credit losses and such losses have been within management's expectations. Cohesion allows, on occasion, its customers to return product for credit, and also allows customers to return defective or damaged product for credit or replacement. Written authorization from Cohesion is required to return merchandise. Some domestic and foreign customers are subject to extended payment terms. These practices have not had a material effect on Cohesion's working capital.
Stock-Based Compensation
The Company accounts for stock based compensation using the intrinsic value method prescribed by APB Opinion No. 25, "Accounting for Stock Issued to Employees." Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company's stock at the date of grant over the amount an employee much pay to acquire the stock. The Company has adopted the disclosure provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" for options issued to employees.
New Accounting Guidance
In June 1998, the Financial Accounting Standards Board issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), which provides a comprehensive and consistent standard for the recognition and measurement of derivatives and hedging activities. SFAS 133 is effective for the Company as of July 1, 2000. The adoption of SFAS 133 is estimated to result in a loss of approximately $130,000, net of tax at June 30, 2000.
2. NEUCOLL, INC.
In February 1999, the Company formed a new subsidiary, NeuColl, Inc., to commercialize products in the orthopedics field, which include Collagraft and NeuVisc(TM), a collagen-based intra-articular implant for the treatment of pain related to osteoarthritis. During the quarter ended March 31, 2000, NeuColl obtained $4 million in financing from a third party, $2 million of which was received in February 2000 and the remaining $2 million on March 31, 2000, reducing the Company's ownership from 100% to approximately 60% and 39%, respectively. For the quarter ended March 31, 2000, the Company consolidated NeuColl's operating results in its results of operations and reported the related minority interest benefit of $133,000 for a two-month period. Upon receipt of the second tranch of financing on March 31, 2000, the Company's voting interest in NeuColl decreased below 50%. Accordingly, Neucoll's operations were no longer consolidated from that date forward, and the Company began to report its share of NeuColl's operating results under the equity method of accounting. As of June 30, 2000, the Company's receivable balance from NeuColl was approximately $331,000, with no carrying value assigned to the investment. The Company holds a warrant to purchase an additional 3.0 million shares of common stock in NeuColl, which expires in February 2006. Cohesion entered into a Service
Agreement with NeuColl effective February 1999. Under the terms of the agreement, Cohesion will provide facility and general and administrative services at specified costs through June 2001. Reimbursements from NeuColl totaled approximately $360,000 in fiscal 2000.
3. MARKETING AND DISTRIBUTION AGREEMENT WITH U.S. SURGICAL
In November 1999, Cohesion entered into a marketing and distribution agreement with USS for CoStasis. The USS territories include the U.S. European Union, Eastern Europe, Latin America, Middle East, Australia, New Zealand and India. The agreement provides for milestone payments which are payable upon certain events. The Company received $1.25 million in payments from USS in fiscal 2000, of which $0.5 million was recognized as Other Revenue in the statement of operations. The remaining $0.75 million was deferred for recognition in future periods. In accordance with our revenue recognition policy, fees for license distribution rights are recognized over the period of the distribution agreement while milestone payments are recognized when the milestone is achieved.
4. CONTRACTUAL AGREEMENTS WITH MCGHAN MEDICAL
Cohesion entered into supply, services, research and development, benefits, tax allocation, and distribution agreements with Collagen effective January 1, 1998. Under the terms of the Collagen Supply Agreement, McGhan supplies certain products to Cohesion at a cost based on a defined formula. If such prospective arrangements had been in place during the periods presented, cost of sales would have increased by $48,000 in fiscal 1998. Under the terms of the Recombinant Technology and Development License Agreement, Cohesion and McGhan are collaborating to develop recombinant human collagen and provide for cost sharing of the project until certain milestones are met. The research and development ("R&D") expenses for fiscal 1998 are based on historical costs. If such prospective arrangements had been in place, R&D expenses, net of reimbursements from Collagen, would have decreased by $1.0 million in fiscal year 1998. Reimbursements for fiscal 2000 and 1999 were approximately $304,000 and $964,000, respectively. Under the Services Agreement, which was effective through June 30, 1999, Cohesion and Collagen provided each other various services as part of the transition. The Benefits Agreement provided for the continuation or replacement of benefits for the employees transferred to Cohesion and employees remaining with Collagen. The Tax Allocation Agreement provides that Collagen will be responsible for all taxes prior to the distribution date and Cohesion will be responsible for all of its tax liabilities subsequent to that date. Under the Vitrogen International Distribution Agreement, which was effective through June 30, 1999, Collagen International, Inc., a subsidiary of Collagen, acted as Cohesion's distributor in Germany for Vitrogen. Under the Collagraft Supply Agreement, McGhan supplies NeuColl with Collagraft product necessary for NeuColl to fulfill its obligations under its agreement with Zimmer, Inc., NeuColl's marketing partner in the United States, at a price that is the greater of a percentage of the NeuColl sales price or a defined multiplier of McGhan's cost.
5. INVESTMENTS IN DEBT SECURITIES
As of June 30, 2000 and 1999, corporate debt securities were held in various short-term corporate obligations totaling $12,510,000 and $2,526,000, respectively. Available-for-sale debt securities are carried at amortized cost which approximates fair value. During fiscal years 2000, 1999 and 1998, the Company had no sales of its available-for-sale debt securities.
6. INVESTMENTS IN EQUITY SECURITIES
The following is a summary of the aggregate estimated fair value, gross unrealized gains and cost of the Company's investment in equity securities:
Equity Collar
To hedge against fluctuations in the market value of a portion of the Boston Scientific common stock, Cohesion entered into costless collar instruments that expire quarterly from August 1998 through May 2001 and will require settlement in cash. At June 30, 2000, 350,000 shares were hedged under these collars. The call options are collateralized by shares of Boston Scientific common stock held by Cohesion.
Impairment of Investment
At June 30, 1999, the Company determined that its cost basis in Innovasive Devices had incurred other-than-temporary impairment and adjusted the cost basis down to market value. The resulting $1.3 million write-down in cost basis at June 30, 1999, was included in "Impairment of investment " in the accompanying consolidated statements of operations.
Realized Gain on Business Combinations
In June 2000, the shares of common stock of Innovasive Devices were exchanged for 80,005 shares of Johnson & Johnson common stock as a result of a business combination between the two companies. At time of the exchange, Cohesion realized a gain of $4.4 million, which is included in "Realized gain on investments" in the statement of operations.
7. ACQUISITIONS OF COHESION CORPORATION
Collagen increased its ownership position in Cohesion Corporation from approximately 40% to 81% in May 1996 and from 81% to approximately 99% in December 1997. Cohesion Corporation was a privately-held company developing novel biomaterials in the area of hemostats, biosealants, and adhesion prevention barriers for surgical applications. In connection with Collagen's investments and purchases of Cohesion Corporation shares, substantially all of the $3.0 million and $10.6 million purchase prices, respectively, were allocated to in-process research and development, which was expensed at the time of the purchases. The $10.6 million fiscal 1998 purchase price included $3.8 million of cash compensation amounts associated with the purchase of certain vested employee stock options, which amounts were expensed in accordance with Accounting Principles Board Opinion No. 25. After consideration of the amounts allocated to in-process technology, there was no excess of purchase price over the fair value of the net assets acquired and no goodwill was recorded.
Cohesion determined the amounts to be allocated to in-process technology for Cohesion Corporation based on whether technological feasibility had been achieved and whether there was any alternative future use for the technology. Cohesion concluded that the in-process technology had no alternative future use after taking into consideration the potential for both usage of the technology in different products and for resale of the technology. At June 30, 1998, there were additional vested and unvested options outstanding providing for the purchase of the remaining shares of Cohesion Corporation common stock. In September 1998, the Company's Board of Directors approved a program to cancel the remaining options to purchase shares of the common stock of Cohesion Corporation (the "Canceled Options"). In connection with such program, the Company offered to pay each holder of Canceled Options a per share amount equal to the excess of $16.70 over the exercise price of the Canceled Option (the "Option Payment"). The Company is making this Option Payment ratably over the original vesting period of the Canceled Option so long as the holder thereof remains an employee or consultant of the Company. The Company recorded compensation expense of approximately $1.4 million and approximately $3.4 million in fiscal 2000 and 1999, respectively. The Company expects to record an additional $0.4 million of compensation expense to be recognized in fiscal 2001 and an additional $0.1 million of compensation expense to be recognized in fiscal 2002.
The unaudited pro forma results of operations of Cohesion assuming the acquisitions of Cohesion Corporation shares occurred on July 1, 1996, on the basis described above with all material intercompany transactions eliminated, are as follows (in thousands):
The unaudited pro forma net income amounts above do not include the charges for in-process research and development aggregating $13.6 million arising from the acquisitions of shares of Cohesion Corporation. The unaudited pro forma information is not necessarily indicative of the actual results of operations had the transaction occurred at the beginning of the periods indicated, nor should it be used to project Cohesion's results of operations for any future dates or periods.
8. CAPITAL LEASE OBLIGATION
The Company entered into a lease agreement that covers manufacturing equipment and leasehold improvements. The lease has a term of 48 months with a one year extension option or a single cash payment of 20% of the leased amount. Rental payments are based on a monthly equivalent rental payment factor of the amount leased. Equipment and certain investments collateralize the lease.
The following is a schedule of future minimum lease payments as of June 30, 2000 (in thousands):
9. COMMITMENTS
Minimum lease payments
Future minimum lease payments to third parties under noncancelable operating leases at June 30, 2000 are as follows (in thousands):
Rental expense was $654,000, $814,000 and $636,000 in fiscal 2000, 1999 and 1998, respectively.
Short-Term Borrowing Agreement
The Company has a short-term borrowing arrangement with a securities brokerage firm. The interest rate on the demand loan is based on LIBOR + 1-1/8% and any borrowings would be collateralized by the investment Boston Scientific common stock (see Note 5, "Investment in Equity Securities"). At June 30, 2000, there was no balance outstanding under the arrangement.
10. STOCKHOLDERS' AND PARENT COMPANY EQUITY
Parent Company Equity
Cohesion's equity account with its parent company, Collagen, was closed out to Additional Paid-in Capital as of the distribution date. Retained earnings has been established thereafter, and includes net income for the Company since August 19, 1998.
Preferred Stock
Cohesion has authorized 5,000,000 shares of preferred stock with a par value of $0.001 per share. Each share of preferred stock is convertible into one share of common stock at the option of the holder. Additionally, the preferred shares automatically convert into common stock concurrent with the closing of an underwritten public offering of common stock under the Securities Act of 1933, as amended, in which Cohesion receives at least $10,000,000 in gross proceeds.
Preferred stockholders are entitled to noncumulative dividends at an annual rate of $0.10 per share. Dividends will be paid only when declared by the Board of Directors out of legally available funds. No dividends have been declared as of June 30, 2000.
Preferred stockholders are entitled to a liquidation preference of $1.00 per share plus all declared and unpaid dividends. If, upon liquidation, the assets of Cohesion are insufficient to permit the payment to the preferred stockholders of the full liquidation preference, the assets of Cohesion will be distributed ratably among the preferred stockholders. If the assets are more than sufficient to pay the full preferences, then, following the payment of the full preferences, the remaining assets of Cohesion shall be distributed ratably to any holders of common stock.
Common Stock
On June 25, 1998, each of the Company's ten outstanding shares of preferred stock converted into 886,104 shares of common stock and the Company's authorized common stock was increased from 10,000,000 to 15,000,000 shares.
Options Held by Employees and Consultants
Each employee (including officers) and consultant of Collagen or any subsidiary of Collagen who, immediately prior to August 18, 1998, the distribution date, held a vested but not exercised stock option to purchase shares of Collagen common stock, in connection with the distribution, received two new options in replacement of the original option, one to acquire shares of Collagen common stock and the other to acquire shares of the Company's Common Stock. Each new option gave the holder the right to purchase a number of shares equal to the number of shares in the original option.
Each employee (including officers) and consultant of Collagen or any subsidiary of Collagen who, immediately prior to the distribution date, held an unvested stock option to purchase shares of Collagen common stock, in connection with the distribution, received a new option in replacement of the original option to acquire the same number of shares of common stock of the entity (the Company or Collagen) by which such optionee was employed or retained as a consultant following the Distribution.
The exercise price of each new option was determined in accordance with Emerging Issues Task Force Issue 90-9 as agreed upon by the Company's Board and the Collagen Board (or any committee thereof), after consultation with legal and accounting advisors. The exercise price, as adjusted in light of the above considerations, was not intended to result in any compensation expense to the Company or Collagen. All other terms of the new options other than the exercise price are the same as those of the original options provided, however, that service as an employee or consultant of Cohesion Corporation or the Company shall be equivalent to providing service as an employee or consultant of Collagen.
Options for Nonemployee Directors
Each nonemployee director of Collagen or any subsidiary of Collagen who, immediately prior to the distribution date, held a vested but not exercised option to purchase shares of Collagen common stock, in connection with the distribution, received two new options in replacement of the original option, one to acquire shares of Collagen common stock and the other to acquire shares of the Company's Common Stock ("Vested Restructured Options"). Each new option gave the holder the right to purchase a number of shares equal to the number of shares in the original option. Each nonemployee director of Collagen who, immediately prior to the distribution date, held an unvested stock option to purchase shares of Collagen common stock, in connection with the distribution, received a new option in replacement of the original option to acquire the same number of shares of Common Stock of the entity (Collagen or the Company) for which such optionee will serve as a director following the Distribution ("Unvested Restructured Options").
The exercise price of each new option was determined in accordance with Emerging Issues Task Force Issue 90-9 as agreed upon by the Collagen Board of Directors and the Company's Board of Directors (or any committees thereof), after consultation with legal and accounting advisors. The exercise price, as adjusted in light of the above considerations, was not intended to result in any compensation expense to Collagen or the Company. All other terms of the new options are the same as those of the original options; provided, however, that service as a director of Cohesion Corporation or the Company shall be equivalent to providing service as a director of Collagen.
Following the Distribution, each nonemployee director of Collagen and Cohesion is eligible to participate in the Company's 1998 directors' stock option plan adopted by the company for which he or she serves as a director and to receive automatic annual option grants pursuant to such plan.
Stock Option Plans
The Company has various stock option plans under which incentive stock options may be granted to officers, directors, employees and consultants to purchase the Company's common stock. The options are granted at no less than fair market value at the dates of grant and generally expire after ten years. Incentive stock options become exercisable at the rate of two percent per month beginning the first full month after the date of grant for fifty months with an initial cliff period of one year.
At June 30, 2000, the total number of shares of common stock reserved for issuance under The Company's 1998 Stock Option Plan and the 1998 Directors' Stock Option Plan were 1,888,185 shares and 224,300 shares, respectively.
Stock option activities under Cohesion's Stock Option Plans were as follows:
Employee Stock Purchase Plan
The Company's 1998 Employee Stock Purchase Plan (the "Purchase Plan") was adopted by the Board of Directors and approved by Collagen as the sole stockholder in April 1998. A total of 250,000 shares of Common Stock have been reserved for issuance under the Purchase Plan. During fiscal 2000 and 1999, 80,434 shares and 70,790 shares, respectively, were purchased. At June 30, 2000, 98,776 shares were available for future sale under the plan. The average issuance price in fiscal 2000 was $3.33. The Purchase Plan consists of a series of overlapping offering periods of 24 months' duration, with new offering periods (other than the first offering period) commencing on January 1 and July 1 of each year. Each offering period consists of four consecutive purchase periods of six months' duration. The initial offering period commenced on August 19, 1999 and ended on June 30, 2000; the initial purchase period ended on December 31, 1998. Under the 1998 Purchase Plan, the Company's employees, subject to certain restricts, may purchase shares at a price equal to the lower of 85% of the fair market value of the Company's Common Stock at the beginning of each offering period or at the end of each purchase period.
Pro Forma Information
Pro forma information regarding net income (loss) is required by SFAS 123. Prior to fiscal 1999, Cohesion and its subsidiaries had accounted for Cohesion Corporation employee stock options granted subsequent to Cohesion's acquisition of a majority ownership in Cohesion Corporation in May 1996 under fair value method of that statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model for the multiple-option approach, with the following weighted-average assumptions for 2000 and 1999:
The pro forma impact is not representative of future years, as future years will include the effect of options vesting as well as the impact of multiple years of stock option grants. The full effect of SFAS 123 will not be fully reflected until 2001.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because the 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 the employee stock options.
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to pro forma net income over the options' vesting period. The pro forma information for 1998 reflects only the Cohesion Corporation subsidiary stock options. Cohesion's pro forma information follows (in thousands):
(1) Pro forma share and per share data has been presented for fiscal 1998 assuming the distribution of shares of the Company's Common Stock to Collagen's stockholders had already occurred based on the number of Collagen common shares and common equivalent shares outstanding for those periods, assuming a one-for-one exchange ratio in the distribution.
The following table summarizes information about Cohesion's stock options outstanding at June 30, 2000:
The weighted-average fair value of options granted during the years ended June 30, 2000 and June 30, 1999 was $5.41 and $1.62 per share, respectively.
Cohesion Corporation Subsidiary Stock Options
In April 1996, the Board of Directors of Cohesion Corporation approved the adoption of the 1996 Cohesion Corporation Stock Option Plan which authorized the issuance of 475,000 shares of Cohesion Corporation common stock under the plan. In May 1997, the Board of Directors of Cohesion Corporation authorized the issuance of an additional 300,000 shares of Cohesion Corporation stock under the plan. Stock options were granted to officers, directors, key employees and consultants to purchase Cohesion Corporation common stock.
In September 1998, the Company's Board of Directors approved a program to cancel options to purchase shares of common stock of Cohesion Corporation (the "Canceled Options"). In connection with such program, the Company offered to pay each holder of Canceled Options a per share amount equal to the excess of $16.70 over the exercise price of the Canceled Option (the "Option Payment"). The Company will make this Option Payment ratably over the original vesting period of the Canceled Option so long as the former holder thereof remains an employee or consultant of the Company or Cohesion Corporation. The Company recorded $1.4 million and $3.4 million of compensation expense related to these Canceled Options during fiscal 2000 and 1999, respectively. The Company expects to record an additional $0.4 million and $0.1 million of compensation expense with respect to the cash-out of Canceled Options, which will be recognized during fiscal years 2000 and 2001, respectively.
Stock option activities under the Cohesion Corporation Stock Option Plan were as follows:
Stockholders' Rights Plan
On April 21, 1999, the Board of Directors of the Company adopted a Rights Agreement, and has authorized and declared a dividend of one preferred share purchase right (a "Right") for each common stock outstanding at the close of business on May 19, 1999. When exercised, each Right will entitle stockholders to purchase 1/1000 of a share of Series A Junior Participating Preferred Stock of the Company at a price of $25.00 per 1/1000 preferred stock share. The Rights only become exercisable in certain limited circumstances involving acquisitions of or tender offers of 15% or more of the Company's common stock. At any time prior to the announcement of any such acquisition or offer, the Rights are redeemable by the Company at a price of $0.01 per Right. The Rights expire on April 21, 2009.
11. SEGMENT AND GEOGRAPHICAL INFORMATION
The Company develops proprietary surgical products, including bioresorbable hemostatic devices and biosealants for tissue repair and regeneration. The Company operated in two segments until it reduced its ownership interest in the NeuColl orthopedics subsidiary during the March 2000 quarter: 1) the surgical business, and 2) an orthopedic business. Both segments reported to the Chief Executive Officer ("CEO") of Cohesion who allocated resources to each segment. The CEO was identified as the Chief Operating Decision Maker as defined by SFAS 131. Currently management does not allocate assets between, or evaluate operating profit or loss of the two segments.
The following table shows revenue by segment by year (in thousands):
During fiscal years 2000, 1999 and 1998, Cohesion, through its orthopedic unit NeuColl, realized product sales of $1.0 million, $1.9 million and $1.5 million, respectively. As of March 31, 2000, Cohesion's ownership interest in NeuColl fell below 50%. From that date forward NeuColl's operations were no longer consolidated with the results of the Company.
Export sales, which are denominated in U.S. dollars and represent substantially all the Company's international sales, represent sales to the Company's customers primarily throughout Europe. The following table displays sales by the Company to customers in different geographic areas, expressed as a percentage of revenue, by year:
12. INCOME TAXES
Cohesion uses the liability method for income taxes required by SFAS No. 109. The provision was prepared on the basis that Cohesion filed separate tax returns in each year. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of Cohesion's deferred tax assets and liabilities as of June 30, 2000 and 1999 are presented below (in thousands):
The valuation allowance decreased by $3,364,000 and $17,000 in fiscal 2000 and 1999, respectively. Significant components of the provision (benefit) for income taxes are as follows (in thousands):
The provision (benefit) for income taxes differs from the amount computed by applying the statutory federal income tax rate to income before taxes. The sources and tax effects of the differences are as follows (in thousands):
13. COMPREHENSIVE INCOME
14. EMPLOYEE BENEFIT PLAN
The Company has a savings plan which qualifies under Section 401(k) of the Internal Revenue Code. Under the plan, participating employees may defer up to 15% of their pre-tax salary; highly compensated employees may defer up to 10% of their pre-tax salary. All regular U.S. employees are eligible to participate. The plan provides for the Company to match based on the first 6% of contribution at 50% for every dollar an employee defers, up to $1,000 annually.
SUPPLEMENTARY QUARTERLY CONSOLIDATED FINANCIAL DATA (UNAUDITED)
SELECTED QUARTERLY FINANCIAL DATA
The Common Stock of the Company is traded over-the-counter on The Nasdaq Stock Market under the symbol CSON. The Company does not expect to pay dividends in the near future.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not Applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item concerning our directors is incorporated by reference from the information under the caption "Proposal No. 1: Election of Directors" in our Proxy Statement for our 2000 Annual Meeting of Stockholders filed on or about September 28, 2000 (the "Proxy Statement").
The information required by this item concerning our executive officers is set forth in "Item1 - Business - Executive Officers" of this Form 10-K.
ITEM 11.
ITEM 11. COMPENSATION
The information required by this item is incorporated by reference from the information under the caption "Proposal No. 1: Election of Directors - Executive Officer Compensation" in the Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated by reference from the information under the caption "Information Concerning Solicitation and Voting - Share Ownership of Certain Beneficial Owners and Management" in the Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated by reference from the information under the caption "Proposal No. 1: Election of Directors - Certain Transactions" in the Proxy Statement.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as a part of this report:
1. Financial Statements - See Index to Consolidated Financial Statements at Item 8 of this report.
2. Financial Statement Schedules - Schedules have been omitted because they are not required or the information required to be set forth therein is included in the Consolidated Financial Statements or notes thereto.
3. Exhibits - A complete listing of required exhibits is given in the Exhibit Index that precedes the exhibits filed with this report.
(b) Reports on Form 8-K:
None
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.
COHESION TECHNOLOGIES, INC.
/s/ David Foster ------------------------------------ David Foster Chief Executive Officer, and Director (Principal Executive Officer and Principal Financial Officer)
Dated: September 25, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX
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(1) Incorporated by reference to the identically numbered exhibit filed with the Company's Registration Statement on Form 10, as amended (File No. 000-24103), which became effective on June 26, 1998.
(2) Confidential treatment has been or will be requested as to certain portions of this Exhibit.
(3) Incorporated by reference to Exhibit 10.24 filed with Collagen Corporation's Annual Report on Form 10-K for the fiscal year ended June 30, 1985.
(4) Incorporated by reference to Exhibit 10.60 filed with Collagen Corporation's Annual Report on Form 10-K for the fiscal year ended June 30, 1993.
(5) Incorporated by reference to Exhibit 10.56 filed with Collagen Corporation's Annual Report on Form 10-K for the fiscal year ended June 30, 1992.
(6) Incorporated by reference to Exhibit 10.63 of Collagen Corporation's Annual Report on Form 10-K for the fiscal year ended June 30, 1994.
(7) Incorporated by reference to Exhibit 10.79 of Collagen Corporation's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 1996.
(8) Incorporated by reference to Exhibit 10.76 of Collagen Corporation's Quarterly Report on Form 10-Q for the fiscal quarter ended December 31, 1995.
(9) Incorporated by reference to Exhibit 10.82 of Collagen Corporation's Annual Report on Form 10-K for the fiscal year ended June 30, 1996.
(10) Incorporated by reference to Exhibit 10.88 of Collagen Corporation's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 1997.
(11) Management contract or compensatory plan or arrangement.
(12) Incorporated by reference to Exhibit 2.1 of Collagen Corporation's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 1998.
(13) Incorporated by reference to Exhibit 10.104 of Collagen Corporation's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 1998.
(14) Incorporated by reference to Exhibit 10.97 of Collagen Corporation's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 1998.
(15) Incorporated by reference to Exhibit 10.103 of Collagen Corporation's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 1998.
(16) Incorporated by reference to Exhibit 10.98 of Collagen Corporation's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 1998.
(17) Incorporated by reference to Exhibit 10.100 of Collagen Corporation's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 1998.
(18) Incorporated by reference to Exhibit 10.101 of Collagen Corporation's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 1998.
(19) Incorporated by reference to Exhibit 10.99 of Collagen Corporation's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 1998.
(20) Incorporated by reference to Exhibit 10.102 of Collagen Corporation's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 1998.
(21) Incorporated by reference to the identically numbered exhibit filed with the Company's Current Report on Form 8-K (File No. 000-24103) dated May 3, 1999.
(22) Incorporated by reference to Exhibit 10.1 of the Company's Form 10-Q for the fiscal quarter ended December 31, 1999.