20-F 1 a2080893z20-f.txt FORM 20-F AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JUNE 14, 2002 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 20-F ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001 COMMISSION FILE NO. 0-28550 VISIBLE GENETICS INC. (Exact name of Registrant as specified in its charter and translation of Registrant's name into English) ONTARIO, CANADA (Jurisdiction of incorporation or organization) 700 BAY STREET, TORONTO, ONTARIO, CANADA M5G 1Z6 (Address of principal executive offices) SECURITIES REGISTERED OR TO BE REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE SECURITIES REGISTERED OR TO BE REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON SHARES, NO PAR VALUE (Title of Class) Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act: None Indicate the number of outstanding shares of each of the Registrant's classes of capital or common stock as of the close of the period covered by the annual report: As of December 31, 2001, the Registrant had outstanding 19,197,191 Common Shares and 25,153 Series A Preferred Shares. Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes /X/ No / / Indicate by check mark which financial statement item the Registrant has elected to follow: Item 17 / / Item 18 /X/ ================================================================================ Visible Genetics Inc. Annual Report on Form 20-F For the Fiscal Year Ended December 31, 2001 FORWARD-LOOKING STATEMENTS This annual report includes forward-looking statements. You can identify these forward-looking statements when you see us using words such as "expect," "anticipate," "estimate," "believe," "intend," "may," "predict," and other similar expressions. These forward looking statements cover, among other items: - our expectations about our ability to sell our company or enter into another strategic transaction; - our expectations about our financial performance; - our future capital needs; - our ability to bring our Atlanta manufacturing facility fully operational in a timely manner; - acceptance of genotyping in the clinical diagnostic market; - acceptance of our products in the clinical diagnostic market; - our expectations about the markets for our products; - our marketing and sales plans; - the performance of our products; - our intention to introduce new products; - FDA and other regulatory approval for certain of our products; - reimbursement of our products by insurance companies and other third-party payors; - our ability to compete in the clinical diagnostic, clinical research and research markets; - our patent applications; and - our expectations about the effect of the existing lawsuits against our company. We have based these forward-looking statements largely on our current expectations. However, forward-looking statements are subject to a number of risks and uncertainties, certain of which are beyond our control. Actual results could differ materially from those anticipated as a result of the factors described under "Risk Factors" including, among others: - whether we sell our company or enter into another strategic transaction; - the timing of our future capital needs or our inability to raise additional capital when needed; - uncertainty of acceptance of genotyping, in general, and of our products, in particular, in the clinical diagnostic market; - failure of the FDA to take enforcement action to restrict the use of home brew genotyping tests to provide drug resistance reports to physicians and other healthcare providers in the clinical diagnostic market in the United States; - refusal of insurance companies and other third-party payors to reimburse patients and clinicians for our products; - problems that we may face in our ability to sell our hepatitis C genotyping kit to the clinical research market; - problems that we may face in manufacturing, marketing and distributing our products; - delays in obtaining, or our inability to obtain, approval by the FDA for changes made to FDA-approved products; - delays in obtaining, or our inability to obtain, approval by foreign regulatory authorities for our HIV OpenGene System and, certain of our other products, for the clinical diagnostic market; - delay in obtaining, or our inability to obtain, approval by the FDA for certain of our other products for the clinical diagnostic market; - problems, delays and expenses we may face with future clinical trials; - problems in acquiring and protecting intellectual property important to our business through patents, licenses and other arrangements. - our ability to successfully defend claims that our products may infringe the intellectual property rights of others; - problems with important suppliers and business partners; and - delays in developing, or the failure to develop, new products and enhanced versions of existing products. We do not undertake any obligation to publicly update or revise any forward-looking statements contained in this annual report, whether as a result of new information, future events or otherwise. Because of these risks and uncertainties, the forward-looking statements and circumstances discussed in this annual report might not transpire. Registered or unregistered trademarks or trade names of Visible Genetics Inc. used in this annual report include: CLIP, GEL TOASTER, GENEOBJECTS, LONG-READ TOWER, MICROCEL, OPEN GENE, SUREFILL, TRUGENE, VISIBLE GENETICS and the Visible Genetics logo. Each trademark, trade name or service mark of any other company appearing in this annual report belongs to its holder. TABLE OF CONTENTS
PAGE PART I Item 1. Identity of Directors, Senior Management and Advisers..........................................1 Item 2. Offer Statistics and Expected Timetable........................................................1 Item 3. Key Information................................................................................1 Selected Financial Data........................................................................1 Risk Factors...................................................................................2 Item 4. Information on the Company....................................................................18 Recent Developments...........................................................................18 Overview......................................................................................18 Property, Plants and Equipment................................................................34 History and Development of the Company........................................................35 Organizational Structure......................................................................35 Item 5. Operating and Financial Review and Prospects..................................................36 Operating Results.............................................................................36 Liquidity and Capital Resources...............................................................41 Item 6. Directors, Senior Management and Employees....................................................46 Directors and Senior Management...............................................................46 Compensation..................................................................................49 Board Committees..............................................................................50 Employees.....................................................................................50 Share Ownership...............................................................................51 Item 7. Major Shareholders and Related Party Transactions.............................................52 Major Shareholders............................................................................52 Related Party Transactions....................................................................54 Item 8. Financial Information.........................................................................54 Consolidated Statements and Other Financial Information.......................................54 Item 9. The Offer and Listing.........................................................................55 Nature of Trading Market......................................................................55 Item 10. Additional Information........................................................................56 By-Laws and Articles of Incorporation.........................................................56 Material Contracts............................................................................61 Exchange Controls.............................................................................62 Taxation......................................................................................62
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PAGE Documents on Display..........................................................................71 Item 11. Quantitative and Qualitative Disclosures About Market Risk....................................71 Item 12. Description of Securities Other than Equity Securities........................................72 PART II.......................................................................................................72 Item 13. Defaults, Dividend Arrearages and Delinquencies...............................................72 Item 14. Material Modifications to the Rights of Security Holders......................................72 PART III......................................................................................................72 Item 17. Financial Statements..........................................................................72 Item 18. Financial Statements..........................................................................72 Item 19. Exhibits......................................................................................72
-ii- PART I ITEM 1. IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS. Not Applicable. ITEM 2. OFFER STATISTICS AND EXPECTED TIMETABLE. Not Applicable. ITEM 3. KEY INFORMATION. SELECTED FINANCIAL DATA The selected consolidated financial data set forth below should be read in conjunction with "Operating and Financial Review and Prospects" and our Consolidated Financial Statements and the Notes thereto. The Consolidated Statements of Operations data for fiscal years 2001, 2000 and 1999, and the Consolidated Balance Sheet data as at December 31, 2001 and 2000, as set forth below, have been derived from our consolidated financial statements which have been audited by PricewaterhouseCoopers LLP, Chartered Accountants in Canada, whose report with respect to such financial statements is included herein. The Consolidated Statements of Operations data for fiscal years 1998 and 1997, and the Consolidated Balance Sheet data as at December 31, 1999, 1998 and 1997, as set forth below, have been derived from audited consolidated financial statements not included in this annual report. Historical results are not necessarily indicative of results to be expected for any future period. SUMMARY CONSOLIDATED FINANCIAL INFORMATION (dollars in thousands, except per share data)
YEARS ENDED DECEMBER 31, ----------------------- STATEMENT OF OPERATIONS DATA: 2001 2000 1999 1998 1997 ----------- ----------- ---------- ---------- ---------- Sales..................................... $ 13,580 $ 13,073 $ 13,627 $ 10,875 $ 3,033 Cost of sales............................. 9,998 10,134 9,273 6,673 1,995 ----------- ----------- ---------- ---------- ---------- Gross margin.............................. 3,582 2,939 4,354 4,202 1,038 Sales, general and administrative expense. 33,986 28,571 19,074 11,516 7,448 Research and development expense.......... 10,835 10,606 7,935 6,289 4,123 Other expense............................. 1,920 - 1,329 420 654 ----------- ----------- ---------- ---------- ---------- Loss from operations before interest...... (43,159) (36,238) (23,984) (14,023) (11,187) Interest income........................... 2,513 4,481 695 264 774 Interest and financing expense............ (8) (17) (1,998) (1,132) (3) ----------- ----------- ---------- ---------- ---------- Net loss.................................. (40,654) (31,774) (25,287) (14,891) (10,416) Cumulative preferred dividends and accretion of discount attributable to preferred shares...................... (3,427) (3,656) (1,770) - - ----------- ----------- ---------- ---------- ---------- Net loss attributable to common shareholders.......................... $ (44,081) $ (35,430) $ (27,057) $ (14,891) $ (10,416) =========== =========== ========== ========== ========== Net loss per common share................. $ (2.67) $ (2.42) $ (2.73) $ (1.91) $ (1.48) Weighted average number of common shares outstanding........................... 16,481,916 14,612,172 9,916,954 7,782,094 7,059,578 DECEMBER 31, ------------ BALANCE SHEET DATA: 2001 2000 1999 1998 1997 ---------- ---------- --------- --------- --------- Cash, cash equivalents and short-term investments........................... $ 53,195 $ 80,399 $ 42,688 $ 11,274 $ 7,588 Working capital........................... 50,985 78,107 45,319 8,432 9,561 Total assets.............................. 93,369 110,176 58,640 27,783 13,936 Indebtedness.............................. - - - 7,495 - Mandatorily redeemable convertible preferred shares ..................... 26,886 24,397 27,556 - - Accumulated deficit ...................... (136,840) (92,039) (59,438) (34,151) (19,260) Shareholders' equity...................... 57,550 76,665 24,351 14,579 12,610
RISK FACTORS ALTHOUGH WE ARE ACTIVELY PURSUING POSSIBLE STRATEGIC TRANSACTIONS, INCLUDING A POSSIBLE SALE OF OUR COMPANY, WE CANNOT BE CERTAIN OF WHETHER WE WILL BE ABLE TO COMPLETE ANY STRATEGIC TRANSACTION OR OF THE TERMS UPON WHICH A STRATEGIC TRANSACTION WOULD BE COMPLETED. We currently are engaging in discussions with third parties regarding strategic alternatives, including the potential sale of our company. We cannot be certain whether we will be able to sell our company or complete any of the other strategic alternatives we currently are pursuing. We also cannot be certain as to the terms upon which any strategic transaction would be completed, including the consideration that would be paid to our common shareholders should we sell our company. If we enter into a strategic transaction that would include an investment in our company, the ownership interest of our existing common shareholders would be diluted. WE MAY NEED TO RAISE ADDITIONAL CAPITAL IN THE FUTURE AND WE CANNOT BE CERTAIN THAT WE WILL BE ABLE TO RAISE CAPITAL WHEN NECESSARY ON ACCEPTABLE TERMS. At this time, our sales are not sufficient to meet our anticipated financing requirements. Based on our current plans, we believe that current cash balances and anticipated funds from operations will be sufficient to enable us to meet our operating needs for the next 9 to 12 months. However, the amount of funds that we will need during this period will be determined by many factors, some of which are beyond our control. These factors, among others, include: - our success in selling our HIV OpenGene System to the clinical diagnostic market; - our ability to manufacture enough of our genotyping kits to meet the needs of our customers; - the costs we incur in pursuing strategic transactions; - our ability to acquire and protect intellectual property important to our business through patents, licenses or other arrangements; - our success in introducing new products during the period; - the costs of conducting clinical trials; - regulatory costs incurred in bringing products to market; - our need to defend claims that our products may infringe the intellectual property rights of others; - the costs of acquiring and integrating any new business or technologies during the period; and - our incurring significant fixed overhead and other expenses prior to increasing our revenues. We expect that we will need to obtain additional funds at the end of this 9 to 12 month period. However, we may need to obtain additional funds sooner or in greater amounts than we currently anticipate. Potential sources of financing include strategic relationships, public or private sales of our shares or debt or other arrangements. Because of our potential long-term capital requirements, we may seek to access the public or private equity markets whenever conditions are favorable, even if we do not have an immediate need for additional capital at that time. We do not have any committed sources of financing at this time and it is uncertain whether additional funding will be available when we need it on 2 terms that will be acceptable to us or at all. If we raise funds by selling additional common shares or other securities convertible into common shares, the ownership interest of our existing shareholders will be diluted. If we are not able to obtain financing when needed, we would be unable to carry out our business plan, we would have to significantly limit our operations and our business, financial condition and results of operations would be materially harmed. OUR LIMITED OPERATING HISTORY MAKES IT DIFFICULT TO EVALUATE OUR FUTURE PROSPECTS AND OUR PROSPECTS MUST BE CONSIDERED IN LIGHT OF THE DIFFICULTIES FREQUENTLY ENCOUNTERED BY COMPANIES IN THE EARLY STAGES OF COMMERCIAL MANUFACTURING AND MARKETING. Although we began operations in 1993, we are only in the early stages of commercially manufacturing and marketing our products. In late 1996, we began manufacturing and selling the initial versions of our automated DNA sequencers and related products to the research and clinical research markets. We began selling our FDA-cleared TRUGENE HIV-1 Genotyping Kit and related DNA sequencing equipment and products, which we call our HIV OpenGene System, to the clinical diagnostic market in the United States in the fourth quarter of 2001. Our limited operating history makes it difficult to evaluate our business and our prospects for future profitability. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in the early stages of commercial manufacturing and marketing. Sales for our fiscal years ended December 31, 2001 and December 31, 2000, were $13.6 million and $13.1 million, respectively. In the future, sales may not increase or they may decrease. WE HAVE A HISTORY OF LOSSES, WE ANTICIPATE ADDITIONAL LOSSES AND WE MAY NEVER BECOME PROFITABLE. We incurred a net loss attributable to common shareholders of $10.8 million in the fiscal quarter ended March 31, 2002 and $44.1 million in the fiscal year ended December 31, 2001. As of March 31, 2002, our accumulated deficit was $147.5 million. Our losses have resulted principally from expenses incurred in connection with sales and marketing of our products, research and development of our technology and products, and from expenses that we have incurred while building our business infrastructure. We expect to continue to incur significant operating losses in the future as we continue our research and development efforts, clinical trials and sales and marketing activities, in an effort to achieve greater sales and expand our business. It is uncertain when, if ever, we will become profitable. Our ability to become profitable will depend on many factors including, among others: - our ability to successfully market and sell our TRUGENE HIV-1 Genotyping Kit and related products, and in the future, other genotyping kits and related products, to the clinical diagnostic market; - our ability to sell our hepatitis C genotyping kit to the clinical diagnostic market; - whether the FDA takes enforcement action to restrict the use of unapproved (also known as "home brew") HIV genotyping tests to provide drug resistance reports to physicians and other healthcare providers in the clinical diagnostic market in the United States; - our ability to manufacture our products according to schedule and within budget; - whether we obtain regulatory approval to sell other genotyping kits and related DNA sequencing equipment and products for other diseases to the clinical diagnostic market in the United States and abroad; - the decision of third-party payors to reimburse clinicians and patients for use of our TRUGENE HIV-1 Genotyping Kit and, in the future, our other products; 3 - our ability to acquire and protect intellectual property important to our business through patents, licenses or other arrangements; - our ability to effectively manage the growth of our business; and - our ability to continue to develop advanced versions of our products and technologies and new products and technologies in a timely manner. OUR OPERATING RESULTS MAY FLUCTUATE FROM QUARTER TO QUARTER DUE TO MANY FACTORS AND, THEREFORE, YOU SHOULD NOT RELY ON PERIOD TO PERIOD COMPARISONS OF OUR OPERATING RESULTS AS AN INDICATION OF FUTURE PERFORMANCE. Our operating results have varied on a quarterly basis in the past and may fluctuate significantly in the future as a result of a variety of factors, many of which are outside our control. Factors that may affect our quarterly operating results include, among others: - our decision to increase or decrease sales of equipment, genotyping kits and other consumables at reduced prices; - our decision to reduce prices of our products in response to price reductions by competitors; - unanticipated costs or delays in manufacturing our products; - the amount and timing of operating costs and capital expenditures relating to research and development, the fluctuations in sales of our products during any given quarter, and the expansion of our business, operations and infrastructure; - unanticipated costs or delays in carrying out our clinical trials; - general economic conditions, as well as economic conditions specific to the biotechnology industry; and - costs of pursuing strategic transactions. We believe that period to period comparisons of our operating results may not be meaningful and you should not rely on any such comparisons as an indication of our future performance. In addition, it is likely that in one or more future quarters our operating results will fall below the expectations of securities analysts and investors. In such event, the market price of our common shares is likely to fall. THE MARKET FOR GENOTYPING PRODUCTS IS NEW AND GENOTYPING MAY NOT BECOME AN ACCEPTED METHOD OF MANAGING DRUG TREATMENT. An essential part of our business strategy is our plan to sell our products to the clinical diagnostic market. Our ability to do so will depend on the widespread acceptance and use by doctors and clinicians of genotyping to manage drug treatment of certain diseases or other medical conditions. The use of genotyping by doctors and clinicians for this purpose is relatively new. We are not aware of any other DNA sequencing products that have been approved by the FDA for clinical diagnostic purposes. We cannot be certain that doctors and clinicians will want or continue to have a need to use DNA sequencing systems designed for these purposes. If genotyping is not accepted by this market or not needed as frequently as we currently anticipate, we will not be able to carry out our business plan and our business, financial condition and results of operations will be materially harmed. 4 IF GENOTYPING IS ACCEPTED AS A METHOD TO MANAGE DRUG TREATMENT, WE CANNOT BE CERTAIN THAT OUR PRODUCTS WILL BE ACCEPTED IN THE CLINICAL DIAGNOSTIC MARKET. If genotyping becomes widely accepted in the clinical diagnostic market, we cannot predict the extent to which doctors and clinicians may be willing to utilize our TRUGENE HIV-1 Genotyping Kit or other genotyping kits to manage drug treatment of HIV and other selected diseases or other medical conditions. Doctors and clinicians may prefer competing technologies and products that can be used for the same purposes as our products such as home brew genetic tests, phenotyping assay services, DNA probe-based diagnostic systems and other DNA sequencers. If our products are not accepted by the clinical diagnostic market, our business, financial condition and results of operations will be materially harmed. IF THE FDA DOES NOT PROHIBIT CERTAIN OF OUR COMPETITORS FROM USING HOME BREW GENOTYPING TESTS TO PROVIDE HIV DRUG RESISTANCE TESTING AND DRUG RESISTANCE REPORTS TO PHYSICIANS, WE WILL SUFFER A SIGNIFICANT COMPETITIVE DISADVANTAGE AND OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS WILL BE MATERIALLY HARMED. Some of our competitors, including some large clinical laboratories, have developed home brew HIV genotyping tests which are not approved for clinical diagnostic use by the FDA or other regulatory agencies. We believe that three of these clinical laboratories currently are the largest commercial users of HIV genotyping tests. The FDA has said that it will not require premarket approval of these home brew tests developed in-house by clinical laboratories if they are used exclusively by the laboratories for HIV monitoring and if the laboratories do not make any medical claims for their tests and provide only analytical results to their customers. We believe that some of these laboratories have interpreted the FDA policy to mean that they are permitted to use their home brew genotyping tests to conduct HIV drug resistance testing in the laboratories and provide drug resistance reports about specific patients to physicians, in direct competition with our TRUGENE HIV-1 Genotyping Kit. We believe, however, that the FDA policy prohibits the use of the HIV home brew genotyping tests for these purposes and that these laboratories are required to obtain FDA approval before using their genotyping tests in this fashion. We are not certain how the FDA will interpret, or whether and when it will enforce, its policy as it applies to these HIV home brew genotyping tests. Since our business plan contemplates that we will generate future revenue from sales of our TRUGENE HIV-1 Genotyping Kit to these laboratories, if the FDA does not prohibit these laboratories from using their home brew genotyping tests in this fashion, we will suffer a significant competitive disadvantage and our business, financial condition and results of operations will be materially harmed. IF INSURANCE COMPANIES AND OTHER THIRD-PARTY PAYORS DO NOT REIMBURSE DOCTORS AND PATIENTS FOR OUR PRODUCTS, OUR ABILITY TO SELL OUR PRODUCTS TO THE CLINICAL DIAGNOSTIC MARKET WILL BE IMPAIRED. Our ability to successfully sell our TRUGENE HIV-1 Genotyping Kit and other genotyping kits to the clinical diagnostic market will depend partly on the willingness of insurance companies and other third-party payors to reimburse doctors and patients for use of our products. Physicians' recommendations to use genotyping, as well as decisions by patients to pursue genotyping, are likely to be influenced by the availability of reimbursement for genotyping by insurance companies or other third-party payors. Government and private third-party payors are increasingly attempting to contain health care costs by limiting both the extent of coverage and the reimbursement rate of products and services for testing and treatment. In particular, services that are determined to be investigational in nature or that are not considered "reasonable and necessary" for diagnosis or treatment may be denied reimbursement coverage. If adequate reimbursement coverage is not available from insurers or other third-party payors, we expect that few, if any, patients would be willing to pay for genotyping. In this case, our anticipated 5 revenues will be substantially reduced, our ability to achieve profitability will be significantly impaired and our business, financial condition and results of operations will be materially harmed. MANUFACTURING PROBLEMS COULD HAMPER OR DELAY OUR ABILITY TO SELL OUR PRODUCTS TO THE MARKETPLACE. We have limited experience in large-scale manufacturing and assembly of our products. Since we started manufacturing and assembling operations in 1996, we have experienced delays, quality control problems and capacity constraints from time to time. Until March 31, 2002, we manufactured genotyping kits at our Pittsburgh, Pennsylvania facility. We closed that facility in April 2002, and we currently do not have another facility available to manufacture genotyping kits for full scale commercial production. We plan to manufacture our genotyping kits at our new facility in Atlanta, Georgia. We have completed construction of this facility and we currently are testing the facility to ensure regulatory compliance. We expect our Atlanta facility to be cleared for full scale commercial production during the third quarter of 2002. However, qualifying the facility for regulatory compliance may take longer than expected. We currently have an adequate supply of genotyping kits in inventory to meet our current orders. Until our Atlanta facility becomes fully operational, we may experience shortages in the supply of genotyping kits from time to time. Any significant delay in making the Atlanta facility fully operational will severely limit our ability to meet our customer's future demands for genotyping kits. When we begin manufacturing genotyping kits at our Atlanta facility, additional problems may arise. These may include technological, engineering, quality control and other production difficulties. We may also have difficulty complying with FDA quality system regulations at each of our facilities. If we experience these problems, we could be delayed in filling orders, shipping existing products and introducing new products to the marketplace. These problems could adversely affect customer satisfaction and the market acceptance of our products, and our business, financial condition and results of operations will be materially harmed. WE NEED TO OBTAIN A LICENSE OR ENTER INTO A DISTRIBUTION AGREEMENT FOR SOME OF THE COMPONENTS INCLUDED IN OUR HEPATITIS C GENOTYPING KIT, BUT MAY NOT BE ABLE TO DO SO ON ACCEPTABLE TERMS. We have developed a genotyping kit for hepatitis C. We need to obtain a license for some of the components included in our hepatitis C genotyping kit, but we do not have a license at this time and we may not be able to obtain a license on acceptable terms or at all. If we are unable to obtain a license, our customers may be able to purchase the required components from a licensed supplier. Alternatively, we may attempt to enter into a distribution arrangement that would enable us to distribute our hepatitis C genotyping kit without our own license. However, we may not be able to enter into a distribution arrangement on acceptable terms or at all. If we are unable to obtain a required license or enter into a distribution arrangement or if we are unable to make alternate arrangements, we may not be able to sell our hepatitis C genotyping kit to the clinical research or clinical diagnostic markets. If we are unable to sell our hepatitis C genotyping kit or if we encounter significant costs in doing so, our business, financial condition and results of operations will be materially harmed. IF WE ARE REQUIRED TO OBTAIN FDA APPROVAL TO SELL OUR HEPATITIS C GENOTYPING KIT TO THE CLINICAL RESEARCH MARKET, OUR SALES OF THIS GENOTYPING KIT WILL BE SIGNIFICANTLY DELAYED. Our hepatitis C genotyping kit identifies the specific hepatitis C subtypes a patient is most likely to have contracted. The report generated does not provide information about a patient's drug resistance or 6 recommend the use of specific drugs for treatment of that patient. We believe that FDA approval is not generally required for hepatitis C genotyping products which are used for epidemiological studies. However, the FDA has not provided definitive guidance as to whether a hepatitis C product used for the purpose and in the manner we intend our hepatitis C genotyping kit to be used, would require approval. We are aware of at least one product similar to ours that is being marketed and sold by a competitor without FDA approval. To our knowledge, the FDA has not advised that company that FDA approval is required to market and sell the product for the purposes for which it is intended to be used and has not initiated enforcement action to stop the marketing or sale of the product. We do not intend to seek FDA clearance to market our hepatitis C genotyping kit for the purposes for which it is intended to be used. However, we cannot be certain that the FDA will not determine that authorization is required for us to market and sell the hepatitis C genotyping kit for these purposes or direct us not to sell the kit without authorization. If we are required to obtain FDA approval, we will not be able to sell our hepatitis C genotyping kit to the clinical research market until FDA approval is obtained. The FDA approval process is lengthy and expensive and we may never receive FDA approval. If we are required to obtain FDA approval and we are unable to do so or if we encounter significant delays in obtaining FDA approval, our business, financial condition and results of operations will be materially harmed. WE DO NOT HAVE MARKETING EXPERIENCE IN THE CLINICAL DIAGNOSTIC MARKET, WE CANNOT BE CERTAIN WE WILL SUCCESSFULLY DEVELOP THE MARKETING CAPABILITIES REQUIRED TO SELL OUR PRODUCTS TO THIS MARKET AND IN SOME MARKETS WE WILL BE DEPENDENT ON THE EFFORTS OF DISTRIBUTORS TO SELL OUR PRODUCTS. We have no experience marketing products to the clinical diagnostic market. We have built a sales force to sell our HIV OpenGene System in the clinical diagnostic market in North America and selected other countries. We began selling our HIV OpenGene System to the clinical diagnostic market in the United States in the fourth quarter of 2001. We cannot be certain that we will successfully market and sell our products to the clinical diagnostic market. We have granted rights to distribute our OpenGene Systems to distributors in the clinical diagnostic, clinical research, and research markets in many countries outside of the United States and Canada. Our ability to successfully sell products in countries in which we rely on distribution agreements will depend to a great extent on the efforts of the distributors. Failure to successfully market our products, will impede our ability to generate significant revenues and become profitable and our business, financial condition and results of operations will be materially harmed. On February 27, 2002, we received notice of a lawsuit that has been filed in Milan, Italy against our company and two of our subsidiaries by Nuclear Laser Medicine Srl. The lawsuit seeks unspecified damages and seeks to enforce an alleged agreement covering distribution of our hepatitis C and HIV products in Italy. We believe that these claims are without merit and intend to vigorously contest the allegations made in the lawsuit. Since the amount of damages are unspecified, we cannot at this time determine, if we are unsuccessful, whether this legal action will have a material adverse effect on our business, financial condition or results of operations. WE MAY NOT RECEIVE APPROVAL OF CERTAIN FOREIGN REGULATORY AUTHORITIES FOR OUR HIV OPENGENE SYSTEM, AND THEREFORE, WE MAY NOT BE ABLE TO SELL OUR HIV OPENGENE SYSTEM TO THE CLINICAL DIAGNOSTIC MARKET IN SOME FOREIGN COUNTRIES. We have obtained regulatory approval to sell our HIV OpenGene System to the clinical diagnostic market in the United States, Argentina, Canada, France and Israel. However, in Canada we will be required to meet additional regulations that become effective in January 2003. We cannot be certain that we will be able to comply with these new 7 regulations. If we do not comply with these new regulations, we will be unable to sell our HIV OpenGene System to the clinical diagnostic market in Canada. We are required to obtain approval from regulatory authorities to sell our HIV OpenGene System to the clinical diagnostic market in some other countries. We believe we currently are able to sell our HIV OpenGene System to the clinical diagnostic market in the following European Union (EU) member states (in addition to France): Belgium, Luxembourg, United Kingdom, Holland, Scandinavia and Spain. We expect that further regulatory approvals will not be required in these EU member states until new EU wide regulations go into effect in December 2003. We anticipate being in compliance with the new EU regulations as they become effective. However, we cannot be certain that we will be able to meet any future EU regulations in a timely manner, or at all. In some EU and other counties, we may face an approval process similar to that required by the FDA. We cannot be certain that we will obtain the necessary approvals to sell our HIV OpenGene System to the clinical diagnostic market in any of these countries. In some cases, the failure to obtain approval could materially harm our business, financial condition and results of operations. EACH TIME WE MAKE ALTERATIONS TO ANY FDA APPROVED PRODUCTS, WE MAY NEED TO SEEK ADDITIONAL FDA APPROVAL, WHICH MAY LENGTHEN THE TIME AND INCREASE THE COST OF BRINGING UPGRADED OR NEW PRODUCTS TO MARKET. We may need to seek additional FDA approval if we make changes to a product specifically approved by the FDA. We will be required to obtain prior clearance from the FDA for those product changes that could significantly affect safety or effectiveness. We also may be required to obtain similar foreign regulatory approval. To obtain additional approval for some types of changes, we may have to conduct additional human clinical trials to demonstrate that the altered product will produce at least the same results as the approved product or will be as safe and effective as the approved product. Obtaining additional FDA or foreign regulatory approval is likely to be time consuming and costly and, as a result, we may experience delays in bringing these upgraded or new products to market. We expect to update the drug resistance algorithms, embedded in the software package included in our HIV OpenGene System, approximately every six months. FDA review and approval of any significant updates may be required. Based on informal discussions with the FDA, we expect that, if FDA approval is required, the FDA's review and approval of these updates will not exceed 90 days, provided we satisfy the FDA's approval requirements. However, there can be no assurance that such review process will not take longer. If the FDA's review process takes longer than 90 days, we may be delayed in bringing these updates to market. WE MAY NOT RECEIVE APPROVAL OF THE FDA FOR OTHER PRODUCTS WE MAY DEVELOP, AND, THEREFORE, WE MAY NOT BE ABLE TO SELL OUR OTHER PRODUCTS TO THE CLINICAL DIAGNOSTIC MARKET IN THE UNITED STATES. In the future, we may seek FDA approval to sell other products, including other genotyping kits, for clinical diagnostic purposes in the United States. In order to obtain FDA approval for our other products we will have to submit an application supported by extensive test data demonstrating the utility, reliability and performance of these products. We will also be required to show the FDA that we maintain good laboratory, clinical and manufacturing practices. The FDA approval process is lengthy and expensive. You should be aware of the following possibilities: - We may never obtain approval from the FDA to sell our other products to the clinical diagnostic market; 8 - The FDA may disagree with us that the data are adequate, and we may therefore have to do additional testing; - The additional testing, if any, may show that our other products are not reliable enough, and therefore cannot be authorized by the FDA, or the additional testing may show that our other products do not work as well as they need to for successful marketing, even if marketing is authorized by the FDA; - The additional testing, if any, may be too costly to carry out, either because we lack adequate funds or because the market potential for our other products does not justify the costs; - There may be significant delays in the FDA review process; - The FDA may approve the sale of our other products with conditions that could limit the market for these products or make them more difficult or expensive to sell than we anticipate; and - The FDA may seek to revoke marketing authorization for certain of our products for a variety of reasons. If we fail to receive FDA approval, if FDA approval is delayed or revoked, or if the FDA imposes conditions that make it difficult to sell or market our other products, we will be unable to carry out our business plan to sell our other products for clinical diagnostic use in the United States and our business, financial condition and results of operations could be materially harmed. OUR BUSINESS IS, AND IN THE FUTURE MAY BECOME, SUBJECT TO ADDITIONAL REGULATIONS AND IF WE ARE UNABLE TO COMPLY WITH THEM OUR BUSINESS MAY BE MATERIALLY HARMED. Our reference laboratory in Atlanta, Georgia, is subject to stringent regulation under the Clinical Laboratory Improvement Amendments of 1988, known as CLIA. Under CLIA, laboratories must meet various requirements, including requirements relating to the validation of tests, training of personnel, and quality assurance procedures. The laboratory must also be certified by a government agency. Our Atlanta laboratory is certified under CLIA and licensed by the State of Georgia. Our failure to comply with state or CLIA requirements can result in various penalties, including loss of certification. The imposition of such penalties could have an adverse impact on us. In addition, some states regulate out-of-state laboratories. The failure to comply with these state requirements could also adversely affect us. We are or may become subject to various other federal, state, provincial and local laws, regulations and recommendations. We are subject to various laws and regulations in Canada, the United States and Europe, relating to product emissions, use and disposal of hazardous or toxic chemicals or potentially hazardous substances, infectious disease agents and other materials, and laboratory and manufacturing practices used in connection with our research and development activities. If we fail to comply with these regulations, we could be fined, we may not be able to operate certain of our facilities or certain portions of our business, and we may suffer other consequences that could materially harm our business, financial condition or results of operations. We are unable to predict the extent of future government regulations or industry standards. You should assume that in the future there may be more government regulations or standards. New regulations or standards may result in increased costs, including costs for obtaining permits, delays or fines resulting from loss of permits or failure to comply with regulations. 9 IF WE ARE UNABLE TO CONTINUE DEVELOPING ADVANCED TECHNOLOGY, ADVANCED VERSIONS OF OUR EXISTING PRODUCTS AND NEW PRODUCTS IN A TIMELY AND COST-EFFECTIVE MANNER, OUR ABILITY TO GENERATE REVENUE AND BECOME PROFITABLE WILL BE IMPAIRED. We believe that if we are to generate additional revenue and become profitable, we must continue to develop advanced technology, advanced versions of our existing products and new products. These technology and products must be developed and introduced to the market in a timely and cost-effective manner to meet both changing customer needs and technological developments. We cannot assure you that we will be able to successfully or timely develop any new technology, products or advanced versions of existing products, or that any new technology, products or advanced versions of existing products will achieve acceptance in the market. If we are unable to successfully develop new technology, products or advanced versions of existing products in the future or if those technologies or products are not accepted in the market, our ability to generate significant revenues will be significantly impaired, we could experience additional significant losses and our business, financial condition and results of operations will be materially harmed. IF WE ARE UNABLE TO SUCCESSFULLY PROTECT OUR INTELLECTUAL PROPERTY OR OBTAIN CERTAIN LICENSES, OUR COMPETITIVE POSITION WILL BE HARMED. Our success will partly depend on our ability to obtain patents and licenses, and to protect our trade secrets. We own or jointly own numerous U.S. and foreign patents. We own or jointly own U.S. patent applications and foreign applications presently pending as PCT applications, or as national phase PCT applications, designating intergovernmental agencies and multiple countries including the European Patent Office, Australia, Canada and Japan. We cannot assure you that our patent applications will result in patents being issued in the United States or foreign countries. In addition, the U.S. Patent and Trademark Office may reverse its decision or delay the issuance of patents that have been allowed. We also cannot assure you that any technologies or products that we may develop in the future will be patentable. In addition, competitors may develop products similar to ours that do not conflict with our patents. Others may challenge our patents and, as a result, our patents could be narrowed or invalidated. From time to time, we may be required to obtain licenses from third parties for some of the technology or components used or included in certain of our genotyping kits or other products. We cannot be certain that we will be able to obtain these licenses on acceptable terms or at all. In certain instances, if we are unable to obtain a required license, our ability to sell or use certain products may be limited. To help protect our proprietary rights in unpatented trade secrets, we generally require our employees, consultants and advisors to sign confidentiality agreements. However, we cannot guarantee that these agreements will provide us with adequate protection if confidential information is used or disclosed improperly. In addition, in some situations, these agreements may conflict with, or be limited by, the rights of third parties with whom our employees, consultants or advisors have prior employment or consulting relationships. Further, others may independently develop similar proprietary information and techniques, or otherwise gain access to our trade secrets. OTHERS COULD CLAIM THAT WE INFRINGE ON THEIR INTELLECTUAL PROPERTY RIGHTS, WHICH MAY RESULT IN COSTLY AND TIME CONSUMING LITIGATION. Our success will also depend partly on our ability to operate without infringing upon the proprietary rights of others, as well as our ability to prevent others from infringing on our proprietary rights. We may be required at times to take legal action in order to protect our proprietary rights. Also, 10 from time to time, we receive notices from third parties claiming that we may infringe their patent or other proprietary rights. Despite our best efforts, we may be sued for infringing on the patent or other proprietary rights of others. Such litigation is costly, and, even if we prevail, the cost of such litigation could harm us. If we do not prevail, in addition to any damages we might have to pay, we could be required to stop the infringing activity or obtain a license. We cannot be certain that any required license would be available to us on acceptable terms, or at all. In certain instances, if we are unable to obtain a required license, our ability to sell or use certain products may be impaired. In addition, if we fail to obtain a license, or if the terms of a license are burdensome to us, our business, financial condition and results of operations could be materially harmed. The Board of Trustees of the Leland Stanford Junior University has filed a lawsuit in the United States District Court for the Northern District of California claiming that our TRUGENE HIV-1 Genotyping Kit infringes patents owned by the University. We have received an attorney opinion that we do not infringe any claim of the patents-in-suit. We believe that these claims are without merit and intend to vigorously contest the allegations made in the lawsuit. Since the amount of damages are unspecified, we cannot at this time determine, if we are unsuccessful, whether this legal action will have a material adverse effect on our business, financial condition or results of operations. CERTAIN SUPPLIES AND PARTS THAT WE NEED ARE AVAILABLE ONLY FROM LIMITED SOURCES AND OUR BUSINESS WILL SUFFER IF WE CANNOT OBTAIN THESE SPECIALIZED ITEMS USED IN OUR GENOTYPING KITS. Our genotyping kits include dyes, reagents and other chemicals supplied by third parties. Certain of these dyes, reagents and other chemicals are available only under license from their manufacturers. We cannot be certain that we will be able to renew these licenses upon expiration on favorable terms or at all. While we believe that alternative dyes, chemicals and reagents are available, alternate products may not be as effective as certain of the products that we presently use. If we switched to an alternative dye, chemical or reagent, we may also have to adapt our analysis software and/or our DNA sequencing equipment to the new product, which could take time. If the genotyping kit is FDA approved, we may also be required to seek FDA approval for the altered genotyping kit if the alternative product were to substantially alter the performance of the genotyping kit or if the changes could significantly affect safety or effectiveness. This could cause delays in production and in bringing the altered genotyping kit to market. We currently purchase acrylamide, an important chemical used in our MicroCel cassettes, from one supplier. This supplier has informed us that it is experiencing financial hardship. We have located one alternative supplier and are seeking others. If we purchase acrylamide from other suppliers, we may experience quality control or other problems with the acrylamide from such other suppliers. We also use certain custom-designed components supplied by third parties in our DNA sequencers and other equipment. We believe that there are alternate suppliers for these custom-designed parts. However, we will incur costs in switching to alternate suppliers and will likely experience delays in production of the products that use any of these parts until such time as we are able to locate alternate suppliers or parts on acceptable terms. WE ARE DEPENDENT ON OUR LICENSE FOR THE POLYMERASE CHAIN REACTION TECHNOLOGY WE USE IN MOST OF OUR GENOTYPING KITS AND OUR BUSINESS WOULD SUFFER IF THE LICENSE IS TERMINATED. We license the polymerase chain reaction technology that we use in most of our genotyping kits from Roche Molecular Systems, Inc. and F. Hoffmann-La Roche Ltd. This license is not exclusive, and therefore, may be granted by the Roche companies to our competitors and others. We are required to pay royalties to the Roche companies for this license. The license is for the life of the patents included within the licensing agreement. The license may be terminated by Roche Molecular Systems and F. Hoffman-La 11 Roche prior to the expiration under certain limited circumstances. The termination of this license would have a material adverse effect on our ability to produce or sell our TRUGENE HIV-1 Genotyping Kit and our other genotyping kits that use this technology. Consequently, we could experience a deterioration of anticipated future sales of those genotyping kits and further losses, and our business, financial condition and results of operations would be materially harmed. WE ARE DEPENDENT ON OUR LICENSE FOR CERTAIN TECHNOLOGY WE USE IN OUR DNA SEQUENCING INSTRUMENTS AND OUR BUSINESS WOULD SUFFER IF THE LICENSE IS TERMINATED. We license certain intellectual property owned or exclusively licensed by Applera Corporation, Applied Biosystems Group, which we refer to in this annual report as Applera. The license enables us to utilize certain Applera technology to manufacture and sell our DNA sequencing instruments, as well as manufacture and sell clinical sequencing kits to run on DNA sequencing instruments manufactured by us, Applera and certain other third parties. We are required to pay royalties to Applera for this license. The license is for the life of the patents included within the licensing agreement. Either party may terminate the agreement under certain limited circumstances. The termination of this license would have a material adverse effect on our ability to produce or sell our DNA sequencing instruments and genotyping kits. Consequently, we could experience a deterioration of anticipated future sales of our genotyping kits and further losses, and our business, financial condition and results of operations would be materially harmed. WE FACE SUBSTANTIAL COMPETITION FROM MANY COMPANIES, AND WE MAY NOT BE ABLE TO EFFECTIVELY COMPETE. The biotechnology industry is highly competitive. We compete with entities in the United States and abroad that are engaged in the development and production of products that analyze genetic information. They include: - purveyors of home brew genetic tests, which may not have undergone clinical validation and have not been approved by the FDA or other regulatory agencies, including Laboratory Corporation of America Holdings, Quest Diagnostics Inc. and Specialty Laboratories, Inc. - manufacturers of genotyping test kits, including the Celera Diagnostics division of Applera; - purveyors of phenotyping or genotyping assay services, including ViroLogic, Inc. and Tibotec-Virco NV (a subsidiary of Johnson & Johnson); - manufacturers and distributors of DNA probe-based diagnostic systems such as Abbott Laboratories, Chiron Corp., Roche Diagnostics, Gene Probe Inc., Innogenetics NV, Digene Corporation and Johnson & Johnson; and - manufacturers and distributors of DNA sequencers such as Applera, Amersham Pharmacia Biotech, Inc., LI-COR, Inc., Hitachi, Ltd. and Beckman Coulter, Inc. Many of our competitors have much greater financial, technical research and development resources and production and marketing capabilities than we do. Smaller companies may also prove to be significant competitors, particularly through collaborative arrangements with large pharmaceutical and biotechnology companies. If any of our competitors were to devote significant resources to developing an integrated solution for genotyping, we would experience significantly more competitive pressure. We cannot predict whether we could successfully compete with these pressures and, if we are unable to do so, our business, financial condition and results of operations could suffer. 12 WE MAY NOT BE ABLE TO HIRE OR RETAIN THE QUALIFIED SCIENTIFIC, TECHNICAL, MANAGEMENT AND SALES AND MARKETING PERSONNEL WE REQUIRE. Because of the specialized scientific nature of our business, we are highly dependent upon our ability to attract and retain qualified scientific and technical personnel. We also must hire additional qualified management and sales and marketing personnel as our business expands. Competition in our industry for scientific, technical, management, and sales and marketing personnel is intense and we cannot assure you that we will be able to hire a sufficient number of qualified personnel. Loss of the services of our key personnel in these areas could adversely affect our research and development and sales and marketing programs and could impede the achievement of our goals. We do not maintain key man life insurance on any of our personnel. IF WE ARE UNABLE TO MANAGE OUR ANTICIPATED FUTURE GROWTH WE MAY NOT BE ABLE TO IMPLEMENT OUR BUSINESS PLAN. If we are successful in increasing sales and expanding our markets, there will be additional demands on our management, marketing, distribution, customer support and other operational and administrative resources and systems. To accommodate future growth, we may add staff and information and other systems. We cannot guarantee that we will be able to do so or that, if we do so, we will be able to effectively integrate them into our existing staff and systems. In addition, our current and future expense levels are based largely on our investment plans and estimates of future revenues and are, to a large extent, fixed. We may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. Therefore, any significant shortfall in revenues as compared to our planned expenditures will materially harm our business, financial condition, and results of operations. If we are unable to manage our growth, we may not be able to implement our business plan and our business, financial condition and results of operations will be materially harmed. IF WE ARE UNABLE TO EFFECTIVELY INTEGRATE FUTURE ACQUISITIONS OF NEW OR COMPLEMENTARY BUSINESSES, PRODUCTS OR TECHNOLOGY, OUR BUSINESS MAY BE HARMED. We have made and in the future may make acquisitions of complementary businesses, products, services or technologies. We have limited experience in integrating newly acquired organizations into our operations. Acquisitions expose us to many risks, including: - difficulty in assimilating technologies, products, personnel and operations; - diversion of management's attention from other business concerns; - large write-offs and amortization expenses related to goodwill and other intangible assets; - entering markets in which we have no or limited experience; and - incurrence of debt or assumption of other liabilities. The occurrence of one or more of these factors could materially harm our business, financial condition and results of operations. In addition, if we issue additional securities in connection with an acquisition, the ownership interests of our existing securities holders will be diluted. 13 WE MAY BE SUED BY CLINICIANS, PATIENTS OR THIRD-PARTY PAYORS AND OUR INSURANCE MAY NOT SUFFICIENTLY COVER ALL CLAIMS BROUGHT AGAINST US. The testing, manufacturing, sale, marketing and use of our products exposes us to the risk of product liability claims. In addition, clinicians, patients, third-party payors and others may at times seek damages based on testing or analysis errors based on a technician's misreading of the sequencing results, mishandling of the patient samples or similar claims. Although we have obtained liability insurance coverage, we cannot guarantee that liability insurance will continue to be available to us on acceptable terms or that our coverage will be sufficient to protect us against all claims that may be brought against us. A liability claim, even one without merit or for which we have substantial coverage, could result in significant legal defense costs, thereby increasing our expenses, lowering our earnings and, depending on revenues, potentially resulting in additional losses. OUR INTERNATIONAL OPERATIONS MAY BE ADVERSELY AFFECTED BY RISKS ASSOCIATED WITH INTERNATIONAL BUSINESS. We sell our products in many countries and operate offices in North America and Europe. Therefore, we are subject to certain risks that are inherent in an international business. These include: - varying regulatory restrictions on sales of our products to certain markets and unexpected changes in regulatory requirements; - tariffs, customs, duties and other trade barriers; - difficulties in managing foreign operations and foreign distribution partners; - longer payment cycles and problems in collecting accounts receivable; - fluctuations in currency exchange rates; - political risks; - foreign exchange controls that may restrict or prohibit repatriation of funds; - varying laws relating to, among other things, employment and employment termination; - export and import restrictions or prohibitions, and delays from customs brokers or government agencies; - seasonal reductions in business activity in certain parts of the world; and - potentially adverse tax consequences. Depending on the countries involved, any or all of the foregoing factors could materially harm our business, financial condition and results of operations. WE MAY REQUIRE APPROVAL OF THE HOLDERS OF OUR SERIES A PREFERRED SHARES IN ORDER TO OBTAIN CERTAIN TYPES OF FINANCING AND WE MAY BE PREVENTED FROM OBTAINING THESE TYPES OF FINANCING BY THE HOLDERS OF OUR SERIES A PREFERRED SHARES. We will be required to obtain the consent of the holders of a majority of our then outstanding Series A preferred shares prior to issuing any equity security that has rights as to dividends and liquidation that are senior or equal to those of the Series A preferred shares. Also, under certain circumstances, if we propose to sell equity securities, including debt securities convertible into equity securities, certain holders of our Series A preferred shares will be entitled to preemptive rights which allow them to purchase a proportional amount of the securities being offered. We will also be required to obtain the consent of the holders of a majority of our then outstanding Series A preferred shares if we 14 wish to borrow money and at such time or as a result of such loans, the total principal amount of our indebtedness and capitalized lease obligations exceeds $15.0 million. In addition, if we were to enter into a credit facility with a financial institution, we may be subject to additional limitations on our ability to incur additional indebtedness. As a result, we may be delayed in, or prohibited from, obtaining certain types of financing. OUR U.S. INVESTORS COULD SUFFER ADVERSE TAX CONSEQUENCES IF WE ARE CHARACTERIZED AS A PASSIVE FOREIGN INVESTMENT COMPANY. Although we do not believe that we were a passive foreign investment company (or PFIC) for United States federal income tax purposes during 2001 there can be no assurance that we will not be treated as a PFIC in 2002 or 2003. We would be a PFIC if 75% or more of our gross income in a taxable year is passive income. We also would be a PFIC if at least 50% of the value of our assets averaged over the taxable year produce, or are held for the production of, passive income. For these purposes, the value of our assets is calculated based on our market capitalization. Passive income includes, among other items, interest, dividends, royalties, rents and annuities. For the 2001 taxable year approximately 16% of our assets averaged over the taxable year produced, or were held for the production of, passive income, and approximately 16% of our gross income was passive income. If we become a PFIC, many of our U.S. shareholders will, in absence of certain elections as discussed below, be subject to the following adverse tax consequences: - They will be taxed at the highest ordinary income tax rates in effect during their holding period on certain distributions on our common shares, and gain from the sale or other disposition of our common shares; - They will be required to pay interest on taxes allocable to prior periods; and - The tax basis of our common shares will not be increased to fair market value at the date of their deaths. If we become a PFIC, our U.S. shareholders could avoid these tax consequences by making a qualified electing fund election or a mark-to-market election. These elections would need to be in effect for all taxable years during which we were a PFIC and during which our U.S. shareholders held our common shares. A U.S. shareholder who makes a qualified electing fund election, will be taxed currently on our ordinary income and net capital gain (unless a deferral election is in effect). A U.S. shareholder who makes a mark-to-market election, will include as ordinary income each year an amount equal to the excess of the fair market value of our common shares over the adjusted tax basis as of the close of each year (with certain adjustments for prior years). If we become a PFIC, our U.S. shareholders will generally be unable to exchange our common shares for shares of an acquiring corporation on a tax-deferred basis under the reorganization rules of the Internal Revenue Code (unless shares are received in an acquiring corporation which itself is a PFIC in the year the reorganization was completed), and the benefits of many other nonrecognition provisions of the Internal Revenue Code will not apply to transfers of our common shares. In addition, if we become a PFIC, pledges of our common shares will be treated as sales for U.S. federal income tax purposes. Our U.S. shareholders should note that state and local taxes may also apply if amounts are included in U.S. federal taxable income under the PFIC rules of the Internal Revenue Code. The PFIC rules are very complex. Our U.S. shareholders are strongly encouraged to consult with their tax advisors concerning all of the tax consequences of investing in our common shares and the possible benefits of making a tax election given their circumstances. Additionally, our U.S. shareholders should review "Item 10. 15 Additional Information - Taxation- U.S. Federal Income Tax Considerations-Tax Status of the Company-Passive Foreign Investments Companies" for a more detailed description of the PFIC rules and how they may affect their ownership of our common shares. OUR AMENDED ARTICLES OF INCORPORATION AND BY-LAWS CONTAIN CERTAIN PROVISIONS THAT MAKE IT DIFFICULT FOR A THIRD-PARTY TO ACQUIRE OUR COMPANY EVEN IF DOING SO WOULD BE BENEFICIAL TO OUR SHAREHOLDERS AND, THEREFORE, OUR SHAREHOLDERS MAY NOT BE ABLE TO MAXIMIZE THE RETURN ON THEIR INVESTMENT. Our authorized capital consists of an unlimited number of preferred shares. The Board of Directors, without any further vote by the common shareholders, has the authority to issue preferred shares and to determine the price, preferences, rights and restrictions, including voting and dividend rights, of these shares. The rights of the holders of common shares are subject to the rights of holders of any preferred shares that the Board of Directors may issue in the future. That means, for example, that with the approval of our Series A Preferred Shareholders, we can issue preferred shares with more voting rights, higher dividend payments or more favorable rights upon dissolution, than the common shares. If we issued certain types of preferred shares in the future, it may also be more difficult for a third-party to acquire a majority of our outstanding voting shares. In addition, we have a "classified" Board of Directors, which means that only approximately one-third of our directors are eligible for election each year. Therefore, if shareholders wish to change the composition of the Board of Directors, it would take at least two years to remove a majority of the existing directors, and three years to change all directors. Also, the holders of our Series A preferred shares are entitled to vote as a class for one director. The Series A Director serves for a one year term and any vacancy may be filled only by a vote of the holders of Series A preferred shares. If we do not redeem our Series A preferred shares as required during 2006, 2007, and 2008, then our Series A shareholders will be entitled to special voting rights enabling them to elect a majority of our Board of Directors, who will continue to serve as directors until we have redeemed our Series A preferred shares as required. Having a classified Board of Directors and these special rights of the Series A preferred shareholders may, in some circumstances, deter or delay mergers, tender offers or other possible transactions which may be favored by some or a majority of our shareholders. BECAUSE OUR PREFERRED SHAREHOLDERS ARE ENTITLED TO CERTAIN PREFERENCES OVER OUR COMMON SHAREHOLDERS, UNDER CERTAIN CIRCUMSTANCES, OUR COMMON SHAREHOLDERS MAY NOT RECEIVE A RETURN OF THE FULL AMOUNT THEY HAVE INVESTED IN OUR COMPANY. In July 1999, we issued 33,948 Series A preferred shares and, as of May 31, 2002, 25,153 remained outstanding. Our Series A preferred shares entitle the holders to certain preferences over our common shares, including the following: - we may not issue any securities that rank senior to, or in parity with, the Series A preferred shares without obtaining the approval of the holders of a majority of the Series A preferred shares; - we may not issue dividends to holders of common shares until all accrued and unpaid dividends on the Series A preferred shares are paid in full; and - if we liquidate or wind-up our company or if we sell our company or in certain other circumstances, holders of Series A preferred shares are entitled to receive an amount equal to $1,000 per Series A preferred share, or approximately $25.2 million in the aggregate, plus accrued and unpaid dividends, before holders of common shares would be entitled to receive any distribution. 16 THE HOLDERS OF OUR SERIES A PREFERRED SHARES HAVE ANTI-DILUTION PROTECTION THAT MAY ENTITLE THEM TO RECEIVE ADDITIONAL COMMON SHARES UNDER SOME CIRCUMSTANCES, WHICH WOULD DILUTE THE OWNERSHIP INTERESTS OF THE HOLDERS OF OUR COMMON SHARES. Currently our Series A preferred shares are convertible, at the holders' option, into common shares at the conversion price of $10.72 per share. However, the conversion price may be adjusted in a number of circumstances. In some circumstances, such as certain issuances of our common shares or securities convertible into our common shares at a price per share less than the conversion price for the Series A preferred shares, the ownership interest of the holders of Series A preferred shares in our company (on a fully-diluted basis) may increase. As a result, the ownership interests of the holders of our common shares would be diluted. THE VOLATILITY OF THE STOCK MARKET OR TRADING ACTIONS OF SOME SHAREHOLDERS COULD DRIVE DOWN THE PRICE OF OUR COMMON SHARES WHICH COULD RESULT IN LOSSES TO OUR SHAREHOLDERS. The market prices for securities of life sciences companies, particularly those that are not profitable, have been highly volatile, especially recently. Publicized events and announcements may have a significant impact on the market price of our common shares. We have publicly announced that we are in discussions with third parties regarding strategic alternatives, including a potential sale of our company. If we sell our company, we cannot be certain of the consideration that would be paid to our common shareholders. However, arbitrageurs and other investors may purchase our common shares with the expectation that, upon the completion of a sale, our common shareholders will be paid a premium over our current market price. If we do not complete a sale of our company, or if investor expectations change prior to the completion of a sale, these investors may sell their common shares, which could drive down the price of our common shares on Nasdaq. In addition, the stock market from time to time experiences extreme price and volume fluctuations which particularly affect the market prices for emerging and life sciences companies, such as ours, and which are often unrelated to the operating performance of the affected companies. These broad market fluctuations may make it difficult for a shareholder to sell shares at a price equal to or above the price at which the shares were purchased. FUTURE SALES BY EXISTING SHAREHOLDERS MAY LOWER THE PRICE OF OUR COMMON SHARES WHICH COULD RESULT IN LOSSES TO OUR SHAREHOLDERS. As of May 31, 2002, we had 22,178,342 outstanding voting shares. This includes 2,975,051 shares issuable upon conversion of our Series A preferred shares. All of these shares (including the common shares to be issued upon conversion of the Series A preferred shares) are eligible for sale under Rule 144, pursuant to currently effective registration statements, or are otherwise freely tradable. In addition: - Our officers and directors own options to acquire an additional 1,031,376 shares. The shares to be issued upon exercise of these options have been registered and may be freely sold when issued. Our officers and directors also own 41,066 shares that may be sold subject to volume restrictions imposed by Rule 144. - Our employees and consultants who are not deemed affiliates hold options to buy a total of 1,057,646 shares. The shares to be issued upon exercise of these options have been registered and may be freely sold when issued. 17 - We may issue options to purchase up to an additional 125,576 shares under our share option plans. The shares to be issued upon exercise of these options have been registered and may be freely sold when issued. - Our Board of Directors has approved the issuance of options to purchase an additional 1,000,000 shares under our 2000 Employee Option Plan and has granted options to officers and employees to purchase 193,375 of these shares, which are not reflected in the option numbers shown above. The shares to be issued upon exercise of these options have not been registered and may be freely sold only pursuant to an effective registration statement. Sales of substantial amounts of common shares into the public market could lower the market price of our common shares. In general, under Rule 144 as currently in effect, a person (or persons whose shares are required to be aggregated) who has owned shares for at least one year would be entitled to sell within any three-month period a number of shares that does not exceed the greater of (i) 1% of the number of our common shares then outstanding (which equals approximately 192,033 common shares as of May 31, 2002) or (ii) the average weekly trading volume of our common shares during the four calendar weeks preceding the filing of a Form 144 with respect to such sale. Sales under Rule 144 are also subject to certain manner of sale provisions and notice requirements and to the availability of current public information about our company. Under Rule 144(k), a person who is not deemed to have been our affiliate at any time during the three months preceding a sale, and who has owned the shares proposed to be sold for at least two years, is entitled to sell his shares without complying with the manner of sale, public information, volume limitation or notice provisions of Rule 144. ITEM 4. INFORMATION ON THE COMPANY. RECENT DEVELOPMENTS We currently are in discussions with third parties regarding strategic alternatives, including the potential sale of our company. We have retained Bear, Stearns & Co. Inc. to act as our financial advisor and to assist us in this process. We cannot be certain whether we will be able to sell our company or complete any other strategic transaction. We also cannot be certain of the terms upon which a sale or any other strategic transaction would be completed. OVERVIEW We develop, manufacture and sell integrated DNA sequencing systems that analyze genetic information to improve the treatment of selected diseases. Our strategy is to become a leader in the emerging field of pharmacogenomics. Pharmacogenomics is the science of individualizing therapy based on genetic differences across patients. Our genotyping technology, which employs DNA sequencing, enables the analysis in the clinical diagnostic laboratory of individual genetic variations. DNA sequencing is generally considered the most thorough and accurate method for genotyping diseases. We believe that individualizing therapy through pharmacogenomics will improve the treatment of many diseases, such as those caused by Human Immunodeficiency Virus, or HIV, hepatitis B, hepatitis C, and some cancers. Our OpenGene System consists of disease-specific genotyping kits and software, automated DNA sequencers, disposable gel cassettes and related equipment. Our genotyping kits contain the necessary 18 chemicals, reagents, third-party licenses and other consumables and materials required for sequencing specific disease-associated genes. The first clinical diagnostic application we are targeting is HIV. We have developed our TRUGENE HIV-1 Genotyping Kit to enable clinicians to genotype the major HIV species infecting patients in order to improve the management of patient treatment. HIV is a highly variable virus with high rates of mutations, which may lead to drug resistance. One of the central challenges in maintaining HIV patients on long-term drug therapy is to adjust each patient's medication as drug-resistant strains of the virus emerge. On September 26, 2001, we received clearance from the U.S. Food and Drug Administration, or FDA, to market our TRUGENE HIV-1 Genotyping Kit for clinical diagnostic use in the United States. We began selling our FDA-cleared TRUGENE HIV-1 Genotyping Kit to the clinical diagnostic market in the U.S. during the fourth quarter of 2001. We also have developed a genotyping kit for hepatitis C. We are developing the next generation of our TRUGENE HIV-1 Genotyping Kit, genotyping kits for other species of HIV not tested for in our TRUGENE HIV-1 Genotyping Kit, a genotyping kit for hepatitis B, the next generation of our hepatitis C genotyping kit, and genotyping kits for certain cancers. SCIENTIFIC BACKGROUND DNA. All cells contain DNA, a complex material that stores the genetic blueprint, or makeup, of an organism. DNA is composed of four chemical building blocks called nucleotides. Each nucleotide consists of, among other things, one of four chemical bases: adenine (A), thymine (T), guanine (G) and cytosine (C). These four bases are the genetic alphabet that is used to write messages and instructions which direct the synthesis or expression of the proteins inside the cell, required to make the cell function. A sequence is the particular order of the nucleotides in the DNA. Changes in the DNA sequence, also called mutations, may occur from time to time. These mutations may alter the function of the cell proteins and affect cell functions. PHARMACOGENOMICS. Different people often respond in different ways to the same drug. A drug that is safe and effective in one patient may be toxic or ineffective in another. We believe that some of these differences in response may reflect underlying genetic differences between the individuals concerned. Pharmacogenomics seeks to establish correlations between specific genetic variations and specific responses to drugs. By establishing such correlations, pharmacogenomics may permit both new and existing drugs to be targeted to those patients in whom they are most likely to be both effective and safe. GENOTYPING. Genotyping is the act of selecting and reading the sequence of nucleotides in a specific strand of DNA in order to understand how changes in the DNA may influence the onset and treatment of some diseases and medical conditions. Genotyping is used by scientists, researchers and clinicians to identify: - genes as potential targets for therapeutic intervention; - mutations in a gene that may predispose an individual to a particular disease; - genetic variation among individuals that may cause different reactions to drug treatment; and - mutations in the genes of infectious organisms (such as viruses and bacteria) and tumors that may result in drug resistance, thereby influencing treatment methods. 19 Genotyping is performed using tests that rely on either DNA probe or DNA sequencing technologies. DNA PROBES. A DNA probe is a single-stranded piece of DNA made to be complementary to the unique base sequence of the target gene. The DNA probe operates on the principle that single strands of DNA seek out complementary strands to form a chemical bond. The DNA probe is placed into prepared samples which may include the target gene. If the target gene is present, the probe will bind to the target, indicating its presence. DNA probes are highly specific, target single mutations, and require advance knowledge of the target mutation. Probes are susceptible to producing erroneous results because they are affected by variations in the sequence immediately surrounding their targeted mutation. As a result, DNA probes are effective in detecting diseases only when the disease-associated mutation is at a fixed, known location within a gene or when the sequence within a particular gene is stable. However, in diseases where the mutation causing the disease is not known, probe-based technology is not as effective. Probes also may not effectively provide genotypes for infectious pathogens, such as viruses, in which the DNA sequence is highly variable or where mutations occur to evade immune responses or to develop drug resistance. DNA SEQUENCING. DNA sequencing identifies all the chemical bases of the DNA strand to be examined, one-by-one, readily detecting variations or new mutations within the DNA sequence. Unlike DNA probes, sequencing reads long segments of DNA and can therefore detect new mutations, multiple mutations and insertions and deletions of DNA within a sequence. DNA sequencing is also less sensitive than probes to surrounding variations in the sequence being examined. As a result, sequencing is generally considered the most thorough and accurate method for genotyping diseases, such as cancer, and certain viruses, including HIV, which have high rates of mutation or numerous strains. DNA sequencing is also used to assess predisposition to many diseases and for tissue typing. The DNA sequencing process involves several steps, some of which must be performed manually and are labor intensive. DNA first must be extracted from the sample, which usually is blood, other body fluid or tissue. After the DNA is extracted, it is amplified, or copied, in order to provide enough DNA so that the DNA sequence can be easily detected. This process of extraction and amplification typically requires the use of various reagents, primers and other chemicals, as well as proprietary processes and technologies, some of which must be licensed from third parties. Some laboratories prepare and use their own homebrew reagents and chemicals which usually are not subject to standardized procedures or quality control processes necessary to ensure reliable results. Once the DNA is extracted and amplified, a process called gel electrophoresis is performed. This process involves placing the DNA on a gel substance and running an electrical current through it. This separates the DNA so that the DNA sequence can be read. While historically many scientists performed the entire DNA sequencing process manually, automated DNA sequencers using a number of disposable products have been developed which simplify and expedite parts of this process. DNA SEQUENCING MARKETS DNA sequencing is an important tool for the clinical diagnostic, clinical research and research markets. THE CLINICAL DIAGNOSTIC MARKET. The clinical diagnostic market consists of life science companies, hospitals, reference laboratories, medical clinics and doctors offices which use clinical molecular genetic tests for the diagnosis and management of diseases. Current tests typically rely on DNA probe-based and other technology including homebrew DNA sequencing tests. Unlike the research market, genotyping for clinical diagnostic purposes generally relies on the sequencing of relatively short DNA strands with high 20 degrees of accuracy. DNA sequencers and related instrumentation used for diagnostic purposes should enable clinicians to rapidly and accurately sequence and analyze a high volume of patient samples at relatively low costs, and fit within the space constraints of a typical clinical laboratory. THE CLINICAL RESEARCH MARKET. The clinical research market includes hospitals, life science companies, pharmaceutical companies, academic institutions and clinical reference laboratories engaged in developing new diagnostic tests, conducting clinical trials, developing drugs and researching targeted therapeutics. Researchers in this sector often work both with DNA probes and DNA sequencing. Researchers typically rely on repetitive sequencing of relatively short DNA strands of targeted gene segments, for which sequencing systems that are smaller in scale than those used in the research market are generally considered most efficient. THE RESEARCH MARKET. The research market includes academic institutions, hospitals, governmental agencies, life science companies and pharmaceutical companies performing molecular genetics and molecular biology research. Researchers generally use DNA sequencing equipment for gene discovery and other large scale research projects which typically must analyze large numbers of samples and sequence long DNA segments. OUR OPENGENE SYSTEM Our OpenGene System consists of automated DNA sequencers, disposable gel cassettes, related equipment and software and disease-specific genotyping kits. Our OpenGene System has been designed expressly to meet the needs of the clinical diagnostic market. We believe that our integrated OpenGene System provides a cost effective and efficient clinical diagnostic solution that will make DNA sequencing a viable diagnostic tool for the management of selected diseases and medical conditions because: - it reads DNA strands faster than existing sequencers designed for the research market; - it is designed to efficiently read and analyze the shorter DNA strands typically used for clinical diagnosis; - it is significantly less expensive than comparable sequencers designed for the research market; - it is small and lightweight; - it utilizes easy to use disposable gel cassettes; - it includes our proprietary software package designed for DNA analysis and patient data management; - our genotyping kits include the reagents, primers and other chemicals, third-party licenses, software and other materials required to conduct tests for specific disease-associated genes; and - our genotyping kits are standardized, validated and undergo quality control testing to provide reliable, reproducible results. OUR BUSINESS STRATEGY Our objective is to be a leader in the emerging field of pharmacogenomics. Our goal is to enable clinicians to use genetic information to monitor and customize treatment of diseases, initially for HIV and later for other diseases. Key elements of our business strategy are to: 21 - PROVIDE AN INTEGRATED GENOTYPING SOLUTION FOR THE CLINICAL DIAGNOSTIC MARKET. We intend to meet the needs of the clinical diagnostic market by providing an efficient, inexpensive, easy-to-use genotyping solution. Our integrated OpenGene System, which we believe incorporates these features, includes automated DNA sequencers, disposable gel cassettes, related equipment and software, and disease-specific genotyping kits. We designed this system for the clinical diagnostic market. - TARGET THE HIV GENOTYPING MARKET. We are focusing initially on the HIV market because there is clinical evidence to suggest that genotyping may be effective in managing the treatment of diseases associated with HIV. By identifying mutations in HIV through genotyping and consistently countering these mutations with appropriate drug therapy, we believe drug treatment can be administered and monitored more effectively. We have received regulatory approval to sell our HIV OpenGene System for clinical diagnostic use in the United States, Argentina, Canada, France and Israel, and we intend to seek approval from regulatory authorities in other countries. - LEVERAGE OUR OPENGENE SYSTEM FOR ADDITIONAL APPLICATIONS. We have developed, and are developing, other disease-specific genotyping kits that we believe have the potential to eliminate or reduce more time consuming and/or expensive tests and that may enable clinicians to better monitor and manage patient treatment. In addition to our HIV genotyping kit, we have developed genotyping kits for hepatitis B and hepatitis C, and are developing genotyping kits for the next generation of our TRUGENE HIV-1 Genotyping Kit, genotyping kits for other species of HIV not tested for in our TRUGENE HIV-1 Genotyping Kit, and genotyping kits for certain cancers. - PROVIDE SOPHISTICATED SOFTWARE FOR THE CLINICAL RESEARCH AND DIAGNOSTIC MARKETS. Our GeneObjects Software operates our OpenGene System, analyzes the results, and prints out a report that shows the drugs to which a patient has become resistant. This software was designed to meet the needs of clinical research and clinical diagnostic markets. We also have developed an enhanced version of this software, called TRUGENE Software, which is specifically targeted to the clinical diagnostic market and simplifies the work flow and report generation for disease specific applications. - OFFER TESTING AND SEQUENCING SERVICES. We maintain an accredited reference testing laboratory that provides genotyping and other testing services for HIV, hepatitis B, hepatitis C, other infectious diseases and various genes associated with cancer. We believe that the data which we obtain in providing these services will also assist us in our efforts to develop new genotyping kits and other technologies. - TAILOR OUR MARKETING EFFORTS TO LOCAL MARKETS. We have established our sales and marketing force in the United States, Canada, selected European countries and in other areas where we believe that the size of the market and our familiarity with regulatory and other local conditions justify the development of our own sales force. In selected geographic and product markets where we believe that regulatory and other market factors make it more prudent to rely on a third-party local sales and marketing effort, we seek to enter into distribution and marketing arrangements with leading distributors. - MAINTAIN OUR TECHNOLOGICAL LEADERSHIP IN GENOTYPING. We plan to continue to invest significant resources in research and development so that we may continue to provide customers with advanced genotyping technologies and products. Where we believe it is cost effective or otherwise appropriate, we will continue to license and acquire technologies and products to include in our OpenGene System and genotyping kits. We will also seek to continue to collaborate with hospitals, academic institutions, pharmaceutical companies and life science companies to develop additional genotyping kits and other products. 22 OUR INTEGRATED OPENGENE SYSTEM Our integrated OpenGene System includes the following components: SEQUENCING SYSTEMS Sequencing systems consist of automated DNA sequencers and related equipment. SOFTWARE SYSTEMS. Software systems consist of our proprietary GeneObjects and TRUGENE Software DNA analysis and data management software. GENOTYPING KITS AND OTHER CONSUMABLES. Genotyping kits consist of various reagents, enzymes, primers and other chemicals, and other consumables consist of disposable gel cassettes, acrylamide and other materials. SEQUENCING SYSTEMS LONG-READ TOWER AUTOMATED DNA SEQUENCER. The Long-Read Tower is a two-dye automated sequencer that can read 400 bases in approximately 40 minutes with high accuracy, suitable for clinical diagnostic applications, and can also read longer DNA sequences used in some research applications. Using our proprietary Long-Read MicroCel cassettes, the Long-Read Tower can read 700 bases in under 3 hours with high accuracy. The Long-Read Tower can read 16 lanes and test up to 8 patient samples per gel cassette, and can be networked with other Long-Read Towers so that multiple units can run from a single workstation, thereby allowing for a significantly greater number of patient samples to be tested simultaneously. The Long-Read Tower is small (47cm x 39cm x 26cm) and lightweight relative to competitive instruments, can be connected to almost any computer network, has no moving parts and consumes only 400 watts of power. SEQ4X4. The Seq4x4 automated DNA sequencer is marketed by Amersham as the Amersham Pharmacia Biotech Seq4x4(TM) built to Amersham's specifications to work with Amersham's one color Cy 5.5 terminator chemistry and ThermoSequenase(TM) Kits. The Seq4x4 is a less expensive version of the Clipper that includes many of the features of the Clipper; however, it is a 16 lane one-dye sequencer, and cannot be networked with other sequencers. The Seq4x4 is sold to the research market where it can be used to complement or replace significantly slower manual DNA sequencing methods and to complement currently available, more expensive automated DNA sequencers. GEL TOASTER. The Gel Toaster is a compact (47 cm x 39 cm x 26 cm), lightweight device that uses ultraviolet light to polymerize, or cure, liquid acrylamide that has been injected into the MicroCel cassette. The acrylamide gel is the medium through which the DNA is separated for sequencing. SOFTWARE SYSTEMS GENEOBJECTS. GeneObjects is our DNA analysis and data management software package which we have designed for use with our sequencing systems. It automates portions of the test process and facilitates analysis and diagnosis. It also automates certain laboratory management tasks. GeneObjects software is able to sort, analyze and store data by patient (regardless of the test or gel source from which the data is derived) or by the test performed. GeneObjects can also be used to control multiple sequencers over the network from a single workstation. It can use existing microcomputers and sequencers, or be installed as a turnkey system with state-of-the-art hardware. TRUGENE. TRUGENE Software, an enhanced version of our GeneObjects software, is a software system we have developed for genotypic analysis of large quantities of patient samples in a 23 clinical diagnostic setting. The first application is for HIV. The software aligns and reads a DNA sequence and further interprets detected mutations that are associated with drug resistance. GENOTYPING KITS AND OTHER CONSUMABLES GENOTYPING KITS. We sell genotyping kits which assist in identifying disease-associated genetic mutations and gene sequences. We sell our TRUGENE HIV-1 Genotyping Kit to the clinical diagnostic market and we sell other genotyping kits to the research and clinical research markets. Our TRUGENE HIV-1 Genotyping Kit and other genotyping kits are described in the section of this annual report entitled "-Applications For Our OpenGene System." GENOTYPING KIT TECHNOLOGIES. We have developed and are developing genotyping kits with features designed to make our genotyping kits suitable for the clinical diagnostic market. We use certain technologies proprietary to us, and other technologies licensed to us, to ensure that our genotyping kits will meet the needs of this market. These technologies include our CLIP and CAS technology, polymerase chain reaction technology, or PCR, Uracil-DNA-glycosylase, or UDG, technology and fluorescent DNA sequencing technology. We have U.S. and foreign patents covering our CLIP technology. We license the PCR technology from Roche Molecular Systems, Inc. and F. Hoffmann-La Roche Ltd., the UDG technology from Invitrogen Corporation, the fluorescent DNA sequencing technology from Applera Corporation and the CAS technology from Genassiance Pharmaceuticals, Inc. Our proprietary CLIP technology enables DNA samples to be prepared in a single test-tube, single-step process that replaces the multiple individual steps currently required to prepare a sample for DNA sequencing. This technology saves time and reduces the cost of DNA sequence-based diagnostic testing, which is important to the clinical diagnostic market. Our CLIP technology is also more sensitive than traditional techniques, which is especially useful for managing viral diseases because it permits the genotyping of patients with very low viral loads that other methods cannot detect. As a result, using CLIP, HIV patients with low viral loads can be genotyped and treated at the earliest indication of drug resistance. Our exclusive license from Genassiance Pharmaceuticals permits us to use CAS technology for research and diagnostic applications. CAS technology performs similar functions to CLIP technology, using different enzyme chemistry on DNA. PCR is a powerful laboratory technique that can detect, copy and amplify specific DNA sequences. Amplifying the DNA is an essential part of DNA sequencing because it allows the technician to start with minute amounts of DNA and finish with at least a million-fold increase in the number of DNA molecules, ensuring that a sufficient amount of DNA is available to obtain the sequence. UDG is a method of incorporating deoxyuracil into a PCR product to control PCR carry-over contamination. We are not currently using UDG in our products. The fluorescent DNA sequencing technology licensed from Applera relates to methods and machines for automated sequencing of DNA. The technology enables the DNA fragments to be labeled with a fluorescent dye, so that the fragments can be detected when they are separated by electrophoresis. MICROCEL CASSETTE. The MicroCel cassette is a disposable, polyacrylamide electrophoretic gel cassette which acts as the detection medium for our DNA sequencers. The gel is injected into the cassette. After the cassette is cured, it is placed into the sequencer for DNA sequencing and other tests. The cassette is comprised of two small glass plates, has a 50 micron gap and can be filled with acrylamide and cured in three minutes through a semi-automated process which uses our Gel Toaster and SureFill products. Competitive slab gel sequencers typically use significantly thicker (200-500 micron gap) gel systems which are assembled manually by technicians and must be disassembled and cleaned after use. We manufacture the MicroCel cassette in three sizes. 24 SUREFILL CARTRIDGE. The acrylamide injected into the MicroCel cassettes is supplied in a 10 cm long disposable syringe-based SureFill cartridge that contains necessary ingredients to fill 10 MicroCels. SureFill protects the technician from directly handling potentially dangerous chemicals and simplifies the gel preparation process. TESTING, SEQUENCING AND OTHER SERVICES We provide DNA testing, sequencing and other services for HIV, hepatitis B, hepatitis C, and other infectious diseases as well as for certain cancers. We maintain a library of cultures of HIV strains with known drug resistant mutations and a patient database on viral drug resistance and high resolution DNA sequencing data. This data may be used to screen new drugs for possible viral resistance and to identify patterns of cross resistance to new drugs as well as for the development of new AIDS treatment strategies. APPLICATIONS FOR OUR OPENGENE SYSTEM HIV Our FDA-approved HIV OpenGene System enables physicians to genotype the major HIV species infecting patients and to diagnose and treat HIV based upon the mutations present in the virus. Our TRUGENE HIV-1 Genotyping Kit contains all of the reagents, chemicals, third-party licenses and other materials required to sequence the DNA from the protease and reverse transcriptase regions of the virus, which are known to develop mutations that make the virus resistant to drugs. In September 2001, we received clearance from the FDA to market our TRUGENE HIV-1 Genotyping Kit for clinical use in the United States. The FDA authorization allows us to sell our TRUGENE HIV-1 Genotyping Kit for support of anti-retroviral therapy in HIV. We are not restricted in the claims we can make with regard to the mutations or our interpretation of them. We initiated the sale of our TRUGENE HIV-1 Genotyping Kit for use in the clinical research market in the fourth quarter of 1998 and the clinical diagnostic market in the fourth quarter of 2001. We have pending and issued patents in the United States and in some foreign countries covering various aspects of our TRUGENE HIV-1 Genotyping Kit. HIV OVERVIEW. HIV is a virus that attacks the cells in the human immune system. Without effective treatment, HIV significantly weakens the immune system, which results in opportunistic infections, neurological dysfunctions, malignant tumors and eventually death. HIV infected patients may develop Acquired Immune Deficiency Syndrome, or AIDS, which is a syndrome of infections, diseases and medical conditions resulting from a weakened immune system. Since the early 1980's, when the HIV epidemic was first identified, it is estimated that more than 21 million people worldwide have died as a result of complications from AIDS. Approximately 940,000 people in North America, 1,560,000 in Europe and Central Asia and a total of 40 million people worldwide are infected with HIV. In 2001 alone, there were approximately 5 million new HIV infections, including 45,000 in North America and 280,000 in Europe and Central Asia, and 3 million deaths as a result of complications from AIDS. HIV is a highly variable virus with a high rate of mutations. Because of HIV's high mutation rate, drugs used to treat the virus, while generally effective for a period of time, often result in the survival of a virus with mutations that confer resistance to those drugs. Today, there are more than 140 known HIV mutations associated with drug resistance. 25 Currently, there are 16 FDA approved anti-HIV drugs. These drugs specifically target the protease and reverse transcriptase enzymes to interfere with and reduce HIV replication. Mutations in the genetic information of the virus that codes for these two enzymes can result in the development of drug resistance. Current drug therapy usually relies on the use of drug cocktails of two or more antiviral drugs, targeting different stages of the HIV life cycle. A number of studies have shown that drugs given in various combinations reduce the viral load in most patients and can significantly improve these patients' overall health. Viral load is a generally used measurement of the concentration of virus in a patient's blood. HIV patients fail drug therapy in many cases either because the virus mutates and develops resistance to drugs, or because the side effects of drugs or the strict dosing regimens are intolerable, leading patients to skip doses or discontinue using the drugs. One of the central challenges in maintaining HIV patients on long-term drug therapy is to adjust each patient's medication as drug-resistant strains of the virus emerge. Because they rely only on viral load, current disease management methods usually provide a warning that the drugs are no longer working only after the drug-resistant virus has asserted itself and viral load has increased. These methods usually do not tell clinicians which drugs are failing due to emerging resistance or to which drugs the patient should be switched. As a result, there is a need to provide doctors and clinicians with information about HIV drug resistance to enable better management of HIV drug therapy. GENOTYPING AND HIV. Genotyping HIV enables clinicians to identify mutations in the genetic material in the virus. Several clinical trials, one of which we conducted, have demonstrated the benefits of genotyping HIV to manage a patient's drug therapy. These studies suggest that by sequencing the patient's HIV, clinicians may be able to detect early in the process that a resistant mutant has emerged and make appropriate changes in medication to manage viral load. Sustaining a low viral load is believed to be a key factor in prolonging the life of an HIV patient. Achieving and maintaining low viral loads may also significantly reduce medical costs because patients with low or undetectable viral loads have fewer opportunistic infections and other symptoms and, therefore, require fewer and shorter hospital stays and fewer other medical services. HEPATITIS C We have developed a genotyping kit for hepatitis C. Hepatitis is an inflammation of the liver. Hepatitis C is one type of virus that causes this inflammation. There are approximately 4.0 million people in the United States who test positive for hepatitis C. There are six major sub-types of hepatitis C. Knowing the sub-type helps the physician determine how long the patient will require drug treatment. Our hepatitis C genotyping kit generates a report which identifies the specific hepatitis C subtypes a patient is most likely to have contracted. The report generated does not provide information about the patient's drug resistance or recommend the use of specific drugs for treatment of that patient. We believe that FDA approval is not generally required for hepatitis C genotyping products which are used for epidemiological studies. However, the FDA has not provided definitive guidance as to whether a hepatitis C product used for the purpose and in the manner we intend our hepatitis C genotyping kit to be used, would require approval. We are aware of at least one product similar to ours that is being marketed and sold by a competitor without FDA approval. To our knowledge, the FDA has not advised that company that FDA approval is required to market and sell the product for the purposes for which it is intended to be used and has not initiated enforcement action to stop the marketing or sale of the product. We do not intend to seek FDA clearance to market our hepatitis C genotyping kit for the purpose for which it is intended to be used. However, we cannot be certain that the FDA will not determine that authorization is required for us to market and sell the hepatitis C genotyping kit for these purposes or direct us not be sell the kit without authorization. 26 We are currently developing a second hepatitis C genotyping kit which will perform drug resistance testing and generate a report recommending the use of specific drugs for treatment of the patient. We may need FDA approval to sell that genotyping kit to the clinical diagnostic market and, if FDA approval is required, we will conduct the necessary clinical studies to obtain FDA approval for diagnostic use. HEPATITIS B We have developed a genotyping kit for hepatitis B which we plan to launch in the next twelve months. Hepatitis B is a second type of virus that causes inflammation of the liver. There are more than 350 million people worldwide who are chronically infected with hepatitis B (HBV), of whom approximately 1.2 million are located in the United States. In the United States, approximately 140,000 people are infected with HBV every year. Chronic HBV infection leads to inflammation of the liver which may progress to cirrhosis and liver cancer. Hepatitis B currently is treated with interferon or lamivudine and several new reverse transcriptase inhibitors are in development. Genotyping may be used to identify the subtype of hepatitis virus present, which has implications for disease progression, and, also, to detect mutations in the virus that cause the disease to become resistant to lamivudine. Our hepatitis B genotyping kit sequences the part of the virus which indicates both viral genotype and lamivudine resistance. The report generated identifies the viral genotype circulating in the patient and the mutations which may be associated with lamivudine resistance. As new reverse transcriptase inhibitors become clinically available, we expect that our current genotyping kit will be useful in identifying new resistance mutations selected by these agents. We also are developing a next-generation HBV genotyping kit which will contain several modules capable of analyzing any part of the HBV genome. This will allow mapping of viral resistance throughout the hepatitis B virus and will also allow clinicians to determine factors associated with disease pathology (HbeAg) and the progression to liver cancer. We expect that this genotyping kit will assist clinicians in therapeutic management of chronic HBV infection. OTHER GENOTYPING KITS We are developing the next generation of our TRUGENE HIV-1 Genotyping Kit and additional genotyping kits for HIV species not covered by our TRUGENE HIV-1 Genotyping Kit. In addition, we are currently developing genotyping kits for certain cancers. REGULATION BY THE FDA AND OTHER GOVERNMENT AGENCIES We sell many of our products for research and clinical research purposes. We believe that we do not need authorization from the FDA or regulatory authorities in foreign countries to sell these products for research purposes, as long as they are properly labeled. However, we must obtain regulatory approval in the United States and many other countries before selling many of our products for clinical diagnostic purposes. We have received approval from the FDA, and from regulatory authorities in Argentina, Canada, France and Israel to sell our TRUGENE HIV-1 Genotyping Kit for clinical diagnostic purposes. FDA APPROVAL PROCESS. Products that are used to diagnose diseases in people are considered medical devices, which are regulated by the FDA. To obtain FDA authorization for a new medical device, a company may have to submit data relating to safety and efficacy based on extensive testing. This testing, and the preparation of necessary applications and the processing of those applications by the FDA, are expensive and may take several years to complete. The following describes several important aspects of the FDA authorization process. 27 The FDA has three classes for medical devices: Class I devices (for example, bandages, manual wheelchairs and ice bags) are the least regulated, but they must still comply with the FDA's labeling, manufacturing, recordkeeping, and other basic requirements. Most Class I devices do not require premarket authorization from the FDA. Class II devices (for example, portable oxygen generators and hypodermic needles and many other medical devices), may be subject to additional regulatory controls, such as performance standards and postmarket surveillance. Class III devices (for example, cardiac pacemakers) require specific FDA approval prior to marketing and distribution, and are, as well, subject to the FDA's basic requirements. To sell a Class II medical device, a company must first obtain permission of the FDA by submitting a 510(k) premarket notification, commonly known as a 510(k), showing that the device is similar to a device already on the market. To sell a Class III medical device, a company must first get specific approval of the FDA for the device by submitting a premarket approval application, commonly known as a PMA application. A company may have to include test data in a 510(k), including human test data. It will almost always have to include such test data in a PMA application. If human test data are required for either a 510(k) or a PMA application, and if the device presents a significant risk, the manufacturer must first file an Investigational Device Exemption submission, or IDE, with the FDA. The IDE must contain data, such as animal and laboratory testing, showing that the device is safe for human testing. If the IDE is granted, human testing may begin. Generally, a 510(k) notification to the FDA that a new device is similar to an existing device requires less data and takes less time for the FDA to process than a PMA. The FDA is supposed to act on a 510(k) notification within 90 days. According to the most recent FDA data available, the average time for FDA clearance of a 510(k) is 102 days. By contrast, a PMA application must be supported by more extensive data to prove the safety and efficacy of the device, and review of a PMA application involves a lengthier FDA process. The FDA conducts a preliminary review of the PMA application. If complete, the PMA application is filed by the FDA. Officially, the FDA then has 180 days to review the PMA application. However, PMA reviews usually take much longer. The average approval time is approximately one year. The FDA may grant expedited (fast-track) review of a PMA application if certain criteria relating to public health importance are met, but that decision is within the FDA's discretion and affects only the timing of the review process, not the outcome. NEED FOR FURTHER FDA APPROVAL OF CHANGES TO FDA APPROVED PRODUCTS. It is necessary to obtain clearance from the FDA before making changes to FDA approved products if those changes could significantly affect safety or effectiveness. To obtain approval of some types of changes, it may be necessary to conduct additional human clinical trials to determine that the altered product will produce at least the same results as the approved product or will be as safe and effective as the approved product. We expect to update the drug resistance algorithms embedded in the software of our FDA approved TRUGENE HIV-1 Genotyping Kit approximately every six months. Based on informal discussions with the FDA, we expect that the FDA's review and approval of these updates will not exceed 90 days, provided we satisfy the FDA's approval requirements. Since it generally takes us at least 90 days to prepare our updated software products for commercial distribution, we do not anticipate that FDA approval of updates will delay the introduction of updated software products to market. OTHER FDA REQUIREMENTS. In addition to government requirements relating to marketing authorization for medical device products, we will also be subject to other FDA requirements. We are registered as a medical device manufacturer with the FDA. We will be inspected on a routine basis by the FDA for compliance with the FDA's quality system regulations, which prescribe standards for manufacturing, testing, distribution, storage, design control and service activities. In addition, because we 28 manufacture some of the components of our OpenGene System in Canada, the FDA, in conjunction with the U.S. Customs Service, could impose a ban on our products if the FDA were to conclude that the products appeared to be in violation of the FDA's regulatory requirements, including restrictions that apply to the sale of research-use only products. Also, the FDA's medical device reporting regulation will require us to provide information to the FDA on deaths or serious injuries associated with the use of our devices, as well as product malfunctions that are likely to cause or contribute to death or serious injury if the malfunction were to recur. Finally, the FDA prohibits promoting a device for unauthorized uses and reviews company labeling for accuracy. The FDA has become aware that certain products being sold by other companies for research purposes only, were in fact being used by some customers for clinical diagnostic purposes. In January 1998, the FDA issued a policy statement describing the conditions under which companies may sell research-use only products. These conditions may restrict our ability to sell research-use only products in the United States. We do not believe these conditions will have any negative effect on our sale of genotyping kits for legitimate scientific research. REGULATORY APPROVAL OUTSIDE THE UNITED STATES. We market or plan to market our products in various countries outside the United States. Government authorization requirements similar to the FDA's exist in some of these countries. Therefore, authorization to sell our products for clinical diagnostic purposes in some of these countries may require lengthy and costly testing procedures. In addition, the regulatory bodies in other countries may be affected or influenced by significantly different criteria than those used by the FDA. Sale of our products in these areas may be materially affected by the policies of these regulatory bodies, as well as the domestic politics and financial stability of the countries involved. We have received approval from French regulatory authorities to market our HIV OpenGene System for clinical diagnostic purposes in France (December 2000), from Argentine regulatory authorities to market our HIV OpenGene System for clinical diagnostic purposes in Argentina (February 2001), from Canadian regulatory authorities to market our TRUGENE HIV-1 Genotyping Kit for clinical or research use in Canada (December 2001), and from the Israeli regulatory authorities to market our OpenGene System in Israel (February 2002). However, in Canada we will be required to meet additional regulations that become effective in January 2003. We cannot be certain that we will be able to comply with these new regulations. If we do not comply with these new regulations, we will be unable to sell our HIV OpenGene System to the clinical diagnostic market in Canada. We believe we are currently able to sell our HIV OpenGene System to the clinical diagnostic market in the following European Union (EU) member states (in addition to France): Belgium, Luxembourg, United Kingdom, Holland, Scandinavia and Spain. We expect that further regulatory approvals will not be required in these EU member states until new EU wide regulations go into effect in December 2003. We anticipate being in compliance with the new EU regulations as they become effective. OTHER GOVERNMENT REGULATIONS. We are or may become subject to various federal, state, provincial and local laws, regulations and recommendations, including those relating to workers compensation, safe working conditions, and laboratory and manufacturing practices used in connection with our research and development activities. In addition, our reference laboratory in Atlanta, Georgia, is subject to stringent regulation under the Clinical Laboratory Improvement Amendments of 1988, known as CLIA. Under CLIA, laboratories must meet various requirements, including requirements relating to the validation of tests, training of personnel, and quality assurance procedures. The laboratory must also be certified by an applicable state government agency. Our Atlanta laboratory performs high complexity tests, and is therefore subject to 29 the most stringent level of regulation under CLIA. This laboratory is certified under CLIA and by the state of Georgia. We are also subject to various laws and regulations in Canada, the United States and Europe, including those relating to product emissions use and disposal of hazardous or toxic chemicals or potentially hazardous substances, infectious disease agents and other materials, workers compensation, safe working conditions, and laboratory and manufacturing practices used in connection with our research and development activities. SALES AND MARKETING We market our OpenGene System in North America and in many European countries to the research and clinical research markets through our direct sales force. We began to market our FDA cleared HIV OpenGene System to the clinical diagnostic market in the United States during the fourth quarter of 2001. We have a sales and marketing force of 75 people. Many members of our sales force have scientific backgrounds. Our marketing force includes a team of trained application specialists who provide intensive on-site training, after-sales support and site-by-site trouble shooting. We offer service contracts to our customers on our sequencers, certain equipment and software. We have established toll-free telephone numbers in North America and Europe for customer service. The members of our internal sales force are compensated on a commission and salary basis. For other areas of the world and in selected product markets, our strategy is to establish relationships with leading distributors to market and sell our products. We granted Amersham the exclusive worldwide license to use and sell the Seq4x4 and related products used and sold with the sequencer, which is designed for the research market. In November 1999, we granted Amersham-Pharmacia Biotech K.K. the exclusive right to distribute our products to the research market in Japan. During 2001 approximately 9% of our revenues were derived from sales of sequencers and other products to Amersham. In addition, we have granted rights to distribute our genotyping kits and OpenGene Systems to distributors in the clinical diagnostic, clinical research, and research markets in over 40 countries outside of the United States and Canada, including Mexico and certain countries in Latin America, Europe, Asia, and Africa. These agreements expire at various times, and in many cases, are subject to automatic renewal. Certain of the agreements may also be terminated by either party upon specified notice periods and may require us to make termination payments under certain circumstances. Certain of the agreements also provide for minimum annual purchases for specified periods. Our ability to successfully sell products in countries in which we rely on distribution agreements will depend to a great extent on the efforts of the distributors. Our marketing strategy for the HIV OpenGene System consists of several components. We have established relationships with leading doctors, laboratories and healthcare providers in the HIV diagnostics market in the United States, Canada, Europe and Latin America. We have installed our equipment in many of these laboratories and other facilities at no cost to the recipient and are training technicians to use our products. We believe that the use of our products by these industry leaders will facilitate our marketing efforts in the rest of the HIV clinical diagnostic market. We have established special marketing relationships with some laboratories, under which we co-sponsor local physician and patient educational events. We also provide other marketing and support services to these laboratories. We advertise in a variety of publications and prepare marketing materials directed to doctors, laboratories, payors and patients. We conduct drug resistance and other seminars for, and provide educational materials to, physicians and other healthcare providers. We also provide educational material for patients, including a pamphlet that explains resistance testing. 30 We are continuing to market and sell our HIV OpenGene System to hospitals, pharmaceutical companies, academic institutions and clinical reference laboratories for research and clinical research purposes. RESEARCH AND DEVELOPMENT We currently conduct research and development through our own staff and through collaborations with researchers at scientific and academic institutions and hospitals. Our current research and development activities are focused on: - developing the next generation of our TRUGENE HIV-1 Genotyping Kit and additional genotyping kits for different HIV species, development of our genotyping kit for hepatitis B and development of our next generation hepatitis C genotyping kit and additional genotyping kits for certain cancers; - developing new technology for our sequencers and related equipment and software; - refining existing proprietary, disposable gel cassette technology in order to improve performance of our sequencers; and - exploring new technologies for future commercial products. In September 2001, we acquired from Virco UK Limited its research laboratory located in Cambridge, England, along with substantially all of the research staff of 25 scientists at that laboratory. The Cambridge facility is our principal international research hub, headed by Dr. Brendan Larder, who joined our company in June 2001 as our Chief Scientific Officer. Dr. Larder ran this facility for Virco UK Limited prior to joining our company. This acquisition was part of a larger restructuring of our research and development operations, which included the closing of a research lab in Toronto in December 2001, that resulted in the elimination of 27 positions. The activities performed at that lab have been transferred to our Atlanta and Cambridge labs. As a result of this restructuring, all of our research and development activity is now located in three centers. Our Cambridge, England facility focuses on chemistry research, our Atlanta facility on genotyping kits and chemistry development, and our Toronto facility on software research and development. As of May 31, 2002, our research and development staff consisted of 97 people. This includes a team of software developers who have developed our GeneObjects software and are developing our TRUGENE Software. Our software developers are working on an advanced version of our software for Windows platform as well as additional software applications for the clinical diagnostic market. We incurred $10.8 million of research and development expenses in 2001, $10.6 million in 2000 and $7.9 million in 1999. MANUFACTURING We assemble our DNA sequencers and related equipment at a manufacturing facility in Toronto, Canada. Component parts are manufactured by third parties in accordance with our design specifications. We manufacture our disposable gel cassettes at our second manufacturing facility in Toronto. Until March 31, 2002, we manufactured genotyping kits at our Pittsburgh, Pennsylvania facility. We closed that facility in April 2002, and we currently do not have another facility available to manufacture genotyping kits for full scale commercial production. 31 We plan to manufacture our genotyping kits at our new facility in Atlanta, Georgia. We have completed construction of this facility and we currently are testing the facility to ensure regulatory compliance. We expect our Atlanta facility to be cleared for full scale commercial production during the third quarter of 2002. We expect that when fully operational, our Atlanta facility will allow us to significantly increase our production of genotyping kits. We manufacture certain chemicals and other components included in the genotyping kits. Other genotyping kit components are manufactured by, or licensed from, third parties. We have documented and installed design and production practices in our Toronto and Atlanta facilities to comply with the FDA's quality system regulations. We have implemented a quality management system at these manufacturing facilities in order to ensure product performance, reliability and quality. We may seek certification of compliance to ISO 9001 for our Toronto and Atlanta facilities. In addition to adhering to ISO goals and FDA quality standards, we have implemented our own quality control and quality assurance standards and programs. We provide one year warranty coverage for product defects on the instrument component of our sequencers. All product repairs are performed by our employees at one of our manufacturing facilities. In connection with our genotyping kits, sequencers and related equipment, we use certain dyes and custom-designed component parts supplied by third parties. We believe that some dyes supplied by Amersham under our worldwide license to use and sell Amersham dyes within our genotyping kits, may not be available from other suppliers, although our customers might be able to purchase some, but not all, dyes directly from Amersham. In addition, certain reagents and other chemicals that we use and include in our genotyping kits are available only under license from their manufacturers. While we believe that alternative reagents and chemicals are available, alternate supplies may not be as effective as certain of the products that we presently use. In addition, we believe that there are alternative suppliers for our custom-designed DNA sequencer parts, but that we would incur costs in switching to alternative suppliers and would likely experience delays in production of the products that use any of these parts until such time as we were able to locate alternate suppliers or parts. PROPRIETARY RIGHTS We rely on patents, licenses from third parties, trade secrets, trademarks, copyright registrations and non-disclosure agreements to establish and protect our proprietary rights in our technologies and products. We own or jointly own numerous U.S. and foreign patents. We own or jointly own U.S. patent applications and foreign applications presently pending as PCT applications, or as national phase PCT applications, designating intergovernmental agencies and multiple countries including the European Patent Office, Australia, Canada and Japan. Our issued and allowed patents and patent applications cover various aspects of our products and technologies, including several of our genotyping kits and various DNA sequencing and genotyping kit technologies, including the MicroCel technology, basecalling technology, and the CLIP technology. Our competitive position is also dependent upon unpatented trade secrets. We are developing a substantial database of information concerning our research and development and have taken security measures to protect our data. However, trade secrets are difficult to protect. In an effort to protect our trade secrets, we have a policy of requiring our employees, consultants and advisors to execute non-disclosure agreements. These agreements provide that confidential information developed or made known to an individual during the course of their relationship with us must be kept confidential, and may not be used, except in specified circumstances. 32 In April 2000, we entered into a worldwide licensing and collaboration agreement with Applera whereby we gained access to certain patents and intellectual property owned or exclusively licensed by Applera. The agreement enables us to utilize certain Applera technology to manufacture and sell DNA sequencing instruments, as well as manufacture and sell clinical sequencing kits to run on DNA sequencing instruments manufactured by us, Applera and other third parties. In addition, Applera may collaborate with us to provide access to technology to facilitate our development and commercialization of new diagnostic tests using the licensed technology. In addition, we gained access to certain other Applera chemistry patents, which are enabling for the manufacture of certain reagent products to be used on Applera manufactured instruments, as well as third party sequencing instruments. We will pay Applera a total licensing fee of $25.0 million over a period of four years, and will also make royalty payments to Applera based on sales in return for access to the Applera technology and installed instrument customer base. We may terminate the agreement upon 60 days written notice to Applera and either party may terminate the agreement under certain other limited circumstances. From time to time, we receive notice from third parties claiming that we may infringe their patents. The Board of Trustees of the Leland Stanford Junior University has filed a lawsuit in the United States District Court for the Northern District of California claiming that our TRUGENE HIV-1 Genotyping Kit infringes patents owned by the University. We have received an attorney opinion that we do not infringe any claim of the patents-in-suit. We believe that these claims are without merit and intend to vigorously contest the allegations made in the lawsuit. Since the amount of damages are unspecified, we cannot at this time determine, if we are unsuccessful, whether this legal action will have a material adverse effect on our business, financial condition or results of operations. COMPETITION The biotechnology industry is highly competitive. We compete with entities in the United States and abroad that are engaged in the development and production of products that analyze genetic information. They include: biotechnology, pharmaceutical, chemical and other companies; academic and scientific institutions; governmental agencies; and public and private research organizations. Some of our major competitors include: - purveyors of home brew tests, which may not have undergone clinical validation and have not been approved by the FDA or other regulatory agencies, including Laboratory Corporation of America Holdings, Quest Diagnostics Inc. and Specialty Laboratories, Inc.; - manufacturers of genotyping test kits, including the Celera Diagnostics division of Applera; - purveyors of phenotyping or genotyping assay services, including ViroLogic, Inc. and Tibotec-Virco NV (a subsidiary of Johnson & Johnson); - manufacturers and distributors of DNA probe-based diagnostic systems such as Abbott Laboratories, Chiron Corp., Roche Diagnostics, Gene Probe Inc., Innogenetics NV, Digene Corporation and Johnson & Johnson; and - manufacturers and distributors of DNA sequencers such as Applera, Amersham Pharmacia Biotech, Inc., LI-COR, Inc., Hitachi, Ltd. and Beckman Coulter, Inc. Many of these companies and many of our other competitors have much greater financial, technical and research and development resources and production and marketing capabilities than we do. Some of our competitors, including some large clinical laboratories, have developed home brew HIV genotyping tests which are not approved for clinical diagnostic use by the FDA or other regulatory 33 agencies. We believe that three of these clinical laboratories currently are the largest commercial users of HIV genotyping tests. The FDA has said that it will not require premarket approval of these home brew tests developed in-house by clinical laboratories if they are used exclusively by the laboratories for HIV monitoring and if the laboratories do not make any medical claims for their tests and provide only analytical results to their customers. We believe that some of these laboratories have interpreted the FDA policy to mean that they are permitted to use their home brew genotyping tests to conduct HIV drug resistance testing in the laboratories and provide drug resistance reports about specific patients to physicians, in direct competition with our TRUGENE HIV-1 Genotyping Kit. We believe, however, that the FDA policy prohibits the use of the HIV home brew genotyping tests for these purposes and that these laboratories are required to obtain FDA approval before using their genotyping tests in this fashion. We are not certain how the FDA will interpret, or whether and when it will enforce, its policy as it applies to these HIV home brew genotyping tests. PROPERTY, PLANTS AND EQUIPMENT The table below lists the locations of our facilities and summarizes certain information about each location.
SQUARE FEET LOCATION USE (APPROXIMATE) TERM OF LEASE -------- --- ------------- ------------- 1. Bay Street* Finance, administration and principal executive 20,628 June 2000 - Toronto, Canada offices May 2005 2. Bay Street Software research and development 6,876 November 2000 - Toronto, Canada May 2005 3. Etobicoke MicroCel manufacturing 10,282 June 1996 - Ontario, Canada October 2002 4. Etobicoke Sequencer manufacturing 10,430 September 1998 - Ontario, Canada August 2003 5. Oakville** Not in use 7,996 September 1998 - Ontario, Canada August 2003 6. Meyerside Drive** Not in use 3,100 May 1999 - Mississauga, Canada April 2004 7. University of Not in use 9,621 September 2000 - Pittsburgh August 2002 Applied Research Center, Pittsburgh, Pennsylvania 8. Technology Park Manufacturing and research and development 7,313 March 1998 - Atlanta, Georgia February 2003 9. Suwanee, Georgia*** Kit manufacturing, chemistry development, 99,822 February 2000 - laboratory, and sales and administrative offices March 2010 10. High Wycombe, European head office 5,118 October 2000 - United Kingdom October 2009
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SQUARE FEET LOCATION USE (APPROXIMATE) TERM OF LEASE -------- --- ------------- ------------- 11. Cambridge Science Chemistry research 20,000 January 1999 - Park, United March 2014 Kingdom**** 12. Epinay, France French sales office 2,421 November 2000 - October 2009 13. Madrid, Spain Iberian sales office 258 January 2002 - December 2002 14. Genoa, Italy Italian sales office 386 January 2000 - December 2002 15. Technology Park,** Not in use 21,032 November 1999 - Atlanta, Georgia October 2004
---------- * Approximately one-third of this facility is sub-leased. ** We have sub-leased these facilities. *** This facility is not yet cleared for full scale commercial genotyping kit production. **** Approximately half of this facility is sub-leased. We believe that additional facilities will be available at reasonable market rates to meet any future needs we may have for additional space. HISTORY AND DEVELOPMENT OF THE COMPANY Our company was incorporated in April 1993 pursuant to the laws of the province of Ontario, Canada under the name Gene-Reader Inc. In May 1994, Gene-Reader amalgamated with its wholly-owned subsidiary, Visible Genetics Inc., and continued operations. Pursuant to the articles of amalgamation, our company retained the articles of incorporation of Gene-Reader and changed its name to Visible Genetics Inc. Our registered office is located at 700 Bay Street, Suite 1000, Toronto, Ontario, Canada M5G 1Z6 and our telephone number is (416) 813-3240. ORGANIZATIONAL STRUCTURE The table below lists our subsidiaries. Unless otherwise indicated, we, or one of our subsidiaries, owns 100% of the outstanding capital stock of the subsidiary.
Name of Subsidiary Country of Incorporation ------------------ ------------------------ Applied Sciences, Inc. United States Gene Foundry, Inc. United States Visible Genetics B.V. Holland Visible Genetics Corp. United States
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Name of Subsidiary Country of Incorporation ------------------ ------------------------ Visible Genetics France S.A.S.* France Visible Genetics Iberia SL Spain Visible Genetics Israel, Ltd. Israel Visible Genetics Unipessoal, Lda. Portugal Visible Genetics Srl. Italy Visible Genetics UK Ltd United Kingdom
---------- * In order to comply with applicable law, Richard T. Daly, the President and Chief Executive Officer of our company, Thomas J. Clarke, the Chief Financial Officer of our company, and Dr. Arthur W.G. Cole, an Executive Vice President of our company and the President of Visible Genetics UK Ltd., each own one common share of Visible Genetics France S.A.S. 36 ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS. YOU SHOULD READ THE FOLLOWING DISCUSSION AND ANALYSIS IN CONJUNCTION WITH ITEM 3 - "SELECTED FINANCIAL DATA" AND OUR CONSOLIDATED FINANCIAL STATEMENTS AND NOTES THERETO INCLUDED ELSEWHERE IN THIS ANNUAL REPORT. IN ADDITION TO HISTORICAL INFORMATION, THE FOLLOWING DISCUSSION CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS THAT INVOLVE KNOWN AND UNKNOWN RISKS AND UNCERTAINTIES, SUCH AS STATEMENTS OF OUR PLANS, OBJECTIVES, EXPECTATIONS AND INTENTIONS. SEE "FORWARD-LOOKING STATEMENTS." OPERATING RESULTS OVERVIEW We began operations in 1993. Until 1996, we devoted substantially all of our resources to the research and development of our technology and products. In late 1996, we began manufacturing and selling our products to the research and clinical research markets. In September 2001, we received clearance from the FDA to market our TRUGENE HIV-1 Genotyping Kit and OpenGene DNA Sequencing System for clinical use in the United States. We began selling our TRUGENE HIV-1 Genotyping Kit to the clinical diagnostic market in the United States during the fourth quarter of 2001. During 2000, we received approval from French regulatory authorities to sell our TRUGENE HIV-1 Genotyping Kit and OpenGene DNA Sequencing System to the clinical diagnostic market in France, and during 2001, we received approval from the appropriate regulatory authorities to sell our TRUGENE HIV-1 Genotyping Kit and OpenGene DNA Sequencing System to the clinical diagnostic markets in Canada and Argentina. Our products and services include: - GENOTYPING KITS AND OTHER CONSUMABLES. Genotyping kits consist of various reagents, enzymes, primers and other chemicals. Other consumables consist of disposable gel cassettes, acrylamide and other materials. - SEQUENCING SYSTEMS. Sequencing systems consist of automated DNA sequencers and related equipment, and our proprietary DNA analysis and data management software. - TESTING, SEQUENCING AND OTHER SERVICES. We provide services, such as viral load testing, genotyping and other molecular services in the U.S.. During the third quarter of 2000 we began to phase-out our testing, sequencing and services business in Europe. During 1996 and 1997, we generated revenues primarily by selling sequencing systems. During this period, our business strategy focused on installing our DNA sequencers and related equipment in research and clinical research facilities. During 1998, we began to shift our strategy to target the clinical diagnostic market and to place greater emphasis on generating recurring revenues from sales of genotyping kits and other consumables initially to the research and clinical research markets and, subject to FDA and foreign regulatory approval, as applicable, to the clinical diagnostic market. As part of this strategy, we may sell our DNA sequencers at reduced prices, or place DNA sequencers at no cost, to customers who commit, or to customers who we anticipate will commit, to purchase significant quantities of genotyping kits and other consumables. This strategy may result, initially, in reduced gross margins and additional losses as we attempt to expand our installed base of DNA sequencers. However, we believe that this strategy, over the long term, will help us maximize recurring sales of our TRUGENE HIV-1 Genotyping Kit and other genotyping kits to the clinical diagnostic market. In addition, in 1999, 37 we sometimes bundled our DNA sequencers and genotyping kits for sale at reduced prices. We discontinued the practice of bundled sales in the second half of 1999. During 2000, in anticipation of our receiving regulatory approval of our TRUGENE HIV-1 Genotyping Kit, we began to de-emphasize marketing and sales of equipment to the research market and sales of testing, sequencing and other services. We have continued to market and sell equipment and genotyping kits to the clinical research market for research and investigational purposes. We anticipate that during 2002 the vast majority of our revenue will be generated by sales of genotyping kits and other consumables to the clinical diagnostic market. OUR OPERATIONS SALES. Sales consist of revenues from the sale of genotyping kits and other consumables, sequencing systems, as well as from the sale of testing services. Sales include shipping charges, but exclude sales and excise taxes. Revenues from the sale of our products are recognized when evidence of an arrangement exists, shipment occurs and title passes to the customer or distributor, sales price is fixed or determinable and there is a reasonable assurance of collectibility. Revenues from the sale of testing and other services are recognized when evidence of an arrangement exists, the services are provided, sales price is fixed or determinable and there is a reasonable assurance of collectibility. Sales of bundled sequencing systems and genotyping kits are recognized proportionately as the components of the bundle are shipped to customers. The total sales price of the bundle is allocated to the components proportionately based on the retail prices typically charged for such components if they were sold individually rather than as part of the bundle. We sell our products in North America, Europe, Asia, Australia, Africa and South America. In the United States, Canada and many countries in Europe, we sell our products directly through our own sales force. In selected geographic and product markets, we seek to sell our products through distribution, marketing or agency agreements with leading distributors. For an analysis of sales by product segment and geographic market for 2001, 2000, and 1999, see Note 13 to our consolidated financial statements. COST OF SALES. Cost of sales consists of manufacturing costs including materials, labor and overheads chargeable to inventory, royalties paid on product sales and amortization of instruments placed with customers. The gross margin from sales of our products and services varies depending on product category, sales volumes, distribution channel and geographic market. Gross margin is calculated by subtracting cost of sales from sales. SALES, GENERAL AND ADMINISTRATIVE EXPENSES. Sales, general and administrative expenses consist primarily of salaries and related expenses, advertising and trade show expenses, occupancy costs, utilities, professional fees, consulting fees, travel costs, capital taxes, depreciation of fixed assets, amortization of license fees and amortization of costs related to patent acquisition. RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses consist primarily of salaries and related expenses for employees engaged in research and development, occupancy costs, consulting fees, travel costs, depreciation and amortization of fixed assets and costs related to FDA clinical trials for our HIV OpenGene System. INTEREST INCOME. Interest income consists of income earned on cash, cash equivalents and marketable securities. 38 INTEREST AND FINANCING EXPENSE. Interest and financing expense consists of interest paid or accrued, and amortization of warrant costs and other financing expenses. Our financial statements are presented in U.S. dollars and are prepared in accordance with generally accepted accounting principles in the United States. RESULTS OF OPERATIONS COMPARISON OF FISCAL YEAR ENDED DECEMBER 31, 2001 TO FISCAL YEAR ENDED DECEMBER 31, 2000 SALES. Sales increased 4% to $13.6 million in 2001, from $13.1 million in 2000. The increase resulted from an increase in sales of genotyping kits and other consumables offset, in part, by a decline in sequencing system sales and services revenue. During 2001, sales of genotyping kits and other consumables increased 31% to $10.7 million from $8.2 million in 2000, while sales of sequencing systems and services decreased to $2.7 million and $0.2 million, respectively, in 2001, from $4.5 million and $0.4 million, respectively, in 2000. The decrease in sales of sequencing systems in 2001 reflects the decision made, in 2000, to de-emphasize sales of sequencing systems to the research market. The decline in services revenue is due primarily to the phase out of testing services in Europe beginning in the third quarter of 2000. In 2001, sales of genotyping kits and other consumables accounted for 78% of total sales, compared to 62% of total sales in 2000. In 2001, sales of sequencing systems and testing services were 20% and 2%, respectively, of total sales compared to 35% and 3%, respectively, in 2000. Sales in North America, Europe, Japan and the rest of the world were $6.6 million, $5.4 million, $1.2 million and $0.4 million, respectively, for 2001, as compared to $6.6 million, $5.0 million, $0.9 million and $0.6 million, respectively, for 2000. During 2001, Amersham International PLC (Amersham) accounted for approximately 9% of sales, of which 8% comprised sequencing systems and 1% comprised genotyping kits and other consumables. During 2000, sales to Amersham accounted for approximately 11% of sales, of which 10% comprised sequencing systems and 1% comprised genotyping kits and other consumables. The sales to Amersham were made on the same general terms and conditions as the majority of other sales during the respective periods. COST OF SALES. Cost of sales decreased 1% to $10.0 million in 2001, from $10.1 million in 2000. In 2001 cost of sales aggregated 74% of sales, compared to 78% in 2000. The decrease in cost of sales as a percentage of sales was primarily due to the increase in sales of genotyping kits and consumables which on a percentage basis have a lower cost of sales than do sales of sequencing systems. SALES, GENERAL AND ADMINISTRATIVE EXPENSES. Sales, general and administrative expenses increased 19% to $34.0 million, from $28.6 million in 2000. The increase resulted primarily from; - Start up costs related to the new Atlanta manufacturing facility; - Operating costs associated with our North American sales and administrative facility in Atlanta (opened in July 2000); - A full years' amortization of license fees for license agreements entered into in 2000; - Continued expansion of our sales force and marketing activities in North America and Europe. Sales and marketing expenses included in sales, general and administrative expenses increased 16%, to $15.5 million, from $13.4 million in 2000. 39 RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses increased 2% to $10.8 million in 2001, from $10.6 million in 2000. EXIT AND TERMINATION COSTS. During 2001, we incurred exit and termination costs of $1.9 million. Of this amount, $1.2 million related to the transfer of certain research and development activities from Toronto to facilities in Atlanta and Cambridge, England (which we acquired in 2001), and $0.5 million related to the planned transfer of genotyping kit manufacturing from Pittsburgh to our new manufacturing facility in Atlanta. In addition, $0.2 million related to the sub-lease of a facility in Norcross, Georgia that was vacated in 1999 in connection with the transfer of certain activities to Atlanta. There were no exit and termination costs in 2000. INTEREST INCOME. Interest income decreased to $2.5 million in 2001, from $4.5 million in 2000. The decrease is due to lower average cash balances and lower average interest rates earned on invested cash during 2001. CUMULATIVE PREFERRED DIVIDENDS AND ACCRETION OF DISCOUNT ATTRIBUTABLE TO PREFERRED SHARES. In 2001, cumulative preferred dividends and accretion of discount attributable to preferred shares decreased to $3.4 million from $3.7 million in 2000. The decrease is due to having fewer Series A preferred shares outstanding. In September 2000 a holder of the Series A preferred shares converted 7,795 shares into common shares, and in March 2001 a second holder of the Series A preferred shares converted 1,000 shares into common shares. COMPARISON OF FISCAL YEAR ENDED DECEMBER 31, 2000 TO FISCAL YEAR ENDED DECEMBER 31, 1999 SALES. Sales decreased 4% to $13.1 million in 2000, from $13.6 million in 1999. The decline resulted from a decrease in sequencing systems sales and services revenue offset, in part, by an increase in sales of our genotyping kits and other consumables. In 2000, sales of sequencing systems decreased to $4.5 million from $7.7 million in 1999. The decrease in sales of sequencing systems in 2000 reflects our decision to de-emphasize the sale of sequencing systems to the research market. Services sales decreased from $1.2 million in 1999 to $0.4 million in 2000. The decline in services sales is due primarily to the phase-out of testing services in Europe beginning in the third quarter of 2000, and to our decision to temporarily re-deploy many of our testing services personnel in North America to assist in completing our FDA submission. During 2000 sales of genotyping kits and other consumables increased to $8.2 million from $4.7 million in 1999. In 2000, sequencing systems accounted for 35% of total sales, compared to 57% of total sales in 1999. In 2000, genotyping kits and other consumables accounted for 62% of total sales, compared to 35% of sales in 1999. In 2000, testing services accounted for 3% of total sales, compared to 8% of total sales in 1999. Sales in North America, Europe, Japan and the rest of the world were $6.6 million, $5.0 million, $0.9 million and $0.6 million, respectively, for 2000, as compared to $5.2 million, $5.5 million, $1.6 million and $1.3 million, respectively, during 1999. During 2000, Amersham accounted for approximately 11% of sales, of which 10% comprised sequencing systems and 1% comprised genotyping kits and other consumables. During 1999, the sales to Amersham accounted for approximately 21% of sales, of which 19% comprised sequencing systems and 2% comprised genotyping and other consumables. The sales to Amersham were made on the same general terms and conditions as the majority of other sales during the respective periods. COST OF SALES. Cost of sales increased 9% to $10.1 million in 2000, from $9.3 million in 1999. In 2000, cost of sales aggregated 78% of sales, compared to 68% of sales in 1999. The increase in cost of sales as a percentage of sales was primarily related to amortization of DNA sequencing systems placed, at 40 no cost, with clinical customers and an increase in discarded materials and other costs attributable to the manufacturing scale up associated with the anticipated U.S. launch of the HIV genotyping kit. SALES, GENERAL AND ADMINISTRATIVE EXPENSES. Sales, general and administrative expenses increased 50% to $28.6 million in 2000, from $19.1 million in 1999. The increase resulted primarily from; - Increased payroll and personnel costs due to continued growth of our business; - Costs associated with opening a North American sales and administrative facility in Atlanta; - Amortization of license fees for license agreements entered into in 2000; - Continued growth of our quality control and regulatory departments; and - Continued expansion of our sales force and our marketing activities in North America and Europe. Sales and marketing expenses included in sales, general and administrative expenses increased 21% to $13.4 million in 2000, from $11.1 million in 1999. RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses increased 34% to $10.6 million in 2000, from $7.9 million in 1999. This increase resulted primarily from increased costs for consultants and increased purchases of laboratory supplies related to preparing our FDA submission. EXIT AND TERMINATION COSTS. There were no exit and termination costs in 2000. During 1999, we incurred exit and termination costs of $1.3 million. Of this amount, $0.8 million related to the transfer of certain of our activities to the new facility in Atlanta, and $0.5 million was for termination benefits payable to two senior officers in connection with the termination of their employment with our company. INTEREST INCOME. Interest income increased to $4.5 million in 2000, from $0.7 million in 1999. This increase reflects interest earned on higher average cash balances as a result of the approximately $30.0 million of cash proceeds received from our July 1999 issuance of Series A preferred shares, approximately $26.7 million of cash proceeds received from our December 1999 private placement of common shares and approximately $75.4 million of cash proceeds received from our April 2000 follow-on public offering of common shares. INTEREST AND FINANCING EXPENSE. Interest and financing expense decreased to approximately nil in 2000, from $2.0 million in 1999. The decrease is due to the repayment in July 1999, concurrent with the issuance of the Series A preferred shares, of our outstanding loans. CUMULATIVE PREFERRED DIVIDENDS AND ACCRETION OF DISCOUNT ATTRIBUTABLE TO PREFERRED SHARES. Cumulative preferred dividends and accretion of discount attributable to preferred shares increased to $3.7 million in 2000, from $1.8 million in 1999. The increase reflects a full year's dividends and amortization of discount on the Series A preferred shares issued in July 1999. LIQUIDITY AND CAPITAL RESOURCES Since inception, we have financed our operations primarily through private placements of equity and public offerings. We have also borrowed funds from institutional lenders. DECEMBER 2001 PRIVATE PLACEMENT. In December 2001, various institutional investors purchased 2,637,890 common shares in a private placement. The investors paid $8.34 per share and we received proceeds, before related fees and expenses, of $22.0 million from the private placement. 41 APRIL 2000 PUBLIC OFFERING. In April 2000, we completed an underwritten follow-on public offering of 2,090,000 common shares at $38 per share. All of the shares were sold by us. After underwriting discounts, but before related fees and expenses, we received proceeds of $75.4 million. DECEMBER 1999 PRIVATE PLACEMENT. In December 1999, various institutional investors purchased 1,916,000 common shares in a private placement. The investors paid $15 per share and we received net proceeds of $26.7 million from the private placement. The institutional investors included the Warburg Pincus Funds and the Hilal Funds (described below), along with certain investors who had purchased our common shares in a November 1998 private placement and certain new institutional investors. WARBURG PINCUS FINANCING. On July 15, 1999, certain affiliated funds managed by E.M. Warburg, Pincus & Co., LLC, which we refer to as the Warburg Pincus Funds, invested $30.0 million in our company. In consideration for this investment, we issued to the Warburg Pincus Funds 30,000 Series A preferred shares convertible at the holders' option into common shares at $11.00 per share, and warrants to purchase 1,100,000 common shares exercisable for four years at a purchase price of $12.60 per share. The Series A preferred shares and warrants included customary anti-dilution provisions, under which the conversion price of the shares and the exercise price of the warrants may be reduced, and the number of shares issuable upon exercise of the warrants may be increased, under certain conditions including the sale of certain securities at a price below the conversion price of the shares or the exercise price of the warrants. As a result of the December 2001 Private Placement, the conversion price of the Series A preferred shares was reduced to $10.72. The value of the net proceeds was allocated between convertible preferred shares and warrants based on the relative fair value of each instrument. The total amount allocated to warrants and preferred shares was $6.4 million and $22.8 million, respectively. The warrants were valued using the Black-Scholes option valuation model. The value of the warrants is treated as a discount to the preferred shares and will be charged directly to retained earnings or, in the absence of retained earnings, against other equity, or in the absence of other equity, against deficit, over seven years, the time period when redemption of the preferred shares first becomes mandatory. The increase in value of the preferred shares to their mandatory redemption price as well as the accrual of dividends on the preferred shares will reduce earnings attributable to common shareholders. In February 2000, the Warburg Pincus Funds exercised all of their warrants at an exercise price of $12.60 per share. Under the terms of our warrant agreement, the Warburg Pincus Funds elected to pay the exercise price for the warrants through a cashless exercise. As a result, the Warburg Pincus Funds received 847,749 of our common shares rather than 1,100,000 common shares they otherwise would have received upon exercise in cash of all of their warrants. The Warburg Pincus Funds subsequently distributed 847,586 of these common shares to their limited partners. In September 2000, the Warburg Pincus Funds, converted a total of 7,795 of our Series A preferred shares, plus a total of $701,550 of dividends that had accrued on those shares, into our common shares at a conversion price of $11.00 per share. As a result of the conversion, the Warburg Pincus Funds received 772,411 of our common shares and continue to hold a total of 22,205 Series A preferred shares. The Warburg Pincus Funds subsequently distributed to their limited partners, all the common shares issued in connection with the conversion of the 7,795 Series A preferred shares. INSTITUTIONAL LOANS. On April 30, 1998, our subsidiary, Visible Genetics Corp., or VGC, borrowed $7.0 million from various funds for which Hilal Capital Management LLC serves or served as general partner, investment advisor or management company. We refer to these funds as the Hilal Funds. In September 1998, VGC borrowed an additional $1.0 million from these lenders. Interest and principal on the $7.0 million loan were payable on or about April 29, 1999, and, on the $1.0 million loan, were 42 payable on December 28, 1999. As part of the loan arrangements we granted the Hilal Funds warrants to purchase a total of 540,000 common shares at an exercise price of $10.00 per share. On April 30, 1999, we and the Hilal Funds agreed to delay the payment date of the $7.0 million loan to December 31, 1999, and to move up the payment date of the $1.0 million loan to July 1, 1999. The Hilal Funds later extended the payment date to the earlier of July 22, 1999, or the completion of the Warburg Pincus financing. On April 30, 1999, we granted the Hilal Funds warrants to purchase an additional 140,000 common shares which may be exercised until April 30, 2006, at a price of $17.00 per share. The warrants were valued using the Black-Scholes option valuation model, resulting in a value being attributed to these warrants of $0.9 million. This amount was recorded as a deferred charge on the balance sheet and was to be amortized to financing expense over the remaining term of the loan maturing on December 31, 1999. As a result, the entire amount was recorded as a non-cash charge to financing expense in 1999. On July 15, 1999, we repaid or satisfied all of the loans made to us by the Hilal Funds. Of the $8.0 million principal amount of the loans, we paid $4.1 million of principal plus accrued interest on the loans in cash. The Hilal Funds converted the remaining $3.9 million principal amount plus accrued interest into 3,948 Series A preferred shares and 147,098 warrants to purchase our common shares at a purchase price of $12.60 per share. The Series A preferred shares and warrants included customary anti-dilution provisions, under which the conversion price of the shares and the exercise price of the warrants may be reduced, and the number of share issuable upon exercise of the warrants may be increased, under certain conditions, including the sale of certain securities at a price below the conversion price of the shares or the exercise price of the warrants. As a result of the December 2001 Private Placement, the number of warrants was increased to 152,420 and the purchase price of the warrants was reduced to $12.16. The value of the net proceeds was allocated between convertible preferred shares and warrants based on the relative fair value of each instrument. The total amount allocated to warrants and preferred shares, was $0.9 million and $3.0 million, respectively. The warrants were valued using the Black-Scholes option valuation model. The value of the warrants is treated as a discount to the preferred shares and will be charged directly to retained earnings or, in the absence of retained earnings, against other equity, or in the absence of other equity, against deficit, over seven years, the time period when redemption of the preferred shares first becomes mandatory. The increase in value of the preferred shares to their mandatory redemption price as well as the accrual of dividends on the preferred shares will reduce earnings attributable to common shareholders. The Series A preferred shares and warrants have the same terms as those granted to the Warburg Pincus Funds. On March 15, 2001, the Hilal Funds converted a total of 1,000 of the Series A preferred shares, plus a total of $139,050 of dividends that accrued on those shares, into 103,550 of our common shares. On November 29, 2001, the Hilal Funds transferred their remaining 2,948 Series A preferred shares to an unrelated party. CAPITAL AND CERTAIN OTHER EXPENDITURES. Additions to fixed assets were approximately $13.2 million, $9.3 million and $1.9 million for the years ended December 31, 2001, 2000 and 1999, respectively. The additions to fixed assets in 2001, include $9.5 million in expenditures related to our Atlanta facility, of which $7.0 million was for leasehold improvements, $1.5 million was for laboratory and scientific equipment, $0.7 million was for computer equipment and software and $0.3 million was for office furniture and equipment. In addition, during 2001 additions to fixed assets for our Canadian facilities were $0.4 million, consisting primarily of additions to computer equipment and software, 43 laboratory and scientific equipment and leasehold improvements. Also, during 2001 additions to fixed assets in Europe were $1.5 million and include $0.8 million for the acquisition of a research laboratory in Cambridge, England. During 2001, we also placed $1.7 million of equipment with certain customers at no charge to those customers. We reflect this on our balance sheet as a component of "Fixed assets." The additions to fixed assets in 2000 include $6.2 million in expenditures related to our Atlanta facility, of which $3.0 million was for leasehold improvements, $1.3 million was for laboratory and scientific equipment, $1.5 million was computer equipment and software and $0.4 million was for office furniture and equipment. In addition, during 2000 additions to fixed assets for our Canadian facilities were $1.2 million, consisting primarily of additions to computer equipment and software, laboratory and scientific equipment and leasehold improvements. During 2000, we also placed $1.4 million of equipment with certain customers at no charge to those customers. The additions to fixed assets in 1999 consisted of $0.9 million for laboratory and scientific equipment, $0.6 million for computer equipment and software and $0.3 million for office furniture, equipment and leasehold improvements primarily to our Canadian facilities. Capital expenditures during these periods were funded from proceeds of private equity placements, public offerings and funds borrowed from institutional lenders. We currently anticipate $2.0 million in regularly planned capital expenditures in 2002. In April 2000 we entered into a worldwide licensing and collaboration agreement with Applera Corporation, Applied Biosystems Group (Applera). Under the terms of the agreement, we paid an initial licensing fee to Applera of $10.0 million in June 2000 and an additional $5.0 million licensing fee in June 2001. We will pay future licensing fees of $5.0 million in each of June 2002 and June 2003, unless the agreement is terminated before those dates. We are not obligated to make any further payments upon the termination of the agreement. In addition, in return for access to the Applera technology and installed instrument customer base, we will pay royalties to Applera based on sales. We may terminate the agreement upon 60 days written notice to Applera and either party may terminate the agreement under certain other limited circumstances. CURRENT AND FUTURE FINANCING NEEDS. We have incurred negative cash flow from operations since we started our business. We have spent, and expect to continue to spend, substantial amounts to complete our planned product development efforts, expand our sales and marketing activities, expand our manufacturing capabilities, conduct our clinical trials, conduct research and build our business infrastructure. At this time, funds from operations are not sufficient to meet our operating needs and other anticipated financial requirements. Based on our current plans we believe that our cash on hand and anticipated funds from operations will be sufficient to enable us to meet our operating needs for the next 9 to 12 months. However, the amount of funds we will need to operate for this time period is subject to many factors, some of which are beyond our control. We may need to obtain additional funds sooner or in greater amounts than we currently anticipate, and we expect that we will need to obtain additional funds at the end of the 9 to 12 month period. Potential sources of financing include strategic relationships, public or private sales of our shares or debt or other arrangements. We do not have any committed sources of financing at this time and it is uncertain whether additional funding will be available when we need it on terms that will be acceptable to us or at all. If we raise funds by selling additional common shares or other securities convertible into common shares, the ownership interest of our existing shareholders will be diluted. If we are not able to obtain financing when needed, we would be unable to carry out our business plan, we would have to 44 significantly limit our operations and our business, financial condition and results of operations would be materially harmed. If we wish to issue equity securities or obtain additional financing, under certain circumstances we will need the consent of the Series A preferred shareholders. We will be required to obtain the consent of the holders of a majority of the then outstanding Series A preferred shares prior to issuing any equity security that has rights as to dividends and liquidation that are senior or equal to those of the Series A preferred shares. We will also be required to obtain the consent of the holders of a majority of the then outstanding Series A preferred shares if we wish to borrow money and at such time or as a result of such loans, the total principal amount of our indebtedness and capitalized lease obligations exceeds $15.0 million. As a result, we may be delayed in, or prohibited from, obtaining certain types of financing. INTEREST RATE AND INVESTMENT RISK. The primary objective of our investment activities is to preserve principal while at the same time maximizing income received from our investments without significantly increasing risk. Our investment portfolio is primarily comprised of cash and short term interest bearing certificates. FOREIGN CURRENCY RATE FLUCTUATIONS. While our financial statements are in U.S. dollars, revenue is generated in U.S. dollars and other currencies. We incur the majority of our expenses in Canadian and U.S. dollars, British pounds and euros. As a result, we may suffer losses due to fluctuations in exchange rates between the U.S. dollar, and the these other currencies. We do not currently engage in foreign exchange hedging activities or use other financial instruments in this regard. EURO CONVERSION Effective January 1, 1999, 12 of the 15 member countries of the European Union adopted the euro as their common legal currency and each participant established fixed conversion rates between their sovereign, or legacy, currencies and the common euro currency. On January 1, 2002, euro-denominated bills and coins were introduced as legal currency for these countries. By July 1, 2002, the legacy currencies will be phased out entirely as legal tender. During this transition period, public and private parties may choose to pay for goods and services using either the euro or the participating country's legacy currency. We currently conduct business operations in U.S. and Canadian dollars, British pounds and euros. We have made all necessary modifications to our information systems, equipment and processes to accommodate euro transactions. 45 ITEM 6. DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES. DIRECTORS AND SENIOR MANAGEMENT The following table sets forth certain information with respect to our executive officers and directors. This information is supplied based upon our records and information furnished by our executive officers and directors.
DIRECTOR'S YEAR TERM NAME AGE POSITION APPOINTED EXPIRES ---- --- -------- --------- ------- Richard T. Daly............................ 52 President, Chief Executive Officer and Director 1998 2004 Thomas J. Clarke........................... 54 Chief Financial Officer 2000 Timothy W. Ellis........................... 54 Chief Operating Officer 1999 Dr. Arthur W.G. Cole....................... 51 Executive Vice President; President, Visible 1996 Genetics UK Ltd. Marguerite Ethier.......................... 39 Vice President, General Counsel 2000 Dr. Brendan Larder......................... 43 Chief Scientific Officer 2001 David A. Galloway.......................... 58 Director 2001 2002 Sheldon Inwentash(1)....................... 46 Director 1994 2002 J. Spencer Lanthier(1)..................... 61 Director 2000 2003 Jacques R. Lapointe(2)..................... 55 Director 2000 2002 Jonathan S. Leff(1)(2)..................... 33 Director 1999 2002 Dr. Heather Munroe-Blum(2)................. 51 Director 2001 2003 Dr. Lloyd M. Smith......................... 47 Director 1995 2004 Dr. Konrad M. Weis......................... 73 Director 1997 2004
---------- (1) Member of Audit Committee (2) Member of Compensation Committee The following is the business experience for at least the last five years of each of our executive officers and directors: RICHARD T. DALY has been a Director of our company since June 1998, and President and Chief Executive Officer since July 1999. Mr. Daly served as Executive Vice President from March 1999 until July 1999. Prior to joining Visible Genetics, Mr. Daly founded, and, from March 1989 through July 1998, served as Chairman and Chief Executive Officer of Clinical Partners, Inc., a San Francisco-based company providing comprehensive, therapy-specific management of HIV and AIDS patients for employers and managed health-care organizations. Prior to founding Clinical Partners, Mr. Daly spent over 15 years in the healthcare industry with several companies in a variety of executive positions in sales, marketing and general management, including serving as the President of Baxter Canada for a period of four years, and President of the Health Data Institute. THOMAS J. CLARKE has been Chief Financial Officer of our company since January 2000. From July 1997 to January 2000, Mr. Clarke was Chief Operating Officer of CCS TrexCom, Inc., a telecommunications software company. From 1991 to July 1997, Mr. Clarke was Chief Financial Officer of CCS TrexCom. Mr. Clarke is a Certified Public Accountant. TIMOTHY W. ELLIS has been Chief Operating Officer of our company since November 1999. From January 1998 to November 1999, Mr. Ellis operated his own management consultant practice. From 1991 46 to 1997, Mr. Ellis was President of Dynex Technologies, a manufacture of instruments and consumables for the clinical research industry. DR. ARTHUR W. G. COLE has been Executive Vice President of our company since May 1996 and the President of our Visible Genetics UK Ltd. subsidiary since September 1999. From May 1996 to September 1999, Dr. Cole also served as Chief Business Officer of our company. From 1995 to May 1996, Dr. Cole was a business consultant to companies in the biotechnology industry through AC Consulting. MARGUERITE ETHIER has been Vice President, General Counsel of our company since January 2000. From 1998 to 1999, Ms. Ethier was a partner in the law firm of McCarthy Tetrault, and from 1995 to 1997 and 1992 to 1993, Ms. Ethier was an associate with McCarthy Tetrault. From 1993 to 1995, Ms. Ethier was an associate with the law firms of Townsend & Townsend Khourie & Crew and Howard Rice Nemerovski Canady Falk & Rabkin. Ms. Ethier holds a B.Sc. degree from the University of Alberta, an M.Sc. degree from the University of Toronto, and an LL.B. degree from Osgoode Hall Law School. Ms. Ethier is a member of the Ontario and California bars, and is qualified as both a registered Canadian Patent Agent and a United States Patent Attorney. DR. BRENDAN LARDER has been Chief Scientific Officer our company since September 2001. From 1997 to July 2001, Dr. Larder was the Chief Scientific Officer at Virco UK Limited. From 1985 to 1997, Dr. Larder was a research scientist at the Wellcome Research Laboratories in London. DAVID A. GALLOWAY was appointed to our Board of Directors in November 2001. From 1988 until November 2001, Mr. Galloway was President and Chief Executive Officer of Torstar Corporation, a Canadian media company. Prior to joining Torstar, Mr. Galloway was one of the founding partners of Canada Consulting Group. Mr. Galloway is currently a director of the Bank of Montreal and Corel Corporation. SHELDON INWENTASH has been a director of our company since April 1994. Since November 1993, Mr. Inwentash has been the Chairman and Chief Executive Officer of GeneVest Inc., a publicly held Canadian biotechnology investment firm. Since February 1992, Mr. Inwentash has been the Chairman and Chief Executive Officer of Pinetree Capital Corp., a venture capital firm. J. SPENCER LANTHIER has been a director of our company since April 2000. From 1993 until his retirement in 1999, Mr. Lanthier was Chairman and Chief Executive Officer of KPMG Canada LLP. Mr. Lanthier is presently a member of the board of directors of Bank of Canada, British Energy (Canada) Ltd., Bruce Power, Inc., Canada Life Assurance Company, Co-Steel, Inc., Ellis-Don, Inc., The Toronto Stock Exchange and Intertape Polymer, Inc. JACQUES R. LAPOINTE has been a director of our company since April 2000. Since May 2001, Mr. Lapointe has been self-employed as a consultant. From June 1998 until May 2001, Mr. Lapointe was President and Chief Operating Officer of BioChem Pharma Inc., a Canadian biotechnology company. From April 1994 to June 1998, Mr. Lapointe was Managing Director and Business Development Director of Glaxo Wellcome Plc. Mr. Lapointe is presently a member of the board of directors of Altarex Corp., Procrea Biosciences Inc., Galileo Genomics Inc., ConjuChem Inc and Bioniche Life Sciences Inc.. JONATHAN S. LEFF has been a director of our company since July 1999, serving as the nominee of the Series A preferred shareholders. Mr. Leff joined E.M. Warburg, Pincus & Co., LLC in July 1996 as an Associate. In January 1999, he became a Vice President, and in January 2000, he became a Managing Director. Mr. Leff is presently a member of the board of directors of Intermune Inc., Synaptic Pharmaceutical Corp., Transkaryotic Therapies, Inc., Triangle Pharmaceuticals Inc., ZymoGenetics, Inc., and a number of private health care companies. 47 DR. HEATHER MUNROE-BLUM was appointed to our Board of Directors in July 2001. Since January 1994, Dr. Munroe-Blum has been Vice-President, Research & International Relations at the University of Toronto. Dr. Munroe-Blum is also a governor of the University of Toronto. Dr. Munroe-Blum is currently a member of the Advisory Board of Nestle Canada. DR. LLOYD M. SMITH has been a director of our company since March 1995. Since June 1994, Dr. Smith has been Professor of Chemistry at the University of Wisconsin-Madison. Dr. Smith is a past member of the National Institutes of Health National Human Genome Research Institute Study Section. Dr. Smith is a member of the Scientific Advisory Board of CuraGen Corp. He also serves, or has served, on the editorial boards of GENOME RESEARCH, DNA SEQUENCE GENETIC ANALYSIS: TECHNIQUES AND APPLICATIONS and JOURNAL OF CAPILLARY ELECTROPHORESIS and was a member of the scientific advisory boards of Fotodyne Incorporated and Boehringer Mannheim Corp. Dr. Smith is presently a member of the board of directors of Third Wave Technologies, Inc. DR. KONRAD M. WEIS has been a director of our company since 1997. Dr. Weis was President and Chief Executive Officer of the company that later became Bayer Corporation from 1974 until his retirement in 1991. He presently is a member of the board of directors of Demegen Inc. and Titan Pharmaceuticals, Inc. EMPLOYMENT AGREEMENTS We have entered into employment agreements with all of our executive officers. We may terminate these employment agreements for any reason, but we will be required to pay severance in varying amounts if we terminate employment without cause. These employment agreements (other than Dr. Larder's) provide for the payment of a change of control benefit if such officer is employed when a "change of control" (as that term is defined in the employment agreement) occurs, except under certain circumstances. We will pay the officer an amount equal to such officers' salary plus the amount of any cash bonus paid to the officer in calendar year 2001, or in one case, the amount of any cash bonus payable for calendar year 2001 (which we refer to as the Officer's 2001 Compensation). In addition, if the officer remains employed for a period of 90 days following a change of control, the officer will be entitled to a retention benefit equal to such Officer's 2001 Compensation, and if the officer remains employed for an additional 90 day period (for a total of 180 days) following a change of control, the officer will be entitled to an additional retention benefit equal to such Officer's 2001 Compensation, for a total retention benefit equal to two times the Officer's 2001 Compensation. Furthermore, if we terminate the officer's employment prior to the end of the 180 day period for any reason other than cause, such officer will also be entitled to the retention benefit. COMPENSATION The following table sets forth information concerning total compensation earned or paid to our executive officers for services rendered to our company during the fiscal year ended December 31, 2001. 48 EXECUTIVE OFFICER COMPENSATION SUMMARY TABLE
------------------------------------------------------------------------------------------------------------------- LONG-TERM ANNUAL COMPENSATION COMPENSATION ------------------------------------------------------------------------------------------------------------------- SECURITIES UNDERLYING OTHER ANNUAL OPTIONS ALL OTHER SALARY BONUS COMPENSATION GRANTED COMPENSATION NAME YEAR ($) ($) ($) (#) ($) ------------------------------------------------------------------------------------------------------------------- Richard T. Daly 2001 300,000 112,500 - - - ------------------------------------------------------------------------------------------------------------------- Thomas J. Clarke 2001 173,523 81,250 - 12,000 - ------------------------------------------------------------------------------------------------------------------- Timothy W. Ellis 2001 196,667 22,000 5,400(1) 10,000 - ------------------------------------------------------------------------------------------------------------------- Dr. Arthur W.G. Cole 2001 156,822 15,682 15,326(2) 10,000 - ------------------------------------------------------------------------------------------------------------------- Marguerite Ethier 2001 126,686 25,737 - 15,000 - ------------------------------------------------------------------------------------------------------------------- Dr. Brendan Larder 2001 64,357(3) 106,924 13,427(4) 95,000 - -------------------------------------------------------------------------------------------------------------------
---------- (1) Consists of Company matching contributions under Employee Stock Purchase Plan. (2) Consists of automobile allowance of $11,405 and pension contribution of $3,921. (3) Dr. Larder joined the Company in June 2001, and from June 4, 2001 through September 12, 2001, Dr. Larder worked on a part-time basis. (4) Consists of automobile allowance of $1,665 and pension contribution of $11,762. All of the directors, except for Jonathan S. Leff (the Series A Director), J. Spencer Lanthier and directors who are employees, receive a $2,500 fee for each Board of Directors and/or committee meeting they attend, up to a maximum of $10,000 per year. Mr. Lanthier, as Chairman of the Audit Committee, receives a $2,500 fee for each meeting of the Audit Committee he attends, up to a maximum of $10,000 per year, and receives a $2,500 fee for each meeting of the Board of Directors he attends, up to a maximum of $10,000 per year, for total fees of up to a maximum of $20,000 per year. Directors who are not employees are also eligible to participate in the 1997 Director Option Plan or the 2000 Employee Share Option Plan. All directors are reimbursed for reasonable out-of-pocket travel expenses incurred by them in attending meetings of the Board of Directors or committee meetings. The directors receive no other compensation for serving in their capacity as directors of our company The following table sets forth information concerning options granted to our executive officers and directors during the fiscal year ended December 31, 2001. OPTION GRANTS DURING 2001
NUMBER OF EXERCISE PRICE NAME OPTIONS GRANTED ($/SHARE) EXPIRATION DATE ------------------------ --------------- -------------- --------------- Thomas J. Clarke 12,000 $14.98 2011 Timothy W. Ellis 10,000 $14.98 2011 Dr. Arthur W.G. Cole 10,000 $14.98 2011 Marguerite Ethier 15,000 $14.98 2011 Dr. Brendan Larder 95,000 $19.25 2011 Dr. Lloyd Smith 15,000 $32.38 2011 Dr. Heather Munroe-Blum 30,000 $22.07 2011 David Galloway 30,000 $17.80 2011
49 In addition to the options set forth above, the following additional options were granted to our executive officers in 2001, pursuant to shareholder approval obtained at our Annual Meeting, held on June 12, 2002, of an increase in the number of common shares authorized for issuance under the 2000 Employee Share Option Plan from 1,000,000 to 2,000,000. Each option expires in 2011 and has an exercise price of $9.40 ADDITIONAL OPTION GRANTS DURING 2001
NUMBER OF NAME OPTIONS GRANTED ----------------------- ----------------- Thomas J. Clarke 25,000 Timothy W. Ellis 10,000 Dr. Arthur W.G. Cole 10,000 Marguerite Ethier 15,000 Dr. Brendan Larder 20,000
BOARD COMMITTEES AUDIT COMMITTEE. The Audit Committee recommends to the Board of Directors the firm to be appointed each year as independent auditors of the company's financial statements and to perform services related to the completion of such audit. The Audit Committee also has responsibility for: - reviewing the scope and results of the audit with the independent auditors; - reviewing with management and the independent auditors the company's interim and year-end financial condition and results of operations; - considering the adequacy of the internal accounting, bookkeeping and control procedures of the company; - reviewing any non-audit services and special engagements to be performed by the independent auditors and considering the effect of such performance on the auditors' independence; - reviewing at least once each year the terms of all material transactions and arrangements between the company and its affiliates; and - ensuring that the Board of Directors is aware of all matters that may significantly impact the financial condition or affairs of the business. The members of the Audit Committee are Messrs. Lanthier, Inwentash and Leff. COMPENSATION COMMITTEE. The Compensation Committee establishes and reviews overall policy and structure with respect to compensation matters, including the determination of compensation arrangements for directors, executive officers and key employees of the company. The Compensation Committee is also responsible for the administration and award of options to purchase shares pursuant to the company's option and share purchase plans. The members of the Compensation Committee are Messrs. Leff and Lapointe, and Dr. Munroe-Blum. EMPLOYEES As of May 31, 2002, we employed 334 full-time employees (including executive officers) and 17 independent contractors, of whom: 50 - 97 are engaged in research and development; - 75 are involved in sales and marketing activities; - 103 in manufacturing and operations; and - 59 are involved in finance, legal and administrative functions. We have 125 employees in Canada, 133 in the United States, and 76 in Europe Our employees are not represented by a union or other collective bargaining unit and we have never experienced a work stoppage. We believe that our employee relations are good. SHARE OWNERSHIP The following table sets forth certain information concerning the share ownership of our directors and executive officers as of May 31, 2002:
--------------------------------------------------------------------------------------------------------------------------- Number of Common Number Shares Which Percentage of May be Range of of Common Common Acquired Range of Expiration Shares Shares Under Option Exercise Prices Dates of Beneficially Name Owned(1) Plans(2) of Options Options Owned(3) --------------------------------------------------------------------------------------------------------------------------- Richard T. Daly 40,822 445,001 $9.10-$32.63 2009-2010 1.4%(4) --------------------------------------------------------------------------------------------------------------------------- Thomas J. Clarke - 37,000 $14.98-$15.00 2009-2011 * --------------------------------------------------------------------------------------------------------------------------- Timothy W. Ellis - 110,000 $14.98-$16.00 2009-2011 * --------------------------------------------------------------------------------------------------------------------------- Dr. Arthur W.G. Cole - 140,000 $3.50-$48.88 2006-2011 * --------------------------------------------------------------------------------------------------------------------------- Marguerite Ethier - 24,375 $14.98-$15.00 2010-2011 * --------------------------------------------------------------------------------------------------------------------------- Dr. Brendan Larder - 95,000 $19.25 2011 * --------------------------------------------------------------------------------------------------------------------------- David A. Galloway - 30,000 $17.80 2011 * --------------------------------------------------------------------------------------------------------------------------- Sheldon Inwentash(5) - 30,000 $8.00-$11.50 2006-2008 * --------------------------------------------------------------------------------------------------------------------------- J. Spencer Lanthier - 30,000 $32.75-$43.13 2010 * --------------------------------------------------------------------------------------------------------------------------- Jacques R. Lapointe - 30,000 $32.75-$43.13 2010 * --------------------------------------------------------------------------------------------------------------------------- Jonathan Leff(6) 244 - - - * --------------------------------------------------------------------------------------------------------------------------- Dr. Heather Munroe-Blum - 30,000 $22.07 2011 * --------------------------------------------------------------------------------------------------------------------------- Dr. Lloyd M. Smith - 15,000 $32.38 2011 * --------------------------------------------------------------------------------------------------------------------------- Dr. Konrad Weis - 15,000 $8.00 2008 * ---------------------------------------------------------------------------------------------------------------------------
---------- * Represents less than 1%. (1) Represents shares owned beneficially by the named individual other than those shares which may be acquired under our company's option plans. Unless otherwise noted, all persons referred to above have sole voting and sole investment power. (2) Includes all shares which the named individual has the right to acquire under all vested and unvested options and warrants granted to such individual under our company's option plans. 51 (3) This information is based on 22,178,342 voting shares outstanding as of May 31, 2002, which includes 2,975,051 common shares issuable upon conversion of our Series A preferred shares as of May 31, 2002, including accrued dividends through April 15, 2002. Common shares subject to options exercisable within 60 days are deemed outstanding for computing the percentage ownership of the person holding the options but are not deemed outstanding for computing the percentage ownership of any other person. (4) Includes 282,492 common shares subject to options exercisable within 60 days of May 31, 2002. (5) Mr. Inwentash is a director of our company. This table does not include 831,684 common shares that are owned of record by GeneVest Inc. ("GeneVest") and 15,000 common shares that are owned by Pinetree Corp. ("Pinetree"). Mr. Inwentash is the President and Chief Executive Officer of GeneVest and together with his affiliates, beneficially owns 45% of its issued and outstanding common shares. Mr. Inwentash is the President and Chief Executive Officer of Pinetree and beneficially owns approximately 43.5% of its issued and outstanding common shares. In addition, this table does not include 23,054 common shares that are owned by Mr. Iwentash's wife. (6) Mr. Leff is a director of our company. The number of common shares which he owns excludes 25,473 common shares and 2,626,367 common shares issuable upon conversion of Series A preferred shares, as of May 31, 2002, owned by certain affiliated funds managed by E.M. Warburg, Pincus & Co., LLC. Mr. Leff, who is a Managing Director at E.M. Warburg, Pincus & Co., disclaims beneficial ownership of those shares. ITEM 7. MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS. MAJOR SHAREHOLDERS The following table sets forth certain information regarding the beneficial ownership of our outstanding common shares, as of May 31, 2002, for all shareholders known to beneficially own or exercise control or direction over more than 5% of our common shares:
NUMBER OF COMMON SHARES BENEFICIALLY OWNED OR OVER WHICH CONTROL OR PERCENTAGE OF NAME TITLE OF CLASS DIRECTION IS EXERCISED CLASS(1) ---- -------------- ----------------------- ------------- Franklin Resources, Inc.(2) Common Shares 3,022,256 13.6% E.M. Warburg, Pincus & Co., LLC(3) Common Shares 2,651,840 12.0% RS Investment Management Co. LLC(4) Common Shares 2,477,983 11.2% Deutsche Bank AG(5) Common Shares 1,716,524 7.7%
(1) The information in this table is based on our records, information provided to us by directors and executive officers and a review of any Schedules 13D and 13G filed in 2001 and 2002 (prior to June 1, 2002) by our shareholders with the Securities and Exchange Commission. Beneficial ownership is determined in accordance with rules of the Securities and Exchange Commission and includes shares over which the indicated beneficial owner exercises voting and/or investment power. Common shares subject to options and/or warrants currently exercisable or exercisable within 60 days are deemed outstanding for computing the percentage ownership of the person holding the options and/or warrants but are not deemed outstanding for computing the percentage ownership of any other person. This information is based on 22,178,342 voting shares outstanding as of May 31, 2002, which includes 2,975,051 common shares issuable upon conversion of our Series A preferred shares as of May 31, 2002, which includes accrued 52 dividends through April 15, 2002. The number of common shares issuable upon conversion of the Series A preferred shares will increase as the dividends payable thereon accrue. (2) Franklin Adviser, Inc., as investment advisor to Franklin Resources, Inc., has sole investment and dispositive power over these securities. Charles B. Johnson and Robert H. Johnson, Jr. each own in excess of 10% of the outstanding common stock of Franklin Resources, Inc. and may be deemed (for purposes of Rule 13d-3 under the Securities Exchange Act of 1934, as amended) to be the beneficial owners of these securities. (3) Consists of (i) 1,241,043 common shares held by Warburg, Pincus Equity Partners, L.P., which includes 1,240,975 common shares issuable upon conversion of Series A preferred shares which it owns; (ii) 1,313,274 common shares held by Warburg, Pincus Ventures International, L.P., which includes 1,313,242 common shares issuable upon conversion of Series A preferred shares which it owns; (iii) 39,396 common shares held by Warburg, Pincus Netherlands Equity Partners, I, C.V., which includes 39,387 common shares issuable upon conversion of Series A preferred shares which it owns; (iv) 26,264 common shares held by Warburg, Pincus Netherlands Equity Partners, II, C.V., which includes 26,258 common shares issuable upon conversion of Series A preferred shares which it owns; (v) 6,555 common shares held by Warburg, Pincus Netherlands Equity Partners III, C.V. (together with Warburg, Pincus Equity Partners, L.P., Warburg, Pincus Ventures International, L.P., Warburg, Pincus Netherlands Equity Partners, I, C.V., and Warburg, Pincus Netherlands Equity Partners, II, C.V., the "WP Funds"), which includes 6,505 common shares issuable upon conversion of Series A preferred shares which it owns; and (vi) 25,308 common shares held by Warburg, Pincus & Co. ("WP"), which is the sole general partner of each of the WP Funds. Each of these funds is managed by E.M. Warburg, Pincus & Co., LLC ("EMW LLC"). Lionel I. Pincus is the managing partner of WP and the managing member of EMW LLC, and may be deemed to control both entities. Jonathan S. Leff, a director of the Company, is a general partner of WP and a managing director and member of EMW LLC. Mr. Leff may be deemed to have an indirect pecuniary interest (within the meaning of Rule 16a-1 under the Securities Exchange Act of 1934, as amended) in an indeterminate portion of the shares beneficially owned by these shareholders. Mr. Leff disclaims beneficial ownership of all such shares. (4) Includes 1,802,425 common shares beneficially owned by RS Investment Management, Inc. and RS Emerging Growth Fund. G. Randall Hecht, in his capacity as Chief Executive Officer of RS Investment Management Co. LLC, RS Investment Management, Inc. and RS Emerging Growth Fund, has voting and dispositive power of the securities held by these entities. (5) Includes 348,684 common shares issuable upon conversion of Series A preferred shares which it owns and, as of December 31, 2001, 765,000 common shares owned of record by DWS Investment GmbH. As of May 31, 2002, there were 25,153 Series A preferred shares issued and outstanding. Of those shares, 22,205 (88.3%) are owned by certain affiliated funds managed by E.M. Warburg, Pincus & Co., LLC, and 2,948 (11.7%) are owned by Deutsche Bank AG. For more information regarding our Series A preferred shares, see "Item 5. Operating and Financial Review and Prospects -Liquidity and Capital Resources." The holders of Series A preferred shares are entitled to vote as a group with the holders of common shares on all matters, except that holders of Series A preferred shares are entitled to vote separately for one director and are not entitled to participate in the vote for any other directors of our company. On all other matters, each holder of Series A preferred shares is entitled to the number of votes 53 corresponding to the number of common shares the holder is entitled to receive upon conversion of his Series A preferred shares. On May 31, 2002, 19,125,852 of our common shares were held by 47 U.S. record holders and 22,205 of our Series A preferred shares were held by 5 U.S. record holders. RELATED PARTY TRANSACTIONS Dr. John K. Stevens served as the President and Chief Executive Officer of our company until his retirement in July 1999. In accordance with the terms of his employment agreement, Dr. Stevens received a severance package of two years salary plus benefits. The termination date of Dr. Stevens' options was extended until 2003. In November 1999, Dr. Stevens retired as Chairman of the Board of Directors. Under the terms of our agreement with Dr. Stevens, we paid him $210,400 and $101,608 in 2000 and 2001, respectively. In November 1999, Dr. Chalom Sayada's employment as Vice-President for European Business Development was terminated. In connection with his termination of employment, we paid him $262,500. In addition, we retained him as a consultant to provide marketing and strategy services for 18 months. In consideration of such services, Dr. Sayada earned $151,248 in 2000 and $72,007 for 5 months of service in 2001. During 2001, we paid an aggregate of $13,283 in consulting fees to Dr. Lloyd M. Smith, one of our directors. . For a description of transactions between the company and the Warburg Pincus Funds, see "Item 5. Operating and Financial Review and Prospects -Liquidity and Capital Resources." ITEM 8. FINANCIAL INFORMATION. CONSOLIDATED STATEMENTS AND OTHER FINANCIAL INFORMATION See Item 19(a) for audited consolidated financial statements. LEGAL PROCEEDINGS The Board of Trustees of the Leland Stanford Junior University has filed a lawsuit in the United States District Court for the Northern District of California claiming that our TRUGENE HIV-1 Genotyping Kit infringes patents owned by the University. We have received an attorney opinion that we do not infringe any claim of the patents-in-suit. We believe that these claims are without merit and intend to vigorously contest the allegations made in the lawsuit. Since the amount of damages are unspecified, we cannot at this time determine, if we are unsuccessful, whether this legal action will have a material adverse effect on our business, financial condition or results of operations. On February 27, 2002, we received notice of a lawsuit that has been filed in Milan, Italy against us and two of our subsidiaries by Nuclear Laser Medicine Srl. The lawsuit seeks unspecified damages and specific performance relating to an alleged distribution agreement pertaining to our hepatitis C and HIV products in Italy. We believe that these claims are without merit and intend to vigorously contest the allegations made in the lawsuit. Since the amount of damages are unspecified, we cannot at this time determine whether, if we are unsuccessful, this legal action will have a material adverse effect on our business, financial condition or results of operations. 54 DIVIDEND POLICY COMMON SHARES. We have not declared or paid any cash dividends on our common shares. We currently intend to retain any future earnings for use in the operation and expansion of our business. We do not anticipate paying any cash dividends on our common shares in the foreseeable future. SERIES A PREFERRED SHARES. Dividends on our Series A preferred shares accrue at the rate of 9% from issuance through July 15, 2002, and, beginning on July 15, 2002, at the rate of 4% per year. Dividends may not be paid until July 15, 2002. Beginning on July 15, 2002, at our option, we may pay dividends in cash. If dividends are not paid in cash, they will continue to accrue. ITEM 9. THE OFFER AND LISTING. NATURE OF TRADING MARKET Our common shares are traded on the Nasdaq National Market under the symbol "VGIN". Our common shares are not listed or quoted for trading on securities markets outside of the United States. The following table sets forth, for the periods indicated, high and low sale prices of our common shares as reported on the Nasdaq National Market. Our Series A preferred shares are not listed or quoted for trading on any securities market.
HIGH LOW ---- --- ANNUAL MARKET PRICES Fiscal Year ended December 31, 1997.................................................... $ 14.25 $ 2.38 Fiscal Year ended December 31, 1998.................................................... $ 14.00 $ 6.00 Fiscal Year ended December 31, 1999.................................................... $ 34.63 $ 8.88 Fiscal Year ended December 31, 2000.................................................... $119.13 $19.38 Fiscal Year ended December 31, 2001.................................................... $ 37.45 $ 8.76 QUARTERLY MARKET PRICES FISCAL YEAR ENDED DECEMBER 31, 2000 First Quarter.......................................................................... $119.13 $29.00 Second Quarter......................................................................... $ 50.44 $19.38 Third Quarter.......................................................................... $ 49.38 $28.00 Fourth Quarter......................................................................... $ 44.25 $21.75 FISCAL YEAR ENDED DECEMBER 31, 2001 First Quarter.......................................................................... $ 37.45 $14.13 Second Quarter......................................................................... $ 24.97 $12.16 Third Quarter.......................................................................... $ 27.10 $16.16 Fourth Quarter......................................................................... $ 20.25 $ 8.76 FISCAL YEAR ENDED DECEMBER 31, 2002 First Quarter ......................................................................... $ 11.59 $ 6.37 Second Quarter (through June 12, 2002)................................................. $ 7.50 $ 2.30 MONTHLY MARKET PRICES December 2001.......................................................................... $ 12.62 $ 8.76 January 2002........................................................................... $ 11.59 $ 8.15 February 2002.......................................................................... $ 10.00 $ 7.09 March 2002............................................................................. $ 8.45 $ 6.37 April 2002............................................................................. $ 7.50 $ 5.82
55 May 2002............................................................................... $ 7.20 $ 2.30 June 2002 (through June 12, 2002)...................................................... $ 3.20 $ 2.62
ITEM 10. ADDITIONAL INFORMATION. BY-LAWS AND ARTICLES OF INCORPORATION The company's Restated Articles of Incorporation, which we refer to as our articles of incorporation, are on file with the Ministry of Consumer and Commercial Relations under Ontario Corporation Number 1079808. Our articles of incorporation do not include a stated purpose. DIRECTORS A director of our company need not be a shareholder. In accordance with our by-laws and the Ontario Business Corporations Act, a majority of our directors must be residents of Canada. The Ontario Business Corporations Act requires that a person must be at least 18 years of age, be of sound mind and not be bankrupt in order to serve as a director. Neither our articles of incorporation or by-laws, nor the Ontario Business Corporations Act, impose any mandatory retirement requirements for directors. A director who is a party to, or who is a director or officer of or has a material interest in any person who is a party to, a material contract or transaction or proposed material contract or transaction with our company shall disclose to the company the nature and extent of his interest at the time and in the manner provided by the Ontario Business Corporations Act. The Ontario Business Corporations Act prohibits such a director from voting on any resolution to approve the contract or transaction unless the contract or transaction: - is an arrangement by way of security for money lent to or obligations undertaken by the director for the benefit of the company or an affiliate; - relates primarily to his or her remuneration as a director, officer, employee or agent of the company or an affiliate; - is for indemnity or insurance; or - is with an affiliate. Our board of directors may, on behalf of the company and without authorization of our shareholders: - borrow money upon the credit of the company; - issue, reissue, sell or pledge bonds, debentures, notes or other evidences or indebtedness or guarantees of our company, either secured or unsecured; - subject to certain disclosure requirements of the Ontario Business Corporations Act, give, directly or indirectly, financial assistance to any person by means of a loan, a guarantee or otherwise on behalf of our company to secure performance or any present or future indebtedness, liability or obligation of any person; and - mortgage, hypothecate, pledge or otherwise create a security interest in all or any currently owned or subsequently acquired real or personal property of our company, including book debts, rights, powers, franchises and undertakings, to secure any bonds, debentures, notes or other evidences of indebtedness or guarantee or any other obligation of the company. COMMON SHARES 56 Our articles of incorporation authorize the issuance of an unlimited number of common shares. The holders of the common shares of our company are entitled to receive notice of and to attend all meetings of the shareholders of our company and have one vote for each common share held at all meetings of the shareholders of our company, except for meetings at which only holders of another specified class or series of shares of the company are entitled to vote separately as a class or series. Subject to the prior rights of the holders of preferred shares of our company and to any other shares ranking senior to the common shares with respect to priority in the payment of dividends, the holders of common shares are entitled to receive dividends and our company will pay dividends, as and when declared by our Board of Directors, out of moneys properly applicable to the payment of dividends, in such amount and in such form as our Board of Directors may from time to time determine, and all dividends which our Board of Directors may declare on the common shares shall be declared and paid in equal amounts per share on all common shares at the time outstanding. In the event of the dissolution, liquidation or winding-up of the company, whether voluntary or involuntary, or any other distribution of assets of the company among its shareholders for the purpose of winding up its affairs, subject to the prior rights of the holders of preferred shares and to any other shares ranking senior to the common shares with respect to priority in the distribution of assets upon dissolution, liquidation or winding-up, the holders of the common shares will be entitled to receive the remaining property and assets of the company. PREFERRED SHARES Our articles of incorporation authorize the issuance of an unlimited number of preferred shares, in one or more series. The Ontario Business Corporations Act does not impose restrictions upon our Board of Directors issuing preferred shares of the type authorized by our articles of incorporation. Our Board of Directors may fix, before issuing, the number of preferred shares of each series, the designation, rights, privileges, restrictions and conditions attaching to the preferred shares of each series, including, any voting rights, any right to receive dividends (which may be cumulative or non-cumulative and variable or fixed) or the means of determining the dividends, the dates of payment, any terms and conditions of redemption or purchase, any conversion rights, and any rights on the liquidation, dissolution or winding-up of the company, any sinking fund or other provisions, the whole to be subject to the issue of a Certificate of Amendment setting forth the designation, rights, privileges, restrictions and conditions attaching to the preferred shares of the series. Our articles of incorporation require that preferred shares of each series must, with respect to the payment of dividends and the distribution of assets in the event of the liquidation, dissolution or winding-up of the company, whether voluntary or involuntary, rank on a parity with the preferred shares of every other series. However, we are prohibited from issuing any equity securities that have rights as to dividends and upon liquidation that are senior or equal in rank to the Series A preferred shares without the approval of the holders of a majority of the Series A preferred shares. Therefore, if we wish to issue a series of preferred shares with rights equal or superior to those of our Series A preferred shares we must obtain the approval of the holders of our Series A preferred shares. If we wish to issue a series of preferred shares with rights superior or inferior to those of our Series A preferred shares, we must obtain the approval of our Series A preferred shareholders and our common shareholders to amend our articles of incorporation. If any amount of cumulative dividends (whether or not declared) or declared non-cumulative dividends or any amount payable on any such distribution of assets constituting a return of capital in respect of the preferred shares of such series shall participate ratably with the preferred shares of every other series in respect of all such dividends and amounts. SERIES A PREFERRED SHARES 57 On July 15, 1999, our Board of Directors authorized the issuance of 33,950 shares of Series A Convertible Preferred Shares. We have issued 33,948 Series A preferred shares, of which, as of May 31, 2002, 8,795 have been converted and 25,153 remain outstanding. The Series A preferred shares are convertible at the holders' option into common shares at $10.72 per share, as adjusted. Upon conversion, the holders will also receive common shares, at the conversion price of $10.72 per share, as adjusted, equal to the amount of all accrued and unpaid dividends. The Series A preferred shares contain provisions under which the conversion price would be reduced on a weighted average basis if we issue shares, options or certain other securities at prices lower than the conversion price (subject to certain exceptions), and will also be adjusted upon the issuance of certain other securities, certain recapitalization events and in certain other circumstances to protect the holders against the dilutive effect of those events. Dividends on the Series A preferred shares accrue quarterly at the rate of 9% per year until July 15, 2002, and 4% per year thereafter, and are compounded annually. Dividends are not payable until July 15, 2002. Beginning on July 15, 2002, at our option, we may pay dividends in cash. If dividends are not paid in cash, they will continue to accrue. After the third anniversary (July 15, 2002) and prior to the seventh anniversary (July 15, 2006) of the date of issuance of the Series A preferred shares, we have the right to redeem the outstanding Series A preferred shares at a price, which we call the redemption price, equal to $1,000 per share, plus accrued but unpaid dividends, provided that the price of our common shares on the Nasdaq National Market equals or exceeds 150% of the conversion price for 20 trading days during a consecutive 30-day period ending within 10 days before we notify shareholders of the redemption. We will be required to redeem one-third of any remaining outstanding Series A preferred shares on each of the seventh, eighth and ninth anniversaries of the date of issuance at the redemption price, and we will be permitted to redeem the Series A preferred shares at any time beginning on the seventh anniversary after issuance. If we fail to redeem the Series A preferred shares as required, the holders may appoint a majority of our Board of Directors, who will continue to serve until we have redeemed the Series A preferred shares as required. The holders of Series A preferred shares are entitled to vote as a group with the holders of common shares on all matters except that holders of Series A preferred shares are entitled to vote separately for one director and are not entitled to participate in the vote for any other directors of our company. On all other matters, each holder of a Series A preferred share is entitled to the number of votes equal to the number of common shares the holder is entitled to receive upon conversion of his Series A preferred shares. Our agreements with the holders of, and the terms of, the Series A preferred shares provide that we are prohibited from declaring or issuing any dividends to holders of our common shares before paying all unpaid dividends on the Series A preferred shares. We also are prohibited from issuing any equity securities that have rights as to dividends and liquidation that are senior or equal in rank to the Series A preferred shares without approval of the holders of a majority of the Series A preferred shares. If our company were to be liquidated or sold or under certain other circumstances, holders of Series A preferred shares would be entitled to receive an amount equal to $1,000 per share, plus accrued dividends, before holders of our common shares would be entitled to any distributions. Certain holders of our Series A preferred shares are also entitled to certain other rights, including the right to participate, on a pro rata basis, in future company financings, subject to certain exceptions. If we propose to sell equity securities of any kind, including debt securities convertible into equity securities, certain holders of our Series A preferred shares are entitled to purchase a proportional amount of the securities being offered based on the number of common shares they own assuming conversion of all convertible securities. These holders are not entitled to exercise this right in connection with securities issued: (i) to the public in a firm commitment underwriting; (ii) upon exercise of any of our options or warrants outstanding on July 15, 1999; (iii) pursuant to the acquisition of another entity by us or one of our subsidiaries by merger, purchase of substantially all of the assets or other form of reorganization; 58 (iv) in connection with our acquisition or license of technology rights or other assets; (v) pursuant to our stock option plans, stock bonus plans, stock purchase plans or other compensation equity agreements or programs; or (vi) upon conversion or exercise of any equity securities, such as warrants, options, or other rights to acquire equity securities and debt securities convertible into equity securities. The right of these holders to participate in future offerings in this manner provides those holders with the opportunity to avoid having their ownership interest in our company diluted under certain circumstances when the interest of our common shareholders would be diluted. We are required to obtain the consent of the holders of a majority of our then outstanding Series A preferred shares if we wish to borrow money and at such time or as a result of such loans, the total principal amount of our indebtedness and capitalized lease obligations exceeds $15.0 million. In addition, if we were to enter into a credit facility with a financial institution, we may be subject to additional limitations on our ability to incur additional indebtedness. ACTION NECESSARY TO CHANGE RIGHTS OF SHAREHOLDERS In order to change the rights of our shareholders, we would need to amend our articles of incorporation to effect the change. Such an amendment would require the approval of holders of two-thirds of the shares cast at a duly called special meeting. If we wish to amend the rights of holders of a specific class of shares, such approval would also be required from the holders of that class. A shareholder is entitled to dissent in respect of such a resolution and, if the resolution is adopted and the company implements such changes, demand payment of the fair value of its shares. MEETINGS OF SHAREHOLDERS An annual meeting of shareholders is held each year for the purpose of considering the financial statements and reports, electing directors, appointing auditors and for the transaction of other business as may be brought before the meeting. The President or the Board of Directors has the power to call a special meeting of shareholders at any time. Notice of the time and place of each meeting of shareholders must be given not less than 21 days, nor more than 50 days, before the date of each meeting to each director, to the auditor and to each shareholder who at the close of business on the record date for notice is entered in the securities register as the holder of one or more shares carrying the right to vote at the meeting. Notice of meeting of shareholders called for any other purpose other than consideration of the minutes of an earlier meeting, financial statements and auditor's report, election of directors and reappointment of the incumbent auditor, must state the nature of the business in sufficient detail to permit the shareholder to form a reasoned judgment on and must state the text of any special resolution or by-law to be submitted to the meeting. The only persons entitled to be present at a meeting of shareholders are those entitled to vote, the directors of the company and the auditor of the company. Any other person may be admitted only on the invitation of the chairman of the meeting or with the consent of the meeting. If a corporation is winding-up, the Ontario Business Corporations Act permits a liquidator appointed by the shareholders, during the continuance of a voluntary winding-up, to call and attend meetings of the shareholders. In circumstances where a court orders a meeting of shareholders, the court may direct how the meeting may be held, including the parties entitled, or required, to attend the meeting. LIMITATIONS ON RIGHT TO OWN SECURITIES There is no limitation imposed by Canadian law or by our articles or other charter documents on the right of a nonresident to hold or vote common shares or preference shares with voting rights 59 (collectively, "Voting Shares"), other than as provided in the Investment Canada Act (the "Investment Act"), as amended by the World Trade Organization Agreement Implementation Act. The Investment Act generally prohibits implementation of a direct reviewable investment by an individual, government or agency thereof, corporation, partnership, trust or joint venture that is not a "Canadian," as defined in the Investment Act (a "non-Canadian"), unless, after review, the minister responsible for the Investment Act is satisfied that the investment is likely to be of net benefit to Canada. An investment in Voting Shares by a non-Canadian (other than a "WTO Investor," as defined below) would be reviewable under the Investment Act if it were an investment to acquire direct control of our company, and the book value of the assets of our company was Cdn$5.0 million or more (provided that immediately prior to the implementation of the investment our company was not controlled by WTO Investors). An investment in Voting Shares by a WTO Investor (or by a non-Canadian other than a WTO Investor if, immediately prior to the implementation of the investment our company was controlled by WTO Investors) would be reviewable under the Investment Act if it were an investment to acquire direct control of our company and the book value of the assets of our company equaled or exceeded Cdn$218.0 million (in 2002). A non-Canadian, whether a WTO Investor or otherwise, would be deemed to acquire control of our company for purposes of the Investment Act if he or she acquired a majority of the Voting Shares. The acquisition of less than a majority, but at least one-third of our Voting Shares, would be presumed to be an acquisition of control of our company, unless it could be established that we were not controlled in fact by the acquirer through the ownership of Voting Shares. In general, an individual is a WTO Investor if he or she is a "national" of a country (other than Canada) that is a member of the World Trade Organization ("WTO Member") or has a right of permanent residence in a WTO Member. A corporation or other entity will be a "WTO Investor" if it is a "WTO investor-controlled entity," pursuant to detailed rules set out in the Investment Act. The United States is a WTO Member. Certain transactions involving Voting Shares would be exempt from the Investment Act, including: (a) an acquisition of Voting Shares if the acquisition were made in the ordinary course of that person's business as a trader or dealer in securities; (b) an acquisition of control of our company in connection with the realization of a security interest granted for a loan or other financial assistance and not for any purpose related to the provisions of the Investment Act; and (c) an acquisition of control of our company by reason of an amalgamation, merger, consolidation or corporate reorganization, following which the ultimate direct or indirect control in fact of our company, through the ownership of voting interests, remains unchanged. CHANGE OF CONTROL Our authorized capital consists of an unlimited number of preferred shares. The Board of Directors, without any further vote by the common shareholders, has the authority to issue preferred shares and to determine the price, preferences, rights and restrictions, including voting and dividend rights, of these shares. The rights of the holders of common shares are subject to the rights of holders of any preferred shares that the Board of Directors may issue in the future. That means, for example, that we can issue preferred shares with more voting rights, higher dividend payments or more favorable rights upon dissolution, than the common shares. If we issued certain types of preferred shares in the future, it may also be more difficult for a third-party to acquire a majority of our outstanding voting shares. In addition, we have a "classified" Board of Directors, which means that only approximately one-third of our directors are eligible for election each year. Therefore, if shareholders wish to change the composition of the Board of Directors, it would take at least two years to remove a majority of the existing directors, and three years to change all directors. Also, the holders of our Series A preferred shares are entitled to vote as a class for one director. The Series A Director serves for a one year term and any vacancy may be filled only by a vote of the 60 holders of Series A preferred shares. If we do not redeem our Series A preferred shares as required during 2006, 2007, and 2008, then our Series A shareholders will be entitled to special voting rights enabling them to elect a majority of our Board of Directors, who will continue to serve as directors until we have redeemed our Series A preferred shares as required. MATERIAL CONTRACTS The following is a summary of our company's material contracts, entered into since January 1, 2000. 1. Lease, dated March 27, 2000, by and between Visible Genetics Inc., as Tenant and LuCliff Company Limited, as Landlord. Pursuant to the terms and conditions of this agreement, we will lease approximately 20,628 square feet of property located at 700 Bay Street, Toronto, Canada, for a term from June 2000 to May 2005. 2. Underwriting Agreement, dated March 30, 2000, by and among, FleetBoston Robertson Stephens Inc., PaineWebber Incorporated, Warburg Dillon Read LLC, Roth Capital Partners, Inc., as representatives of the several underwriters, and Visible Genetics Inc. Pursuant to the terms and conditions of this agreement, we completed an underwritten follow-on public offering of 2,090,000 common shares at $38 per share. All of the shares were sold by us. After underwriting discounts, but before related fees and expenses, we received proceeds of $75.4 million. 3. Licensing and Collaboration Agreement, dated April 25, 2000, by and between Visible Genetics Inc. and Applera Corporation, Applied Biosytems Group (formerly PE Biosystems). Pursuant to the terms and conditions of this agreement, we gained access to certain patents and intellectual property owned or exclusively licensed by Applera. We will pay Applera a total licensing fee of $25.0 million over a period of four years, and will also make royalty payments to Applera based on sales in return for access to the Applera technology and installed instrument customer base. We may terminate the agreement upon 60 days written notice to Applera and either party may terminate the agreement under certain other limited circumstances. 4. Lease, dated October 1, 2000, by and between Visible Genetics Inc., as Tenant and LuCliff Company Limited, as Landlord. Pursuant to the terms and conditions of this agreement, we will lease approximately 6,876 square feet of property located at 700 Bay Street, Toronto, Canada, for a term from November 2000 to May 2005. 5. Lease, dated November 30, 2000, by and between Visible Genetics Inc., as Tenant and LuCliff Company Limited, as Landlord. Pursuant to the terms and conditions of this agreement, we leased approximately 6,876 square feet of property located at 700 Bay Street, Toronto, Canada, for a term from June 2001 to November 2001. This lease was not renewed. 6. Deed, dated September 12, 2001, by and among Visible Genetics Inc., Visible Genetics UK Ltd., Virco U.K. Limited and Tibotec-Virco N.V. Pursuant to the terms and conditions of this agreement, we, through our wholly-owned subsidiary Visible Genetics UK Ltd, acquired certain assets from Virco U.K. Limited relating to Virco's research laboratory located in Cambridge, England, together with substantially all of Virco's research staff of 25 scientists at the laboratory, for $829,000. In addition, we assumed the lease for the premises at an annual cost of $419,000 (see No. 7 below). 7. Licence to Assign, dated October 10, 2001, by and among Visible Genetics Inc., Visible Genetics UK Ltd., Virco UK Limited and The Master Fellows and Scholars of Trinity College Cambridge. Pursuant to the terms and conditions of this agreement, Visible Genetics UK Ltd., as Assignee, assumed the lease between The Master Fellows and Scholars of Trinity College Cambridge, as 61 Landlord, and Virco U.K. Limited, as Tenant, for approximately 20,000 square feet of property located at Unit 184, Phase 3, Cambridge Science Park, Milton Road, Cambridge, England, for a term from January 1999 to March 2014. We are currently sub-leasing approximately 10,000 square feet of this facility. 8. Common Shares Purchase Agreement, dated December 24, 2001, by and among Visible Genetics Inc. and the Investors who are signatories thereto. Pursuant to the terms and conditions of this agreement, various institutional investors purchased 2,637,890 common shares of our company in a private placement. The investors paid $8.34 per share and we received proceeds, before related fees and expenses of $22.0 million from the private placement. In addition, the investors were granted registration rights for these shares. 9. Registration Rights Agreement, dated December 24, 2001, by and among Visible Genetics Inc. and the Investors who are signatories thereto. Pursuant to the terms and conditions of this agreement, various institutional investors received registration rights for the 2,637,890 common shares purchased by them in a private placement. 10. Employment Agreements with Executive Officers. On December 15, 2001, we entered into an employment agreement with Brendan Larder, our Chief Scientific Officer. On February 1, 2002, we entered into employment agreements with Thomas J. Clarke, our Chief Financial Officer, Timothy W. Ellis, our Chief Operating Officer, and Marguerite Ethier, our General Counsel. Also, on February 1, 2002, we amended and restated our employment agreements with Richard T. Daly, our President and Chief Executive Officer and Dr. Arthur W.G. Cole, President of our subsidiary Visible Genetics UK Ltd. For a description of these employment agreements with our executive officers, see "Item 6. Directors, Senior Management and Employees - Employment Agreements." EXCHANGE CONTROLS There is no law, government decree or regulation in Canada restricting the export or import of capital or affecting the remittance of dividends, interest or other payments to a nonresident holder of common shares, other than withholding tax requirements. TAXATION CANADIAN FEDERAL INCOME TAX CONSIDERATIONS The following summary describes certain material Canadian federal income tax consequences generally applicable to a holder of common shares and a holder of Series A preferred shares each of whom at all relevant times, for purposes of the Income Tax Act (Canada) (the "ITA"), (i) acquires and holds such shares as capital property (including common shares acquired on a conversion of Series A preferred shares) and (ii) deals at arm's length with our company and, in case of a holder of Series A preferred shares, is a resident of the United States and not a resident of Canada for purposes of the Canada-United States Income Tax Convention, 1980 (a "Holder" and a "Series A Holder", with reference to a holder of common shares and a holder of Series A preferred shares, respectively). Generally, common shares and Series A preferred shares will be considered to be capital property to a Holder or a Series A Holder provided that such Holder or Series A Holder does not use or hold such shares in the course of carrying on a business, has not acquired such shares in a transaction or transactions considered to be an adventure in the nature of trade, and is not a financial institution subject to the rules whereby gains and losses on certain securities are recorded on a mark-to-market basis. Some Holders may be entitled to have their common shares treated as capital property by making the irrevocable election in subsection 39(4) of the ITA. 62 This summary is based upon the current provisions of the Canada-United States Income Tax Convention, 1980 (the "U.S. Treaty"), the ITA and the regulations thereunder and on an understanding of the published administrative practices of the Canada Customs and Revenue Agency (the "CCRA"). This summary does not take into account or anticipate any possible changes in law, or in the administration thereof, whether by legislative, governmental or judicial action, except proposals for specific amendment thereto which have been publicly announced by the Minister of Finance (Canada) prior to the date hereof. This summary does not address all aspects of Canadian federal income tax law that may be relevant to Holders or Series A Holders based upon their particular circumstances, and does not deal with provincial, territorial or foreign income tax legislation or considerations, which might differ significantly from the Canadian federal income tax considerations summarized herein. This summary is of a general nature only and is not intended to be, nor should it be construed as, advice to any particular Holder or Series A Holder. Holders and Series A Holders are advised to consult their tax advisors regarding the application of the Canadian federal income tax law to their particular circumstances, as well as any provincial, territorial and other tax consequences of the acquisition, ownership and disposition of their common shares or Series A preferred shares, as the case may be. All amounts relevant in computing the liability of a Holder or Series A Holder under the ITA are to be computed in Canadian currency at the rate of exchange prevailing at the relevant time. COMMON SHARES NONRESIDENTS OF CANADA TAXATION OF DIVIDENDS. A Holder who, at all relevant times, is not resident in Canada for purposes of the ITA (a "NonResident Holder") will be subject to Canadian non-resident withholding tax on dividends paid or credited, or deemed under the ITA to be paid or credited, to the NonResident Holder on the common shares. The rate of withholding tax under the ITA on dividends is 25% of the gross amount of the dividend. Such rate may be reduced under the provisions of an applicable international tax treaty. Pursuant to the U.S. Treaty, the rate of Canadian withholding tax applicable in respect of dividends paid or credited by our company to a NonResident Holder resident in the United States is generally reduced to 15%, or 5% in the case of a corporate NonResident Holder that owns beneficially 10% or more of the voting stock of our company. Moreover, pursuant to Article XXI of the U.S. Treaty, an exemption from Canadian withholding tax generally is available in respect of dividends received by certain trusts, companies and other organizations whose income is exempt from tax under the laws of the United States. DISPOSITION OF COMMON SHARES. A NonResident Holder will not be subject to tax under the ITA in respect of a capital gain realized on the disposition of a common share unless the common share constitutes or is deemed to constitute "taxable Canadian property" (as defined in the ITA) and the capital gain is not exempt from tax under the ITA pursuant to an applicable international tax treaty. Shares of a Canadian corporation that are listed on a prescribed stock exchange (which includes the National Association of Securities Dealers Automated Quotation System) will generally not be considered to be taxable Canadian property to a NonResident Holder, unless, at any time during the five year period immediately preceding the disposition or deemed disposition of the common share, the NonResident Holder, persons with whom the NonResident Holder did not deal at arm's length or any combination thereof owned or had an option to acquire not less than 25% of the issued shares of any class or series of shares of our company. For the purposes of determining whether a property is a taxable Canadian property, a person holding an option to acquire shares or other securities convertible into or exchangeable for shares, or otherwise having an interest in shares, will be considered to own the shares that could be acquired upon 63 the exercise of the option, the conversion or exchange rights or in which there is such interest. The aforementioned rules can apply to any class of shares. A common share acquired by a NonResident holder on the conversion of a Series A preferred share will be considered to be taxable Canadian property. A NonResident Holder whose common shares constitute or are deemed to constitute taxable Canadian property and who would not be eligible for an exemption from tax under the ITA in respect of any gains realized on the disposition of such shares pursuant to an applicable international tax treaty is referred to the discussion below under "Canadian Residents - DISPOSITION OF COMMON SHARES" for information regarding the treatment of the disposition under the ITA. Even if the common shares constitute or are deemed to constitute taxable Canadian property to a NonResident Holder and their disposition would give rise to a capital gain, an exemption from tax under the ITA may be available under the terms of an applicable international tax treaty. A NonResident Holder resident in the United States for purposes of the U.S. Treaty will generally be exempt from tax under the ITA in respect of a gain on the disposition of common shares provided that the value of the common shares is not derived principally from real property situated in Canada. Paragraph 5 of Article XIII of the U.S. Treaty provides that paragraph 4 of Article XIII, which normally provides such an exemption for U.S. residents from Canadian tax on the disposition of property such as shares, generally does not apply where the U.S. resident is an individual who was a Canadian resident for 120 months during any period of twenty consecutive years preceding the time of the disposition of the property, the individual was resident in Canada at any time during the ten years immediately preceding the disposition of the property, and the individual owned the property at the time the individual ceased to be a resident of Canada. As discussed below under "Canadian Residents - DISPOSITION OF COMMON SHARES", a purchase of common shares by our company (other than a purchase of common shares by our company on the open market in a manner in which shares would normally be purchased by any member of the public in the open market) will give rise to a deemed dividend under the ITA. Any such dividend deemed to have been received by a NonResident Holder will be subject to non-resident withholding tax as described above. The amount of any such deemed dividend will reduce the proceeds of disposition of the common share to the NonResident Holder for the purpose of computing the amount of the NonResident Holder's capital gain or loss under the ITA. CANADIAN RESIDENTS TAXATION OF DIVIDENDS. Dividends received on a common share held by a Holder who at all relevant times, is a resident of Canada for purposes of the ITA (a "Resident Holder"), will be required to be included in the Resident Holder's income as computed under the ITA. Under Part I of the ITA, gross-up and dividend tax credit rules normally applicable to taxable dividends received from taxable Canadian corporations by individuals will apply to dividends received by the a Resident Holder who is an individual. Dividends received by a Resident Holder that is a corporation normally will be deductible in computing the taxable income of the Resident Holder. Certain corporations may be liable to pay a 33 1/3% refundable tax under Part IV of the ITA on such dividends. DISPOSITION OF COMMON SHARES. Upon the disposition or deemed disposition of a common share, a Resident Holder will realize a capital gain (or a capital loss) to the extent that the proceeds of disposition are greater than (or less than) the aggregate of the adjusted cost base to the Resident Holder of the common share and any reasonable costs of disposition. One-half of any capital gain, referred to as a taxable capital gain, realized by a Resident Holder will be included in the Resident Holder's income for the year of disposition and one-half of any capital 64 loss, referred to as an allowable capital loss, realized by a Resident Holder may be deducted from the Resident Holder's taxable capital gains for the year of disposition. Subject to the detailed rules in the ITA, any excess of allowable capital losses over taxable capital gains of the Resident Holder may be carried back up to three years and forward indefinitely and deducted against net taxable capital gains in those other years. Where capital losses net of capital gains realized in one taxation year are applied to capital gains net of capital losses realized in another taxation year for which there is a different inclusion rate, the amount of such net capital losses will be adjusted to match the inclusion rate applicable to such net capital gains. In certain cases, a capital loss otherwise determined from the disposition of a common share may be reduced by the amount of dividends previously received. A purchase of common shares by our company (other than a purchase of common shares by our company on the open market in a manner in which shares would normally be purchased by any member of the public in the open market) will give rise to a deemed dividend (except to the extent that such dividend may be regarded under the ITA as proceeds of disposition or a capital gain and not as a dividend for Resident Holders that are corporations) under the ITA. The amount of any such deemed dividend will reduce the proceeds of disposition of the common shares to the Resident Holder for the purpose of computing the amount of the Resident Holder's capital gain or loss under the ITA. SERIES A PREFERRED SHARES TAXATION OF DIVIDENDS. A Series A Holder will be subject to Canadian non-resident withholding tax on dividends paid or credited, or deemed to be paid or credited, to the Series A Holder on the Series A preferred shares. The rate of non-resident withholding tax under the ITA on dividends is 25% of the gross amount of the dividend. Pursuant to the U.S. Treaty, the rate of Canadian non-resident withholding tax applicable in respect of dividends paid or credited to a Series A Holder is generally reduced to 15%, or 5% in the case of a corporate Series A Holder that owns beneficially 10% or more of our voting shares. Moreover, pursuant to Article XXI of the U.S. Treaty, an exemption from Canadian non-resident withholding tax is generally available in respect of dividends received by certain trusts, companies and other organizations whose income is exempt from tax under the laws of the United States. Where our company pays or is deemed to pay a dividend on the Series A preferred shares we will generally be subject to a tax under Part VI.1 of the ITA equal to 25% of the amount of the dividend. We will generally be entitled to deduct nine-fourths of the amount of such tax in computing our taxable income for purposes of Part I of the ITA. REDEMPTION OF THE SERIES A PREFERRED SHARES. A redemption of a Series A preferred share will give rise to a deemed dividend equal to the difference between the amount we paid on the redemption of the Series A preferred share and the paid-up capital of such share as determined in accordance with the ITA. The paid-up capital of such share may be less than the Series A Holder's cost of such share. The amount of any such deemed dividend will reduce the proceeds of disposition to the Series A Holder for purposes of computing the amount of the Series A Holder's capital gain (or capital loss) under the ITA. A redemption of a Series A preferred share will be considered to be disposition under the ITA and will give rise to a capital gain (or capital loss) to the extent that the Series A Holder's proceeds of disposition (excluding any deemed dividend on redemption) exceed the total of the Series A Holder's adjusted cost base of such share and any reasonable costs of disposition. A redemption of a Series A preferred share will trigger certain filing requirements under section 116 of the ITA. For information regarding the treatment of the deemed dividend, see TAXATION OF DIVIDENDS, above. For information regarding the treatment of the capital gain or capital loss, see DISPOSITION OF SERIES A PREFERRED SHARES, below. CONVERSION OF THE SERIES A PREFERRED SHARES. The conversion of a Series A preferred share into common shares will be deemed by the ITA not to be a disposition of the Series A preferred share and, 65 accordingly, a Series A Holder will not be considered to have realized a capital gain or capital loss on such conversion. If, and to the extent that, a dividend is deemed to be paid or credited on the conversion, such dividend will be subject to withholding tax, see TAXATION OF DIVIDENDS, above. Although the matter is not free from doubt, no dividend should be deemed to be paid or credited on the conversion. For purposes of the conversion, the cost of the common shares acquired on conversion will be equal to the adjusted cost base of the Series A preferred shares to the Series A Holder that have been converted. The adjusted cost base to the Series A Holder of the common shares acquired on the conversion will be determined by averaging the cost of the common shares acquired on the conversion with the adjusted cost base to the Series A Holder of all other common shares held as capital property at that time by the Series A Holder. A common share acquired on a conversion will constitute taxable Canadian property under the ITA. Therefore a Series A Holder that disposes of a common share acquired on a conversion will be subject to tax under the ITA in respect of a capital gain realized on the disposition, unless relief under an applicable international tax treaty is available. For more information regarding the treatment of the disposition under the ITA and the U.S. Treaty, see DISPOSITION OF SERIES A PREFERRED SHARES, below. Under the current administrative practice of the CCRA, a Series A holder who, upon conversion of a Series A preferred share, receives cash not in excess of C$200 in lieu of a fraction of a common share may either treat this amount as proceeds of disposition of a portion of the Series A preferred share or, alternatively, reduce the adjusted cost base of the common share received on the conversion by the amount of case received. In the event that the Series A Holder chooses to recognize a disposition of a portion of the Series A preferred share, a capital gain or loss may be realized. For information regarding the treatment of the capital gain or capital loss, see DISPOSITION OF SERIES A PREFERRED SHARES, below. DISPOSITION OF THE SERIES A PREFERRED SHARES. A Series A Holder will be subject to tax under the ITA in respect of a capital gain realized on the disposition of a share if the share constitutes or is deemed to constitute "taxable Canadian property" (as defined in the ITA) and the disposition is not exempt from tax under the ITA due to the application of the U.S. treaty. A Series A preferred share will constitute taxable Canadian property for purposes of the ITA. However, a Series A Holder resident in the United States for purposes of the U.S. Treaty will generally be exempt from Canadian tax in respect of a gain on the disposition of a Series A preferred share provided that the value of the Series A preferred share is not derived principally from real property situated in Canada. Paragraph 5 of Article XIII of the U.S. Treaty provides that paragraph 4 of Article XIII, which normally provides such an exemption for U.S. residents from Canadian tax on the disposition of property such as shares, generally does not apply where the U.S. resident is an individual who was a Canadian resident for 120 months during any period of twenty consecutive years preceding the time of the disposition of the property, the individual was resident in Canada at any time during the ten years immediately preceding the disposition of the property, and the individual owned the property at the time the individual ceased to be a resident of Canada. A disposition of a Series A preferred share will trigger certain filing requirements under section 116 of the ITA, regardless of whether relief from taxation under an applicable international tax treaty is available. 66 U.S. FEDERAL INCOME TAX CONSIDERATIONS The following summary describes certain material United States federal income tax consequences applicable to a U.S. Holder (as described below) arising from the purchase, ownership and disposition of common shares. This summary is based on the provisions of the Internal Revenue Code of 1986, as amended (the "Code"), final, temporary and proposed United States Treasury Regulations promulgated thereunder, and the administrative and judicial interpretations thereof, all as in effect as of the date of this annual report and all of which are subject to change, possibly on a retroactive basis. The consequences to any particular U.S. Holder may differ from those described below by reason of that U.S. Holder's particular circumstances. This summary does not address all aspects of United States federal income taxation that may be relevant to a particular U.S. Holder in light of such U.S. Holder's circumstances, including, without limitation, financial institutions, mutual funds, broker-dealers, insurance companies, taxpayers who have elected mark-to-market accounting, tax-exempt organizations, taxpayers who hold common shares as part of a straddle, "hedge" or "conversion transaction" with other investments, persons who own (directly, indirectly or through attribution) 10% or more of our company's outstanding voting stock, taxpayers whose functional currency is not the U.S. dollar, shareholders subject to the alternative minimum tax provisions of the Code, and persons who hold common shares through a partnership or other pass-through entity. In addition, not discussed are any aspects of foreign, state or local tax laws or the potential applicability of United States federal and state estate and/or gift taxation. This summary is addressed only to a holder of common shares who is (i) a citizen or resident of the United States for federal income tax purposes, (ii) a corporation, or other entity treated as a corporation under United States federal income tax law, organized in the United States or under the laws of the United States or any state thereof, (iii) an estate, the income of which is includable in gross income for United States federal income tax purposes regardless of source, or (iv) a trust, if a court within the United States is able to exercise primary supervision over the administration of the trust and one or more U.S. persons have the authority to control all substantial decisions of the trust (a "U.S. Holder"). This summary is for general information purposes only and does not purport to be a comprehensive description of all of the tax considerations that may be relevant to the purchase, ownership or disposition of our common shares. This summary assumes that U.S. Holders hold their common shares as capital assets within the meaning of Section 1221 of the Code. Each shareholder should consult with such shareholder's own tax advisor as to the particular tax consequences to such shareholder of the purchase, ownership and disposition of its common shares including the effects of applicable state, local, foreign or other tax laws and possible changes in the tax laws. TREATMENT OF DIVIDEND DISTRIBUTIONS Subject to the discussion below under "Tax Status Of The Company - Passive Foreign Investment Companies," a distribution by our company to a U.S. Holder in respect of the common shares (including the amount of any Canadian taxes withheld thereon) will generally be treated for United States federal income tax purposes as a dividend to the extent of our company's current and accumulated earnings and profits, as determined under United States federal income tax principles. To the extent, if any, that the amount of any such distribution exceeds our company's current and accumulated earnings and profits, as so computed, it will first reduce the U.S. Holder's tax basis in the common shares owned by him, and to the extent it exceeds such tax basis, it will be treated as capital gain from the sale of common shares. While it is not anticipated that our company will pay dividends in the foreseeable future, the gross amount of any distribution from our company received by a U.S. Holder which is treated as a dividend for United States federal income tax purposes (before reduction for any Canadian tax withheld at source) will 67 be included in such U.S. Holder's gross income, will be subject to tax at the rates applicable to ordinary income and generally will not qualify for the dividends received deduction applicable in certain cases to United States corporations. For United States federal income tax purposes, the amount of any dividend paid in Canadian dollars by our company to a U.S. Holder will equal the U.S. dollar value of the amount of the dividend paid in Canadian dollars, at the exchange rate in effect on the date of the distribution, regardless of whether the Canadian dollars are actually converted into United States dollars at that time. Canadian dollars received by a U.S. Holder will have a tax basis equal to the U.S. dollar value thereof determined at the exchange rate on the date of the distribution. Currency exchange gain or loss, if any, recognized by a U.S. Holder on the conversion of Canadian dollars into U.S. dollars will generally be treated as U.S. source ordinary income or loss to such holder. U.S. Holders should consult their own tax advisors concerning the treatment of foreign currency gain or loss, if any, on any Canadian dollars received which are converted into dollars subsequent to distribution. A U.S. Holder generally will be entitled to deduct any Canadian taxes withheld from dividends in computing United States taxable income, or to credit such withheld taxes against the United States federal income tax imposed on such U.S. Holder's dividend income. No deduction for Canadian taxes may be claimed, however, by a noncorporate U.S. Holder that does not itemize deductions. The amount of foreign taxes for which a U.S. Holder may claim a credit in any year is subject to complex limitations and restrictions, which must be determined on an individual basis by each shareholder. Distributions with respect to common shares that are taxable as dividends will generally constitute foreign source income for purposes of the foreign tax credit limitation. The limitation on foreign taxes eligible for credit is calculated separately with respect to specific classes of income. For this purpose, dividends distributed by our company with respect to the common shares will generally constitute "passive income" or, in the case of certain shareholders, "financial services income." The rules relating to the determination of the amount of foreign income taxes which may be claimed as foreign tax credits are complex and U.S. Holders should consult their tax advisors to determine whether and to what extent a credit would be available. SALE OR EXCHANGE OF A COMMON SHARE Subject to the discussion below under "Tax Status Of The Company - Passive Foreign Investment Companies," the sale or exchange by a U.S. Holder of a common share generally will result in the recognition of gain or loss by the U.S. Holder in an amount equal to the difference between the amount realized and the U.S. Holder's basis in the common share sold. Such gain or loss will be capital gain or loss provided that the common share is a capital asset in the hands of the holder. The gain or loss realized by a noncorporate U.S. Holder on the sale or exchange of a common share will be long-term capital gain or loss if the common share had been held for more than one year. If the common share had been held by such noncorporate U.S. Holder for not more than one year, such gain will be short-term capital gain. Gains or losses recognized by a U.S. Holder on a sale, exchange or other disposition of common shares generally will be treated as United States source income for United States federal income tax purposes. The deductibility of a capital loss recognized on the sale, exchange or other disposition of common shares is subject to limitations. A U.S. Holder that receives foreign currency upon disposition of common shares and subsequently converts the foreign currency into U.S. dollars generally will have foreign exchange gain or loss based on any appreciation or depreciation in the value of the foreign currency against the U.S. dollar. U.S. Holders should consult their own tax advisors regarding treatment of any foreign currency gain or loss on any Canadian dollars received in respect of the sale, exchange or other disposition of common shares. TAX STATUS OF THE COMPANY PERSONAL HOLDING COMPANIES. A non-U.S. corporation may be classified as a personal holding company (a "PHC") for United States federal income tax purposes if both of the following two tests are 68 satisfied: (i) if at any time during the last half of the company's taxable year, five or fewer individuals (without regard to their citizenship or residency) own or are deemed to own (under certain attribution rules) more than 50% of the stock of the corporation by value and (ii) 60% or more of such non-U.S. corporation's gross income derived from U.S. sources or effectively connected with a U.S. trade or business, as specifically adjusted, is from certain passive sources such as dividends and royalty payments. Such a corporation generally is taxed on the amounts of such passive source income, after making adjustments such as deducting dividends paid and income taxes, that are not distributed to shareholders. We believe that our company was not a PHC in 2001 and is not currently a PHC. However, no assurance can be given that either test will not be satisfied in the future. FOREIGN PERSONAL HOLDING COMPANIES. A non-U.S. corporation will be classified as a foreign personal holding company (an "FPHC") for United States federal income tax purposes if both of the two following tests are satisfied: (i) five or fewer individuals who are United States citizens or residents own or are deemed to own (under certain attribution rules) more than 50% of all classes of the corporation's stock measured by voting power or value and (ii) the corporation receives at least 60% (50% if previously an FPHC) of its gross income (regardless of source), as specifically adjusted, from certain passive sources. If such a corporation is classified as a FPHC, a portion of its "undistributed foreign personal holding company income" (as defined for United States federal income tax purposes) would be imputed to all of its shareholders who are U.S. Holders on the last taxable day of the corporation's taxable year, or, if earlier, the last day on which it is classifiable as a FPHC. Such income would be taxable as a dividend, even if no cash dividend is actually paid. U.S. Holders who dispose of their shares prior to such date would not be subject to tax under these rules. We believe that our company is not currently a FPHC. However, no assurance can be given that our company will not qualify as a FPHC in the future. PASSIVE FOREIGN INVESTMENT COMPANIES. A company will be a passive foreign investment company ("PFIC") if 75% or more of its gross income (including the pro rata share of the gross income of any company (United States or foreign) in which the company is considered to own 25% or more of the shares (determined by market value)) in a taxable year is passive income. Alternatively, the company will be considered to be a PFIC if at least 50% of the value of the company's assets (averaged over the year) (including the pro rata share of the value of the assets of any company in which the company is considered to own 25% or more of the shares (determined by market value)) in a taxable year are held for the production of, or produce, passive income. For these purposes, the value of our assets is calculated based on our market capitalization. Passive income generally includes, among others, interest, dividends, royalties, rents and annuities. If our company is a PFIC for any taxable year, a U.S. Holder, in the absence of an election by such U.S. Holder to treat our company as a "qualified electing fund" (a "QEF election"), as discussed below, would, upon certain distributions by our company and upon disposition of the common shares at a gain, be liable to pay tax at the highest tax rate on ordinary income in effect for each period to which the income is allocated, plus interest on the tax, as if the distribution or gain had been recognized ratably over the days in the U.S. Holder's holding period for the common shares during which our company was a PFIC. A U.S. Holder who is an individual is not allowed a deduction for interest on the deferred tax liability. Additionally, were our company a PFIC, U.S. Holders who acquire ordinary shares from decedents would be denied the normally available step-up of the income tax basis for such common shares to fair market value at the date of death and instead would have a tax basis equal to the decedent's basis, if lower. If our company is treated as a PFIC for any taxable year, U.S. Holders should consider whether to make a QEF Election for United States federal income tax purposes. If a U.S. Holder has a QEF Election in effect for all taxable years that such U.S. Holder has held the common shares and our company was a PFIC, distributions and gain will not be recognized ratably over the U.S. Holder's holding period or 69 subject to an interest charge, gain on the sale of common shares will be characterized as capital gain and the denial of basis step-up at death described above would not apply. Instead, each such U.S. Holder is required for each taxable year that our company is a qualified electing fund to include in income a pro rata share of the ordinary earnings of our company as ordinary income and a pro rata share of the net capital gain of our company as long-term capital gain, subject to a separate election to defer payment of taxes, which deferral is subject to an interest charge. These amounts would be included in income by an electing U.S. Holder for its taxable year in which our company's taxable year ends, whether or not such amounts are actually distributed to the U.S. Holder. In order to comply with the requirements of a QEF Election, a U.S. Holder must receive from our company certain information. We intend to supply U.S. Holders with the information needed to report income and gain pursuant to a QEF Election in the event our company is classified as a PFIC. The QEF Election is made on a shareholder-by-shareholder basis and can be revoked only with the consent of the Internal Revenue Service (the "IRS"). A shareholder makes a QEF Election by attaching a completed IRS Form 8621 (including the PFIC annual information statement) to a timely filed United States federal income tax return and by filing such form with the IRS Service Center in Philadelphia, Pennsylvania. Even if a QEF Election is not made, a shareholder in a PFIC who is a U.S. Holder must file a completed IRS Form 8621 every year. As an alternative to making a QEF Election, a U.S. Holder may elect to make a mark-to-market election (the "Mark-to-Market Election") with respect to the common shares owned by him. If the Mark-to-Market Election were made, then the rules set forth above would not apply for periods covered by the election. Under such election, a U.S. Holder includes in income each year an amount equal to fair market value of the common shares owned by such U.S. Holder as of the close of the taxable year over the U.S. Holder's adjusted basis in such shares. The U.S. Holder would be entitled to a deduction for the excess, if any, of such U.S. Holder's adjusted basis in his common shares over the fair market value of such shares as of the close of the taxable year; provided however, that such deduction would be limited to the extent of any net mark-to-market gains with respect to the common shares included by the U.S. Holder under the election for prior taxable years. The U.S. Holder's basis in his common shares is adjusted to reflect the amounts included or deducted pursuant to this election. Amounts included in income pursuant to the Mark-to-Market Election, as well as gain on the sale or exchange of the common shares, will be treated as ordinary income. Ordinary loss treatment applies to the deductible portion of any mark-to-market loss, as well as to any loss realized on the actual sale or exchange of the common shares to the extent that the amount of such loss does not exceed the net mark-to-market gains previously included with respect to such common shares. The Mark-to-Market election applies to the tax year for which the election is made and all later tax years, unless the common shares cease to be marketable or the IRS consents to the revocation of the election. We do not believe our company was a PFIC during 2001. However, there can be no assurance that our company will not be classified as a PFIC in 2002 or thereafter because the tests for determining PFIC status are applied annually and it is difficult to make accurate predictions of future income and assets, which are relevant to this determination. U.S. Holders who hold common shares during a period when our company is a PFIC will be subject to the foregoing rules, even if our company ceases to be a PFIC, subject to certain exceptions for U.S. Holders who made a QEF election. U.S. Holders are urged to consult with their own tax advisors about making a QEF Election or Mark-to-Market Election and other aspects of the PFIC rules. BACK-UP WITHHOLDING AND INFORMATION REPORTING U.S. Holders generally are subject to information reporting requirements with respect to dividends paid in the United States on common shares. Under existing regulations, such dividends are not 70 subject to back-up withholding. U.S. Holders generally are subject to information reporting and back-up withholding on proceeds paid from the disposition of common shares at a rate of 31% for proceeds paid on or before August 6, 2001, 30.5% for proceeds paid from August 7, 2001 through December 31, 2001 and 30% for proceeds paid after December 31, 2001, unless the U.S. Holder provides IRS Form W-9 or otherwise establishes an exemption. DOCUMENTS ON DISPLAY We have filed this Annual Report on Form 20-F with the Securities and Exchange Commission under the Securities Exchange Act of 1934. Statements made in this annual report as to the contents of any contract, agreement or other document referred to are not necessarily complete. With respect to each such contract, agreement or other document filed as an exhibit to this annual report, reference is made to the exhibit for a more complete description of the matter involved, and each such statement shall be deemed qualified in its entirety by such reference. We are subject to the informational requirements of the Exchange Act and file reports and other information with the Securities and Exchange Commission. Reports and other information which we file with the Securities and Exchange Commission, including this Annual Report on Form 20-F, may be inspected and copied at the public reference facilities of the Securities and Exchange Commission at: Public Reference Room Northeast Regional Office Midwest Regional Office 450 Fifth Street N.W. 233 Broadway 175 West Jackson Boulevard Room 1024 New York, New York 10279 Suite 900 Washington D.C. 20549 Chicago, Illinois 60604
You can also obtain copies of this material by mail from the Public Reference Section of the Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549, at prescribed rates. Additionally, copies of this material may also be obtained from the Securities and Exchange Commission's Internet site at http://www.sec.gov. The Commission's telephone number is 1-800-SEC-0330. ITEM 11. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. INTEREST RATE RISK. The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we invest in may have market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the market value of our investment will probably decline. We currently maintain an investment portfolio primarily of United States Treasury obligations. The average duration of all of our investments in 2001 was less than one year. Due to the short-term nature of these investments, we believe we have no material exposure to interest rate risk arising from our investments. Therefore, no quantitative tabular disclosure is required. FOREIGN CURRENCY RATE FLUCTUATIONS. Our financial statements are prepared in U.S. dollars and much of our business is conducted in U.S. dollars. However, we incur expenses in Canadian dollars, euros and in other foreign currencies. We also sell products to customers in foreign countries and bill those customers in local currencies at predetermined exchange rates. As our business expands, we anticipate that we will increasingly incur expenses and bill and receive payments in local currencies at prevailing exchange rates. As a result, we may suffer losses due to fluctuations in the exchange rates between the U.S. dollar and the Canadian dollar and the U.S. dollar and the currencies of other countries. We currently engage in limited foreign exchange hedging activities by sometimes purchasing Canadian 71 funds before they are actually required to protect ourselves against the risk of losses due to fluctuations in exchange rates. We do not currently engage in hedging activities for any other foreign currencies. ITEM 12. DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES. Not Applicable. PART II ITEM 13. DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES. None. ITEM 14. MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS. There were no material modifications effecting the rights of securities holders made during the fiscal year ended December 31, 2001. PART III ITEM 17. FINANCIAL STATEMENTS. Not applicable. ITEM 18. FINANCIAL STATEMENTS. See the Index to Consolidated Financial Statements accompanying this report on page F-1. ITEM 19. EXHIBITS. 3.1 Certificate and Restated Articles of Incorporation of the Company.(1) 3.2 Certificate and Articles of Amendment of the Company.(2) 3.3 Amended and Restated Bylaws of the Company.(3) 4.1 Specimen of Certificate for Common Shares.(4) 4.2 Certificate of Designations, Number, Voting Powers, Preference and Rights of Series A Convertible Preferred Shares of Visible Genetics Inc.(5) 10.1 Visible Genetics Inc. Employee Pool Stock Option Plan.(6) 10.2 Visible Genetics Inc. 1997 Director Option Plan.(7) 10.3 Visible Genetics Inc. Employee Share Option Plan, Amended through May 19, 1999.(8) 10.4 Visible Genetics Inc. Employee Share Ownership Plan.(9) 10.5 Visible Genetics Inc. 2000 Employee Share Option Plan.(10) 72 10.6 PCR Diagnostic License Agreement, dated August 18, 1997, by and between Roche Molecular Systems, Inc., F. Hoffmann-La Roche Ltd. and Visible Genetics Inc. (THIS AGREEMENT IS FILED IN REDACTED FORM BASED UPON A GRANT OF CONFIDENTIAL TREATMENT BY THE SEC.)(11) 10.7 Securities Purchase Agreement, dated as of July 15, 1999, by and among Visible Genetics Inc., Warburg, Pincus Equity Partners, L.P., Warburg, Pincus Ventures International, L.P., Warburg, Pincus Netherlands Equity Partners I, C.V., Warburg, Pincus Netherlands Equity Partners II, C.V. and Warburg, Pincus Netherlands Equity Partners III, C.V.(12) 10.8 Registration Rights Agreement, dated as of July 15, 1999, by and among Visible Genetics Inc. and the Investors listed on Schedule I thereto.(13) 10.9 Common Shares Purchase Agreement, dated December 14, 1999, by and among Visible Genetics Inc. and the Investors who are signatories thereto.(14) 10.10 Registration Rights Agreement, dated as December 14, 1999, by and among Visible Genetics Inc. and each of the Investors to that certain Common Shares Purchase Agreement.(15) 10.11 Lease between Visible Genetics Corp. and Duke-Weeks Realty Limited Partnership, dated December 22, 1999.(16) 10.12 Lease between Visible Genetics Inc. and LuCliff Company Limited, dated March 31, 1992.(17) 10.13 Lease between Visible Genetics Inc. and Royal Trust Corporation of Canada, as trustee and RT Pensior Properties Limited dated June 1, 1996.(18) 10.14 Lease between Visible Genetics Inc. and Comwest Properties Limited dated July 20, 1998.(19) 10.15 Lease between Visible Genetics Corp. and the University of Pittsburgh of the Commonwealth System of Higher Education dated Dec 1, 1996.(20) 10.16 Master Agreement, dated as of February 22, 1996 and executed on April 1, 1996, between Amersham International plc., Amersham Canada Limited and the Company. (THIS AGREEMENT IS FILED IN REDACTED FORM BASED UPON A GRANT OF CONFIDENTIAL TREATMENT BY THE SEC.)(21) 10.17 Amersham Supply Agreement, dated as of February 22, 1996 and executed on April 1, 1996, between Amersham International plc, Amersham Canada Limited and the Company. (THIS AGREEMENT IS FILED IN REDACTED FORM BASED UPON A GRANT OF CONFIDENTIAL TREATMENT BY THE SEC.)(22) 10.18 VGI Supply Agreement, dated as of February 22, 1996 and executed on April 1, 1996 between Amersham International plc, Amersham Canada Limited and the Company. (THIS AGREEMENT IS FILED IN REDACTED FORM BASED UPON A GRANT OF CONFIDENTIAL TREATMENT BY THE SEC.)(23) 10.19 Amendment No. 1 to Guarantee, dated as of April 30, 1999 to the Guarantee dated as of April 30, 1998, by and among Visible Genetics Inc., Hilal Capital, L.P., Hilal Capital QP, LP, Hilal Capital International, Ltd., Highbridge International LLC, C.J. Partners L.P. and Hilal Capital Management LLC, as adviser for Leo Holdings, Inc.(24) 73 10.20 Amendment No. 2 to Term Loan Agreement, dated as of April 30, 1999, to the Term Loan Agreement, dated as of April 30, 1999 as amended by Amendment No. 1 to the Term Loan Agreement dated as of September 29, 1998, by and among Visible Genetics Corp., Hilal Capital, L.P., Hilal Capital QP, LP, Hilal Capital International, Ltd., Highbridge International LLC, C.J. Partners L.P. and Hilal Capital Management LLC, as adviser for Leo Holdings, Inc.(25) 10.21 Letter Agreement between Visible Genetics Inc. and Hilal Capital Management dated July 15, 1999.(26) 10.22 Underwriting Agreement, dated March 30, 2000, by and among, FleetBoston Robertson Stephens Inc., PaineWebber Incorporated, Warburg Dillon Read LLC, Roth Capital Partners, Inc., as representatives of the several underwriters, and Visible Genetics Inc.(27) 10.23 Licensing and Collaboration Agreement, dated April 25, 2000, by and among Visible Genetics and Applera Corporation, Applied Biosytems Group (formerly PE Biosystems). ). (THIS AGREEMENT IS FILED IN REDACTED FORM AS IT IS SUBJECT TO A REQUEST FOR CONFIDENTIALITY SUBMITTED TO THE SEC.)(28) 10.24 Lease, dated March 27, 2000, by and between Visible Genetics Inc., as Tenant and LuCliff Company Limited, as Landlord.(29) 10.25 Lease, dated November 30, 2000, by and between Visible Genetics Inc., as Tenant and LuCliff Company Limited, as Landlord.(30) 10.26 Lease, dated October 1, 2000, by and between Visible Genetics Inc., as Tenant and LuCliff Company Limited, as Landlord.(31) 10.27 Common Shares Purchase Agreement, dated December 24, 2001, by and among Visible Genetics Inc. and the Investors who are signatories thereto. 10.28 Registration Rights Agreement, dated December 24, 2001, by and among Visible Genetics Inc. and the Investors who are signatories thereto. 10.29 Amended and Restated Employment Agreement, dated as of February 1, 2002, among Visible Genetics Corporation, Visible Genetics Inc. and Richard T. Daly. 10.30 Amended and Restated Employment Agreement, dated as of February 1, 2002, among Visible Genetics Inc., Visible Genetics UK, Ltd. and Arthur Cole. 10.31 Employment Agreement, dated as of February 1, 2002, among Visible Genetics Inc., Visible Genetics Corporation and Thomas J. Clarke. 10.32 Employment Agreement, dated as of February 1, 2002, among Visible Genetics Inc., Visible Genetics Corporation and Tim Ellis. 10.33 Employment Agreement, dated as of February 1, 2002, between Visible Genetics Inc. and Marguerite Ethier. 10.34 Service Agreement, dated December 15, 2001, between Visible Genetics UK, Ltd. and Brendan Larder. 10.35 Deed, dated September 12, 2001, by and among Visible Genetics Inc., Visible Genetics UK Ltd., Virco U.K. Limited and Tibotec-Virco N.V. 74 10.36 Licence to Assign, dated October 10, 2001, by and among Visible Genetics Inc., Visible Genetics UK Ltd., Virco UK Limited and The Master Fellows and Scholars of Trinity College Cambridge, including that certain Lease, dated January 19, 1999, by and among The Master Fellows and Scholars of Trinity College Cambridge, Virco U.K. Limited and Virco NV, attached as Schedule A thereto. ---------- (1) Incorporated by reference from Exhibit 3.1 to Amendment No. 1 to the Company's Registration Statement on Form F-1, File No. 333-3118 filed with the Securities and Exchange Commission on May 16, 1996 (2) Incorporated by reference from Exhibit 3.2 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 13, 2000. (3) Incorporated by reference from Exhibit 3.2 to Amendment No. 1 to the Company's Registration Statement on Form F-1, File No. 333-3118 filed with the Securities and Exchange Commission on May 16, 1996 (4) Incorporated by reference from Exhibit 4.1 to Amendment No. 1 to the Company's Registration Statement on Form F-1, File No. 333-3118 filed with the Securities and Exchange Commission on May 16, 1996. (5) Incorporated by reference from Exhibit 4.2 to the Company's Registration Statement on Form F-3, File No.333-91155 filed with the Securities and Exchange Commission on November 17, 1999 (6) Incorporated by reference from Exhibit 4.4 to the Company's Registration Statement on Form S-8, File No. 333-06454 filed with the Securities and Exchange Commission on February 18, 1997. (7) Incorporated by reference from Exhibit 2.1 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on April 28, 1997. (8) Incorporated by reference from Exhibit 10.3 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 13, 2000. (9) Incorporated by reference from Exhibit 2.2 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on April 28, 1997. (10) Incorporated by reference from Exhibit B to the Company's Report on Form 6-K, Filing No. 2 for the Month of April 2000, dated April 19, 2000. (11) Incorporated by reference from Exhibit 3.11 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on July 19, 1999. (12) Incorporated by reference from Exhibit 10.10 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 13, 2000. (13) Incorporated by reference from Exhibit 10.11 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 13, 2000. (14) Incorporated by reference from Exhibit 10.12 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 13, 2000. 75 (15) Incorporated by reference from Exhibit 10.13 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 13, 2000. (16) Incorporated by reference from Exhibit 10.14 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 13, 2000. (17) Incorporated by reference from Exhibit 10.15 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 13, 2000. (18) Incorporated by reference from Exhibit 10.16 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 13, 2000. (19) Incorporated by reference from Exhibit 10.17 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 13, 2000. (20) Incorporated by reference from Exhibit 10.18 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 13, 2000. (21) Incorporated by reference from Exhibit 10.8 to Amendment No. 1 to the Company's Registration Statement on Form F-1, File No. 333-3118 filed with the Securities and Exchange Commission on May 16, 1996. (22) Incorporated by reference from Exhibit 10.9 to Amendment No. 1 to the Company's Registration Statement on Form F-1, File No. 333-3118 filed with the Securities and Exchange Commission on May 16, 1996. (23) Incorporated by reference from Exhibit 10.10 to Amendment No. 1 to the Company's Registration Statement on Form F-1, File No. 333-3118 filed with the Securities and Exchange Commission on May 16, 1996. (24) Incorporated by reference from Exhibit 10.22 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 13, 2000. (25) Incorporated by reference from Exhibit 10.23 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 13, 2000. (26) Incorporated by reference from Exhibit 10.24 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 13, 2000. (27) Incorporated by reference from Exhibit 1.1 to Amendment No. 1 to the Company's Registration Statement on Form F-3, File No. 333-32258 filed with the Securities and Exchange Commission on March 29, 2000. (28) Incorporated by reference from Exhibit 10.23 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 20, 2001. (29) Incorporated by reference from Exhibit 10.24 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 20, 2001. (30) Incorporated by reference from Exhibit 10.25 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 20, 2001. 76 (31) Incorporated by reference from Exhibit 10.26 to the Company's Annual Report on Form 20-F, File No. 0-28550 filed with the Securities and Exchange Commission on March 20, 2001. 77 SIGNATURES The registrant hereby certifies that it meets all of the requirements for filing on Form 20-F and has duly caused and authorized the undersigned to sign this annual report its behalf. VISIBLE GENETICS INC. By: /s/ RICHARD T. DALY ------------------------------ Richard T. Daly, President and Chief Executive Officer Date: June 14, 2002 78 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE Audited Consolidated Financial Statements for the years ended December 31, 2001, 2000 and 1999 Independent Auditors' Report.............................................................................................. F-2 Consolidated Balance Sheets as at December 31, 2001 and 2000.............................................................. F-3 Consolidated Statements of Operations for the years ended December 31, 2001, 2000 and 1999................................ F-4 Consolidated Statements of Deficit for the years ended December 31, 2001, 2000 and 1999................................... F-5 Consolidated Statements of Comprehensive Loss for the years ended December 31, 2001, 2000 and 1999........................ F-5 Consolidated Statements of Cash Flows for the years ended December 31, 2001, 2000 and 1999................................ F-6 Notes to Consolidated Financial Statements................................................................................ F-7
F-1 INDEPENDENT AUDITORS' REPORT TO THE SHAREHOLDERS OF VISIBLE GENETICS INC. We have audited the consolidated balance sheets of Visible Genetics Inc. as at December 31, 2001 and 2000 and the consolidated statements of operations, deficit, comprehensive loss, and cash flows for the years ended December 31, 2001, 2000 and 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America and Canada. Those standards require that we plan and perform an audit to obtain reasonable assurance 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. In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of the Company as at December 31, 2001 and 2000 and the results of its operations and its cash flows for the years ended December 31, 2001, 2000 and 1999 in accordance with generally accepted accounting principles in the United States of America. /s/ PRICEWATERHOUSECOOPERS LLP ----------------------------------- Chartered Accountants Toronto, Canada February 15, 2002, except as to note 17 which is as of February 27, 2002 F-2 VISIBLE GENETICS INC. CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEETS
DECEMBER 31 ----------- 2001 2000 ---- ---- ASSETS CURRENT ASSETS Cash and cash equivalents............................................. $ 15,502,095 $ 18,476,303 Short-term investments................................................ 37,692,756 61,922,687 Trade receivables (net of allowance for doubtful accounts of $742,156; 2000-$1,311,530)............................. 3,136,754 3,214,934 Other receivables (Note 4)............................................ 437,888 884,995 Prepaid and deposits.................................................. 392,454 452,124 Inventory (Note 5).................................................... 2,756,950 2,268,877 ------------ -------------- TOTAL CURRENT ASSETS...................................................... 59,918,897 87,219,920 Fixed assets (Note 6)..................................................... 18,656,995 10,292,282 Patents and licenses (Note 7)............................................. 14,336,439 12,182,112 Other long-term assets.................................................... 456,744 481,383 ------------ -------------- $ 93,369,075 $ 110,175,697 ============ ============== LIABILITIES CURRENT LIABILITIES Accounts payable...................................................... $ 3,851,701 $ 3,847,364 Accrued liabilities (Note 8).......................................... 5,081,814 5,265,864 ------------ -------------- 8,933,515 9,113,228 ------------ -------------- TOTAL CURRENT LIABILITIES................................................. MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED SHARES (NOTE 9)............................................. 26,886,004 24,397,398 ------------ -------------- SHAREHOLDERS' EQUITY Share capital (Note 10)................................................... 195,408,884 169,717,379 Other equity (Note 10).................................................... - - Cumulative translation adjustment......................................... (1,018,839) (1,013,459) Deficit................................................................... (136,840,489) (92,038,849) ------------ -------------- 57,549,556 76,665,071 ------------ -------------- $ 93,369,075 $ 110,175,697 ============ ==============
COMMITMENTS AND CONTINGENCIES (NOTES 14 AND 17) THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. F-3 VISIBLE GENETICS INC. CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31 -------------------------------------------------------------- 2001 2000 1999 ---- ---- ---- SALES Products......................................... $ 13,330,346 $ 12,659,783 $ 12,455,775 Services......................................... 249,568 412,780 1,171,145 ------------- -------------- ------------- 13,579,914 13,072,563 13,626,920 ------------- -------------- ------------- COSTS OF SALES Products......................................... 9,789,570 9,815,741 8,593,774 Services......................................... 208,207 317,748 679,112 ------------- -------------- ------------- 9,997,777 10,133,489 9,272,886 ------------- -------------- ------------- GROSS MARGIN........................................... 3,582,137 2,939,074 4,354,034 ------------- -------------- ------------- EXPENSES Sales, general and administrative (Note 7)....... 33,986,435 28,570,747 19,073,546 Research and development......................... 10,834,731 10,606,516 7,935,327 Exit and termination costs (Note 11) ............ 1,920,000 - 1,329,083 ------------- -------------- ------------- 46,741,166 39,177,263 28,337,956 ------------- -------------- ------------- LOSS FROM OPERATIONS BEFORE INTEREST................... (43,159,029) (36,238,189) (23,983,922) Interest income........................................ 2,513,697 4,480,589 694,549 Interest and financing expense......................... (8,402) (16,536) (1,997,512) ------------- -------------- ------------- NET LOSS FOR THE YEAR.................................. (40,653,734) (31,774,136) (25,286,885) Cumulative preferred dividends and accretion of discount attributable to preferred shares (Note 9).................................. (3,426,827) (3,656,355) (1,770,069) ------------- -------------- ------------- NET LOSS ATTRIBUTABLE TO COMMON SHAREHOLDERS........... $ (44,080,561) $ (35,430,491) $ (27,056,954) ============= ============== ============= Weighted average number of common shares outstanding... 16,481,916 14,612,172 9,916,954 Basic and diluted loss per common share................ $ (2.67) $ (2.42) $ (2.73)
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. F-4 VISIBLE GENETICS INC. CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED STATEMENTS OF DEFICIT
YEARS ENDED DECEMBER 31 --------------------------------------------------------------- 2001 2000 1999 ---- ---- ---- Deficit, beginning of year................................... $ (92,038,849) $ (59,438,142) $ (34,151,257) Net loss for the year........................................ (40,653,734) (31,774,136) (25,286,885) Cumulative preferred dividends and accretion of discount attributable to preferred shares................. (4,147,906) (826,571) - ------------- -------------- -------------- DEFICIT, END OF YEAR......................................... $(136,840,489) $ (92,038,849) $ (59,438,142) ============= ============== ==============
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
YEARS ENDED DECEMBER 31 --------------------------------------------------------------- 2001 2000 1999 ---- ---- ---- Net loss for the year........................................ $ (40,653,734) $ (31,774,136) $ (25,286,885) Other comprehensive income Foreign currency translation adjustments................. (5,380) (393,548) (704,733) -------------- -------------- -------------- COMPREHENSIVE LOSS FOR THE YEAR.............................. $ (40,659,114) $ (32,167,684) $ (25,991,618) ============== ============== ==============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. F-5 VISIBLE GENETICS INC. CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31 ------------------------------------------------------------ 2001 2000 1999 ---- ---- ---- CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES Net loss for the year....................................... $ (40,653,734) $ (31,774,136) $ (25,286,885) Add: Items not involving cash - Depreciation............................................ 4,651,803 3,078,551 1,722,886 Amortization............................................ 3,069,946 2,211,253 393,979 Patents and licenses written off........................ 65,014 142,165 451,085 Non-cash financing expense related to warrants granted.. -- -- 1,466,691 Amortization of discount on accounts receivable......... -- -- (48,158) Foreign exchange ....................................... 13,903 (163,252) 26,789 Increase (decrease) from changes in - Trade receivables....................................... 47,568 2,436,001 (1,804,006) Other receivables....................................... 418,349 (267,177) 719,519 Prepaids and deposits................................... 55,530 (19,863) (209,338) Inventory............................................... (486,797) 219,221 1,290,997 Other long-term assets.................................. 24,639 (188,979) (292,404) Accounts payable........................................ 50,497 789,233 (734,230) Accrued liabilities..................................... (77,522) 1,783,467 1,956,660 --------------- -------------- -------------- (32,820,804) (21,753,516) (20,346,415) --------------- -------------- -------------- CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES Purchase of fixed assets.................................... (13,192,037) (9,269,045) (1,919,092) Licenses and patents acquired............................... (5,289,287) (12,413,163) (698,261) Purchase of short-term investments.......................... (116,002,357) (356,812,514) (50,503,643) Redemption of short-term investments........................ 140,232,288 334,784,805 15,716,919 --------------- -------------- -------------- 5,748,607 (43,709,917) (37,404,077) --------------- -------------- -------------- CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES Preferred shares issued, net of expenses.................... -- -- 22,719,748 Warrants issued in connection with preferred shares......... -- -- 6,397,448 Common shares issued, net of expenses....................... 24,026,825 80,929,608 29,009,385 Repayment of notes payable.................................. -- -- (4,100,000) Other equity................................................ -- -- 29,851 Repayment of loan from an officer .......................... -- -- 323,405 --------------- -------------- -------------- 24,026,825 80,929,608 54,379,837 --------------- -------------- -------------- EFFECT OF EXCHANGE RATE FLUCTUATIONS ON CASH BALANCES.......... 71,164 217,143 (2,284) --------------- -------------- -------------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS DURING THE YEAR............................................. (2,974,208) 15,683,318 (3,372,939) CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR................ 18,476,303 2,792,985 6,165,924 --------------- -------------- -------------- CASH AND CASH EQUIVALENTS, END OF YEAR...................... $ 15,502,095 $ 18,476,303 $ 2,792,985 =============== ============== ============== SUPPLEMENTAL INFORMATION Interest paid............................................... $ 8,402 $ 16,536 $ 786,585 Income taxes paid........................................... $ $ -- $ --
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. F-6 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - NATURE OF OPERATIONS Visible Genetics Inc. (the "Company") develops, manufactures and sells integrated DNA sequencing systems and genotyping kits that analyze genetic information to improve the treatment of selected diseases. The Company's products are intended for clinical diagnostic and research purposes. Prior to marketing some of its products for use in the clinical diagnostic market, the Company will require appropriate regulatory approval. In September 2001, the Company received clearance from the United States Food and Drug Administration ("FDA") to market its TRUGENE(TM) HIV-1 Genotyping Kit and OpenGene(TM) DNA Sequencing System for clinical use in the United States. In addition, the Company has obtained appropriate regulatory approval to market such product in Canada, France and Argentina. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES These financial statements have been prepared in United States dollars, in accordance with the accounting principles generally accepted in the United States. The principal accounting policies of the Company, which have been consistently applied, are summarized as follows: PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements of the Company include the following wholly owned subsidiaries: Visible Genetics Corp., Visible Genetics B.V., Applied Sciences, Inc., Gene Foundry Inc., Visible Genetics France S.A.S., Visible Genetics Israel Ltd., Visible Genetics Iberia SL, Visible Genetics UK Ltd., Visible Genetics Srl. and Visible Genetics Portugal, Unipessoal, Lda. All intercompany accounts and transactions have been eliminated upon consolidation. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and 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. REVENUE RECOGNITION AND WARRANTY Revenue from the sale of the Company's products is recognized when evidence of an arrangement exists, shipment occurs and title passes to the customer or distributor, sales price is fixed or determinable and there is reasonable assurance of collectibility. There are no significant customer acceptance requirements or post shipment obligations on the part of the Company. Revenue from the sale of services is recognized when evidence of an arrangement exists, the services are provided, sales price is fixed or determinable and there is reasonable assurance of collectibility. A provision is made for estimated warranty costs at the time of the sale. Revenue from extended warranty contracts is recognized over the life of the contract. Sales of bundled sequencing systems and testing kits are recognized pro rata as the components of the bundle are shipped to customers. F-7 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 - CONTINUED CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS As required under Statement of Financial Accounting Standards (SFAS) No. 95, cash equivalents consist of short-term investments that are highly liquid, are readily convertible into cash and have initial terms to maturity of three months or less. Short-term investments consist of United States treasury bills and corporate debt securities. They are classified as held-to-maturity and are recorded at amortized cost. Contractual maturities of short-term investments at December 31, 2001 and December 31, 2000 range from one to five months. FINANCIAL INSTRUMENTS The carrying values of the Company's financial instruments, consisting of cash and cash equivalents, short-term investments, trade and other receivables and accounts payable, approximate their fair values due to their short-term nature. CONCENTRATION OF CREDIT RISK The Company's financial instruments that are exposed to concentration of credit risk consist primarily of cash and cash equivalents, short-term investments and receivables. The Company maintains its accounts for cash and cash equivalents and short-term investments with the United States treasury and a number of large low-credit-risk financial institutions and corporations in Canada and the United States in order to reduce its exposure. In addition, the Company limits its maximum investment to any one counterparty to limit its credit exposure. At December 31, 2001 and December 31, 2000 no customers accounted for greater than 10% of gross trade receivables. INVENTORY Inventory is stated at the lower of cost and estimated realizable value. Cost is determined by the first-in first-out method, and includes material, labor, and an allocation of overhead. FIXED ASSETS Fixed assets are recorded at cost. Depreciation and amortization is provided on a straight-line basis over the estimated useful lives of the assets, as follows: Laboratory and computer equipment 2 to 5 years Equipment on loan to customers 2 years Leasehold improvements term of the lease
PATENTS AND LICENSES External costs of patents and licenses are recorded at cost and amortized over their estimated useful lives, which are generally up to ten years. If the carrying amount of a patent or license is no longer recoverable, the related unamortized cost is written down to fair value. F-8 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 - CONTINUED IMPAIRMENT OF LONG-LIVED ASSETS In accordance with the provisions of SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of," the Company reviews long-lived assets, including fixed assets, patents and licenses, for impairment whenever events or changes in business circumstances indicate that the carrying amount of the asset may not be fully recoverable. Under SFAS No. 121, an impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition are less than its carrying amount. Impairment, if any, is measured using discounted cash flows. FOREIGN CURRENCY TRANSLATION Monetary assets and liabilities denominated in foreign currencies are translated into United States dollars at the exchange rate prevailing at the balance sheet date. Other assets, liabilities and operating items are translated at exchange rates prevailing at the respective transaction dates. Resulting translation adjustments are included in the consolidated statements of operations. Assets and liabilities of subsidiaries with functional currencies other than United States dollars are translated at the exchange rate prevailing at the balance sheet date, and the results of their operations are translated at average exchange rates for the year. The resulting translation adjustments are reflected in a separate component of shareholders' equity. Other exchange gains or losses are included in the consolidated statements of operations. INCOME TAXES The Company provides for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes," which prescribes an asset and liability approach that results in the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the consolidated financial statements or tax returns. RESEARCH AND DEVELOPMENT EXPENSES Research and development costs are expensed in the period incurred. The Company is entitled to certain Canadian federal and provincial tax incentives for qualified research and development. They are accounted for as a reduction of the related expenditure for current expenses and a reduction of the related asset for capital assets when it is more likely than not that the credit will be realized. The Company is entitled to Canadian federal investment tax credits at a rate of 20% on eligible current and capital expenditures, claimable against income taxes otherwise payable. ADVERTISING COSTS The Company expenses the cost of advertising as incurred. The Company incurred advertising costs of approximately $1,607,000, $811,000 and $560,000 for 2001, 2000 and 1999, respectively. STOCK OPTIONS The Company follows SFAS No. 123, "Accounting for Stock-Based Compensation" which permits the use of APB No. 25, "Accounting for Stock Issued to Employees" to account for stock options issued to F-9 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 - CONTINUED employees and directors. Under that method, the Company uses the intrinsic value method to measure the cost associated with the granting of stock options to employees and directors. The amount by which the market price of the underlying shares exceeds the exercise price of the options at the date of grant, if any, is accounted for as compensation expense over the periods in which services are rendered. Options issued to consultants are recorded at their fair market value at the date of the grant. This amount is charged to operations over the periods in which services are rendered. EARNINGS (LOSS) PER SHARE The Company follows SFAS No. 128, "Earnings Per Share" to calculate basic and diluted earnings (loss) per share. Basic earnings (loss) per share are calculated using the weighted average number of common shares outstanding during the year. Diluted earnings (loss) per share are calculated using the weighted average number of common and potential common shares outstanding during the year. Potential common shares consist of the incremental common shares issuable upon conversion of outstanding convertible preferred stock (using the if converted method) and shares issuable upon the exercise of stock options and warrants (using the treasury stock method). Potential common shares are excluded from the calculation if their effect is anti-dilutive, as was the case for the years ended December 31, 2001, 2000 and 1999. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES The Company follows SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". SFAS No. 133 establishes accounting and reporting standards for derivative instruments and for hedging activities and is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. The Company does not hold derivative instruments or participate in hedging activities, therefore SFAS No. 133 does not have a significant impact on its financial position or results of operations. RECENT ACCOUNTING PRONOUNCEMENTS In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 141, "Business Combinations", and SFAS No. 142, "Goodwill and Other Intangible Assets". These new standards eliminate pooling as a method of accounting for business combinations and feature new accounting rules for goodwill and intangible assets. The Company does not foresee any impact on a cumulative effect of an accounting change or on the carrying values of assets and liabilities recorded in the consolidated balance sheets upon adoption. SFAS No. 141 is effective for business combinations initiated from July 1, 2001. SFAS No. 142 will be adopted on January 1, 2002. Also issued in June 2001 was SFAS No. 143, "Accounting for Asset Retirement Obligations". This statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. It requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. The Company is analyzing the impact of SFAS No. 143 and will adopt the standard on January 1, 2003. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-lived Assets". This statement addresses accounting for discontinued operations and the impairment or F-10 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 - CONTINUED disposal of long-lived assets. The Company is analyzing the impact of SFAS No. 144 and will adopt the standard on January 1, 2002. NOTE 3 - COLLABORATIVE AND DISTRIBUTION AGREEMENTS COLLABORATIVE AGREEMENTS The Company has agreements with several parties for the use of certain intellectual property in the manufacture of the Company's products, the most significant of which are as follows: Certain technology used in the manufacture of the DNA sequencing instruments and reagents is licensed from Applera Corporation, Applied Biosytems Group (formerly PE Biosystems) (Applera) (see Note 7). The Polymerase Chain Reaction (PCR) is used in most of the kits made by the Company and is produced and sold under license from Roche Molecular Systems, Inc. and F. Hoffman-La Roche, Ltd. The reverse transcriptase enzyme used in the TRUGENE(TM) HIV-1 genotyping kit is Superscript II TM licensed from Invitrogen Corporation (formerly Life Technologies, Inc.). A portion of the method of CLIP(TM) sequencing, which is used in most of the kits made by the Company, is licensed from Genaissance Pharmaceuticals, Inc. Uracil-DNA-glycosylase (UDG) is a method of incorporating deoxyuracil into a PCR product, to control PCR carry-over contamination. At present, none of the Company's products incorporate this technology, however, it is possible that future kits may do so. This method is licensed from Invitrogen Corporation (formerly Life Technologies, Inc.). Under these agreements, the Company is required to make certain up-front payments and certain royalty payments on specified product sales ranging from 0.5% to 25% of covered products. Included in accounts payable is an amount of approximately $605,000 and $642,000, relating to royalties payable at December 31, 2001 and 2000, respectively. DISTRIBUTION AGREEMENTS Commencing in 1999, the Company entered into various distribution and marketing arrangements with distributors to sell the Company's products to the research and clinical diagnostic markets in selected geographic markets outside North America and certain European countries. NOTE 4 - OTHER RECEIVABLES
DECEMBER 31 ----------------------------------------- 2001 2000 --------------- -------------- Refundable taxes.................................. $ 367,962 $ 753,521 Other............................................. 69,926 131,474 --------------- -------------- $ 437,888 $ 884,995 =============== ==============
F-11 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 5 - INVENTORY
DECEMBER 31 ----------------------------------------- 2001 2000 --------------- -------------- Raw materials...................................... $ 939,622 $ 988,927 Work in process.................................... 258,935 149,078 Finished goods..................................... 1,558,393 1,130,872 --------------- -------------- $ 2,756,950 $ 2,268,877 =============== ==============
NOTE 6 - FIXED ASSETS
DECEMBER 31 ----------------------------------------- 2001 2000 --------------- -------------- COST Laboratory and computer equipment............ $ 14,302,970 $ 10,638,719 Equipment on loan to customers............... 3,291,654 1,632,286 Leasehold improvements....................... 11,968,882 4,673,064 --------------- -------------- 29,563,506 16,944,069 --------------- -------------- ACCUMULATED DEPRECIATION AND AMORTIZATION Laboratory and computer equipment............ 7,726,365 5,303,454 Equipment on loan to customers............... 1,764,426 492,592 Leasehold improvements....................... 1,415,720 855,741 --------------- -------------- 10,906,511 6,651,787 --------------- -------------- $ 18,656,995 $ 10,292,282 =============== ==============
NOTE 7 - PATENTS AND LICENSES In April 2000, the Company entered into a worldwide licensing and collaboration agreement with Applera, whereby the Company gained access to certain patents and intellectual property owned by or licensed to Applera. The agreement enables the Company to utilize certain Applera technology to manufacture and sell DNA sequencing instruments, as well as manufacture and sell sequencing kits to run on DNA sequencing instruments manufactured by the Company, Applera and certain other third parties. In addition, Applera may collaborate with the Company to provide access to technology to facilitate the Company's development and commercialization of new diagnostic tests using the licensed technology. In June 2000 and 2001, the Company paid Applera licensing fees of $10 million and $5 million, respectively, and will pay additional licensing fees totaling $10 million over the next two years. The Company is amortizing the cost of the license fee on a straight-line basis over a ten-year period. In 2001 and 2000, amortization expense related to this agreement was $2,500,000 and $1,743,054, respectively, and is included in "sales, general and administrative" expenses in the consolidated statements of operations. In return for access to the Applera technology and customer base the Company also makes royalty payments to Applera based on sales. The Company may terminate the agreement upon 60 days' F-12 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS written notice to Applera and either party may terminate the agreement under certain other limited circumstances. In March 2000, the Company amended a license agreement with Genaissance Pharmaceuticals, Inc. (Genaissance) whereby in exchange for a one-time, up front payment of $2,050,000, the license field was broadened and the royalty paid by the Company to Genaissance on certain sales in the United States was reduced. Such up front payment is being amortized on a straight-line basis over a ten-year period. In 2001 and 2000, the Company recorded $205,000 and $162,565, respectively, in amortization expense related to this agreement and is included in "sales, general and administrative" expenses in the consolidated statements of operations. The Company's investment in patents and licenses is as follows:
DECEMBER 31 ---------------------------------------- 2001 2000 -------------- -------------- COST Patents................................... $ 1,082,166 $ 1,280,479 Licenses.................................. 18,763,408 13,665,283 --------------- -------------- 19,845,574 14,945,762 --------------- -------------- ACCUMULATED AMORTIZATION Patents................................... 291,505 400,391 Licenses.................................. 5,217,630 2,363,259 --------------- -------------- 5,509,135 2,763,650 --------------- -------------- $ 14,336,439 $ 12,182,112 =============== ==============
The net book value of patents and licenses at December 31, 2001 reflects an impairment loss of $51,451 and $13,563 respectively, recorded during the year. The net book value of patents and licenses at December 31, 2000 reflects impairment losses of $100,045 and $42,120, respectively, recorded during the year. These impairment losses were recorded as a result of the Company abandoning certain patents and licensed technologies and such losses are included in "sales, general and administrative" expenses in the consolidated statements of operations. F-13 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 8 - ACCRUED LIABILITIES
DECEMBER 31 ---------------------------------------- 2001 2000 ---- ---- Warranty provision................................ $ 397,256 $ 378,593 Salaries and benefits............................. 879,252 1,849,879 Professional fees................................. 589,748 425,995 Value added taxes................................. 469,285 796,705 Provision for exit costs.......................... 1,462,539 332,650 Grant payable..................................... 262,876 357,132 Inventory and supplies............................ 264,132 473,448 Other............................................. 756,726 651,462 --------------- -------------- $ 5,081,814 $ 5,265,864 =============== ==============
NOTE 9 - MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED SHARES (a) AUTHORIZED AND ISSUED Authorized share capital consists of an unlimited number of preferred shares, which may be issued in one or more series. On July 15, 1999, the Board of Directors authorized the issuance of 33,950 Series A Mandatorily Redeemable Convertible Preferred Shares (Series A Shares), of which 33,948 were issued during 1999. On July 15, 1999, the Company issued 30,000 Series A Shares and warrants to purchase 1,100,000 common shares to certain affiliated funds managed by E.M. Warburg, Pincus & Co., LLC (Warburg Pincus) for net proceeds of $29,219,854. In addition, on July 15, 1999, in connection with the repayment of certain loans with institutional lenders, the Company issued 3,948 Series A Shares and warrants to purchase 147,098 common shares for net proceeds of $3,845,008. The fair market value of the warrants was estimated at the date of grant using the Black-Scholes option valuation model based upon the following assumptions: dividend yield - nil, risk-free interest rate - 5.61%, average expected volatility - 70%, expected term - 4 years. The value of the net proceeds was allocated between warrants and Series A Shares based on the relative fair value of each instrument. The total amount relating to Warburg Pincus, net of issue costs of $780,146 allocated to warrants and Series A Shares was $6,420,672 and $22,799,182, respectively. The total amount relating to the institutional investors, net of issue costs of $102,992 allocated to warrants and Series A Shares was $858,607 and $2,986,401, respectively. The value of the warrants is treated as a discount to the Series A Shares and will be charged directly to retained earnings or, in the absence of retained earnings, against other equity, or in the absence of other equity against deficit, over seven years, the time period when redemption of the Series A Shares first becomes mandatory. F-14 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 9 - CONTINUED (b) RIGHTS AND CONDITIONS OF SERIES A SHAREHOLDERS CONVERSION The Series A Shares are convertible at any time, at the option of the holders, into common shares of the Company. The initial conversion price was $11.00, subject to certain adjustments. As a result of the December 24, 2001, sale of 2,637,890 of the Company's common shares at a price of $8.34 per common share the conversion price of the Series A Shares was adjusted to $10.72. Upon conversion, the holders will also receive common shares at a conversion price of $10.72 per share, equal to the amount of all accrued and unpaid dividends. On March 15, 2001 a holder of 3,948 Series A Shares converted a total of 1,000 of the Series A Shares, plus a total of $139,050 of dividends that accrued on those shares, into 103,550 of the Company's common shares. Upon conversion of the 1,000 Series A Shares, $938,221 attributable to such shares and carried in Mandatorily Redeemable Convertible Preferred Shares on the consolidated balance sheets was transferred to share capital. On September 14, 2000, the Warburg Pincus funds converted a total of 7,795 Series A Shares, plus a total of $701,550 of dividends that accrued on those shares, into 772,411 of the Company's common shares. Upon conversion of the 7,795 Series A Shares, $6,814,550, attributable to such Series A Shares was transferred to share capital on the consolidated balance sheets. As of December 31, 2001, a total of 25,153 Series A Shares remain outstanding and such shares, including dividends accrued on such shares through December 31, 2001, are convertible into 2,901,894 shares of the Company's common shares. The Series A Shares contain provisions under which the conversion price would be further reduced on a weighted average basis if the Company issues shares, options or certain other securities at prices lower than the conversion price (subject to certain exceptions), and will also be adjusted upon the issuance of certain other securities, certain recapitalization events and in certain other circumstances to protect the holders against the dilutive effect of those events. The conversion right will terminate on any redemption of the Series A Shares or any liquidation of the Company. Each Series A Share will automatically convert into common shares at its then effective conversion price, if at least a majority of the Series A Shares are either voted to be converted or have already been converted into common shares. DIVIDENDS Dividends on the Series A Shares accrue quarterly at the rate of 9% per year during the first three years after issuance, and 4% per year thereafter and are compounded annually. Dividends are not payable for the first three years. After three years, at the Company's option, dividends are payable in cash. If dividends are not paid in cash, they will continue to accrue. The Company is prohibited from declaring or issuing any dividends to holders of common shares before paying all unpaid dividends on Series A Shares. The Company is also prohibited from issuing any equity securities that are senior or equal in rank to the Series A Shares without approval of the holders of a majority of such shares. If the Company were to be liquidated or sold or under certain other circumstances, holders of Series A Shares would be entitled to receive an amount equal to $1,000 per share, plus accrued dividends, before holders of common shares would be entitled to any distributions. The dividends will be charged directly to retained earnings, or in the absence of retained earnings, against other equity, or in the absence of other equity, against the deficit. F-15 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 9 - CONTINUED REDEMPTION After the third anniversary and prior to the seventh anniversary of the date of issuance of the Series A Shares, the Company has the right to redeem the outstanding Series A Shares at the redemption price, equal to $1,000 per share, plus accrued but unpaid dividends, subject to certain conditions. The Company will be required to redeem one-third of any remaining outstanding Series A Shares on each of the seventh, eighth and ninth anniversaries of the date of issuance at the redemption price. If the Company fails to redeem the shares as required, holders may appoint a majority of the Board of Directors, who will continue to serve until the Company has redeemed the Series A Shares as required. VOTING The holders of the Series A Shares are entitled to vote as a group with the holders of common shares on all matters, except that holders of the Series A Shares are entitled to vote separately for one director and are not entitled to participate in the vote for any other directors of the Company. On all other matters, each holder of Series A Shares is entitled to the number of votes equal to the number of common shares the holder is entitled to receive upon conversion of the preferred shares. OTHER Certain holders of Series A Shares are also entitled to certain other rights, including the right to participate, on a pro rata basis, in future Company financings, subject to certain exceptions. The right of certain holders of Series A Shares to participate in future offerings in this manner provides those shareholders with the opportunity to avoid having their ownership interest in the Company diluted under certain circumstances when the interest of common shareholders would be diluted. The Company is also prohibited from incurring indebtedness for borrowed money and capital lease obligations in excess of $15,000,000 outstanding at any one time, without first obtaining approval of the holders of a majority of the then outstanding Series A Shares. F-16 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 10 - SHARE CAPITAL (a) AUTHORIZED AND ISSUED SHARE CAPITAL Authorized share capital consists of an unlimited number of common shares, without par value.
NUMBER OF AVERAGE COMMON ISSUE SHARES PRICE AMOUNT ------ ----- ------ BALANCE, DECEMBER 31, 1998.............................. 9,248,233 $ 46,412,685 ========== ============== Issued for cash under stock option arrangements....... 384,217 $ 4.68 1,798,266 Issued upon exercise of warrants...................... 73,665 $ 7.40 545,337 Issued for private placement offering, net of issue costs............................................... 1,916,000 $ 13.92 26,665,782 ---------- -------------- BALANCE, DECEMBER 31, 1999.............................. 11,622,115 75,422,070 ========== ============== Issued for cash under stock option arrangements....... 905,307 $ 7.34 6,646,945 Issued upon exercise of warrants...................... 854,786 $ 7.37 6,299,348 Issued upon conversion of Series A preferred shares... 772,411 $ 8.82 6,814,550 Issued for secondary public offering, net of issue costs............................................... 2,090,000 $ 35.66 74,534,466 ---------- -------------- BALANCE, DECEMBER 31, 2000 ............................. 16,244,619 169,717,379 ========== ============== Issued for cash under stock option arrangements ...... 205,997 $ 13.93 2,869,105 Issued upon exercise of warrants...................... 5,135 $ 9.15 46,995 Issued upon conversion of Series A preferred shares... 103,550 $ 9.06 938,221 Issued for private placement offering, net of issue costs............................................... 2,637,890 $ 8.28 21,837,184 ---------- -------------- BALANCE, DECEMBER 31, 2001.............................. 19,197,191 $ 195,408,884 ========== ==============
On December 24, 2001, the Company completed a private placement of 2,637,890 common shares at a price of $8.34 per share before fees and expenses. On April 5, 2000, the Company completed an underwritten public offering of 2,000,000 common shares at $38.00 per common share, before underwriter's discount, and on May 3, 2000, pursuant to the terms of the underwriting agreement, the Company sold an additional 90,000 common shares, also at a price of $38.00 per common share, to cover the underwriter's over-allotment. VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 10 - CONTINUED (b) OTHER EQUITY
DECEMBER 31 ----------- 2001 2000 1999 ---- ---- ---- Options................................................ $ 322,838 $ 922,714 922,714 Warrants............................................... 3,494,688 3,615,890 9,782,470 Contributed surplus.................................... 61,250 61,250 61,250 Cumulative preferred dividends attributable to Series A Shares...................................... (6,806,046) (4,231,179) (1,400,344) Cumulative accretion of discount attributable to Series A Shares...................................... (2,047,207) (1,195,246) (369,728) Employee share purchase loans.......................... - - (9,034) Cumulative preferred dividends and accretion of discount attributable to preferred stock transferred to deficit............................... 4,974,477 826,571 - ------------- -------------- ---------- $ - $ - 8,987,328 ============= ============== ==========
(c) OPTIONS The Company has incentive plans under which options to purchase common shares may be granted to its employees, consultants or directors at the discretion of the Board of Directors. In addition to the options outstanding, at December 31, 2001, an additional 26,791 options can be granted under the various option plans. Under the plans, each option is for the purchase of one common share, expires up to ten years from the date of issue, and is generally earned over a three to four year period. There are no repurchase features. Certain options issued to employees may be canceled if employment is terminated within three to four years. The number of options that may be canceled is reduced in stages over that period. Options issued to employees after May 1996 must be exercised within 90 days of the termination of employment. On August 21, 2001, the Board of Directors voted to amend the 2000 Employee Share Option Plan (the Plan) to increase the number of options available for grant under the Plan from 1,000,000 to 2,000,000 common shares. Such increase is subject to shareholder approval and is expected to be voted on at the next shareholders' meeting. At December 31, 2001, contingent upon shareholder approval of the increase in the number of options available for grant under the Plan from 1,000,000 to 2,000,000, the Company had granted a total of 216,000 options at a weighed average exercise price of $9.40 per share. Should the shareholders not approve the increase in options available for grant, such options would automatically be canceled. Accordingly, in the following tables such options are not considered to be outstanding. F-18 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 10 - CONTINUED
WEIGHTED AVERAGE NUMBER EXERCISE PRICE ------ -------------- BALANCE, DECEMBER 31, 1998........................ 1,698,051 $ 6.11 ========= ======= Granted at $3.50 to $19.08...................... 1,001,545 $ 11.69 Exercised....................................... (383,749) $ 4.82 Canceled........................................ (170,294) $ 7.51 --------- BALANCE, DECEMBER 31, 1999........................ 2,145,553 $ 8.82 ========= ======= Granted at $3.00 to $53.00...................... 609,054 $ 31.67 Exercised....................................... (904,441) $ 7.50 Canceled........................................ (86,770) $ 5.17 --------- BALANCE, DECEMBER 31, 2000........................ 1,763,396 $ 17.57 ========= ======= Granted at $9.35 to $35.81...................... 673,950 $ 18.60 Exercised....................................... (205,997) $ 9.45 Canceled........................................ (108,873) $ 25.66 --------- BALANCE, DECEMBER 31, 2001........................ 2,122,476 $ 17.83 ========= =======
The fair market value of options granted to directors and employees in 2001 was approximately $7,859,000 (2000 - $13,058,000; 1999 - $6,689,000). If directors' and employee options granted had been recorded at their fair market value, the pro forma net loss attributable to common shareholders in 2001 would have been $(51,540,000) or $(3.13) per share (2000 - $(41,723,000) or $(2.86) per share; 1999 - $(30,533,000) or $(3.08) per share). The fair market value of each option is estimated at the date of grant using the Black-Scholes option valuation model based upon the following assumptions: dividend yield - nil, risk-free interest rate (for four-year zero coupon bond) - 3.5% (2000 and 1999 - 5.5%), average expected volatility - 70% (2000 - 85%; 1999 - 70%), expected average option term - 4 years (2000 - 4.5 years; 1999 - 4 years). The weighted average fair value for options granted in 2001 was $11.66 (2000 - $21.44; 1999 - $6.68). The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's stock option plans have characteristics significantly different from those of traded options, and because change in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. F-19 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 10 - CONTINUED
WEIGHTED NUMBER AVERAGE EXERCISE NUMBER WEIGHTED AVERAGE OUTSTANDING AT PRICE OF WEIGHTED EXERCISABLE AT EXERCISE PRICE RANGE OF DECEMBER 31, OUTSTANDING AVERAGE DECEMBER 31, OF EXERCISABLE EXERCISE PRICES 2001 OPTIONS REMAINING LIFE 2001 OPTIONS --------------- -------------- ---------------- -------------- -------------- ---------------- $.92-$2.36 70,683 $ 1.52 3.21 years 70,683 $ 1.52 $3.50 135,288 $ 3.50 4.39 years 135,288 $ 3.50 $6.07 1,200 $ 6.07 5.64 years 1,200 $ 6.07 $7.12-$7.87 47,002 $ 7.78 6.16 years 47,002 $ 7.78 $8.00-$9.90 214,702 $ 8.99 7.58 years 169,534 $ 8.93 $10.00-$11.50 399,000 $10.92 8.09 years 168,677 $10.91 $11.76-$16.94 439,286 $15.23 8.78 years 115,625 $15.44 $17.00-$20.88 246,945 $18.87 9.20 years 29,896 $18.07 $21.00-$29.94 119,508 $24.28 8.87 years 26,845 $25.21 $30.00-$39.13 333,237 $33.08 8.65 years 135,938 $32.90 $41.00-$44.88 36,625 $43.22 8.68 years 12,015 $43.20 $45.88-$53.00 79,000 $48.90 8.10 years 29,625 $48.90 --------- ------- 2,122,476 942,328 ========= =======
(d) WARRANTS
EXERCISE NUMBER PRICE EXPIRY DATE ------ -------- ----------- BALANCE, DECEMBER 31, 1998.................................. 741,754 ========= Granted in connection with loans ......................... 140,000 $17.00 April, 2006 Granted in connection with Series A Shares (Note 9)....... 1,247,098 $12.60 July, 2003 Exercised................................................. (76,734) $ 6.90 ---------- BALANCE, DECEMBER 31, 1999.................................. 2,052,118 ========== Granted in connection with real estate lease.............. 10,000 $31.88 January, 2010 Exercised................................................. (1,113,069) $12.47 ---------- BALANCE, DECEMBER 31, 2000.................................. 949,049 ========== Adjustment to number of warrants granted in connection with Series A Shares........................ 5,322 $12.16 July, 2003 Exercised................................................. (12,576) $12.81 ---------- BALANCE, DECEMBER 31, 2001 941,795 ==========
As a result of the December 24, 2001, sale of 2,637,890 of the Company's common shares, the number of unexercised warrants granted in connection with the Series A Shares was increased by 5,322 and the exercise price of the 152,420 unexercised warrants granted in connection with the Series A Shares was adjusted to $12.16. F-20 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 10 - CONTINUED On July 9, 2001, warrants to purchase 12,576 common shares were exercised at a price of $12.81 per common share. Under terms of the warrant agreement, the warrant holders elected to pay the exercise price for the warrants through a non-cash exercise. As a result, the warrant holders received 5,135 common shares rather than 12,576 common shares they would otherwise have received upon exercise in cash of all of their warrants. On February 17, 2000, warrants to purchase 1,100,000 common shares were exercised at a price of $12.60 per common share. Under terms of the warrant agreement, the warrant holders elected to pay the exercise price for the warrants through a non-cash exercise. As a result, the warrant holders received 847,749 common shares rather than the 1,100,000 common shares they would otherwise have received upon exercise in cash of all of their warrants. NOTE 11 - EXIT AND TERMINATION COSTS EXIT COSTS In September 2001, the Company acquired the Cambridge, England research laboratory of Virco UK Ltd., together with substantially all the research staff of approximately 25 scientists. The Company paid approximately $830,000 for the laboratory assets and assumed the lease of a 20,000 square foot building, which houses the laboratory. The Cambridge facility is the Company's principal international research facility. During 2001, concurrent with the acquisition of the Cambridge research facility and related staff, the Company approved a plan to close the Company's Toronto, Canada research facility. Also, during 2001, the Company approved a plan to close its Pittsburgh manufacturing facility and move all of its kit manufacturing operations to production lines in the Company's Atlanta facility. As a result of the decisions to close the Toronto research and the Pittsburgh manufacturing facilities certain employees have been or will be terminated and the research and production facilities in Toronto and Pittsburgh will be vacated. Accordingly, during 2001 the Company recorded a charge of $1,180,000 related to the closure of the Toronto research facility and a separate $540,000 charge related to the closure of the Pittsburgh manufacturing facility. Such charges, which are reflected in the consolidated statements of operations in 2001, represent costs related to employee severance, the remaining future lease commitments, net of estimated sub-lease income, the unamortized balance of leasehold improvements, and other estimated costs of closing such facilities. As of December 31, 2001, approximately $608,000 of these costs were paid and the balance is included in accrued liabilities. During 1999, the Company approved a plan to move the sales, marketing and various other functions from Canada to the Company's United States facility in Atlanta. In 2000 these functions were moved to the United States facility. As a result of the decision to centralize United States operations in Atlanta, certain premises leased by the Company were vacated. In December 1999, the Company commenced efforts to sub-lease the premises to be vacated. Accordingly, the Company recorded a charge of approximately $790,000 in the consolidated statements of operations in 1999. This amount represents the remaining future lease commitments, net of estimated sub-lease income, the unamortized balance of leasehold improvements, and other estimated costs of sub-leasing the vacated facilities. All of the vacated facilities were sub-leased during 2000. During 2001 the sub-lessee on one of the facilities that had been sub-leased in 2000 declared bankruptcy and as a result the Company took back the facility and sub-leased the facility to another organization. As a result, during 2001 the Company recorded an additional charge in the consolidated statements of operations of $200,000 to reflect the costs to again sub-lease this facility. F-21 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS TERMINATION COSTS During 1999, two senior officers of the Company received special termination benefits in connection with their departure from the Company. The termination benefits included lump-sum payments and periodic future payments, as specified in the related termination agreements, offered by the Company and accepted by the officers. The present value of the obligations for special termination benefits approximated $539,000, which was included in the consolidated statements of operations in 1999. NOTE 12 - INCOME TAXES The Company's income tax provision has been determined as follows:
YEARS ENDED DECEMBER 31 ------------------------------------------------------------------ 2001 2000 1999 ---- ---- ---- Net loss for the period comprised of Domestic................................. $ (17,862,925) $ (10,170,354) $ (8,081,807) Foreign.................................. (22,790,809) (21,603,782) (17,205,078) ----------------- --------------- ---------------- $ (40,653,734) $ (31,774,136) $ (25,286,885) ================= =============== ================ Income taxes at 41.75% (44%-2000; 44.6%-1999) $ (16,970,901) $ (13,964,733) $ (11,283,008) Decrease resulting from permanent non- tax deductible expense................... 866,623 1,486,785 736,478 Decrease resulting from foreign rate differences.............................. 354,936 649,188 835,867 Net operating loss and temporary differences for which no benefit has been recognized..... 15,749,342 11,828,760 9,710,663 ----------------- --------------- ---------------- $ - $ - $ - ================= =============== ================
As at December 31, 2001, the Company has available losses in various countries that may be used to reduce taxable income in future years, and expire as follows:
OTHER CANADA UNITED STATES NETHERLANDS FRANCE JURISDICTIONS ------ ------------- ----------- ------ ------------- 2002 $ 1,347,000 $ - $ - $ - $ - 2003 2,590,000 - - - - 2004 5,642,000 - - - - 2005 3,366,000 - - 223,000 778,000 2006 3,376,000 - - 1,991,000 541,000 2007 4,476,000 - - - - 2008 8,284,000 - - - - 2010 - - - - 429,000 2011 - - - - 663,000 2012 - 1,238,000 - - - 2018 - 3,962,000 - - - 2019 - 6,514,000 - - - 2020 - 11,913,000 - - - 2021 - 20,609,000 - - - Subsequent to 2021 - - 12,870,000 - 3,365,000 ----------- ------------- ----------- ---------- ---------- TOTAL $29,081,000 $ 44,236,000 $12,870,000 $2,214,000 $5,776,000 =========== ============= =========== ========== ==========
F-22 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 12 - CONTINUED In addition to the Canadian losses above, the Company has certain scientific research and development expenditures eligible for tax purposes incurred by the Company that may also be deferred and deducted in future years. These unclaimed deductions, which can be carried forward indefinitely, amounted to approximately $15,864,500 at December 31, 2001. In addition, the Company has earned non-refundable investment tax credits amounting to approximately $3,756,000 that can be used to reduce future federal income taxes payable. These tax credits expire as follows: 2006 $ 459,000 2007 381,000 2008 452,000 2009 758,000 2010 773,000 2011 933,000 ---------- $3,756,000 ==========
The benefit of these losses, unclaimed deductions and non-refundable investment tax credits has not been reflected in these consolidated financial statements. The deferred tax balances are summarized as follows:
DECEMBER 31, ------------ 2001 2000 ---- ---- DEFERRED TAX ASSETS Research expenses................................. $ 4,778,400 $ 6,989,800 Non-capital losses................................ 34,959,000 20,903,500 Investment tax credits............................ 2,624,700 1,704,300 Fixed assets...................................... 3,116,000 2,414,800 Share issue costs................................. 1,143,200 2,662,900 Warranty and other provisions..................... 1,433,100 537,300 ---------------- ---------------- 48,054,400 35,212,600 Valuation allowance............................... (48,054,400) (35,212,600) ---------------- ---------------- Net deferred tax asset (liability)................ $ - $ - ================ ================
The valuation allowance increased by $12,841,800 during 2001 (2000 - $9,203,900). Realization of the future tax benefits related to the deferred tax assets is dependent upon many factors, including the Company's ability to generate taxable income within the loss carryforward periods. NOTE 13 - SEGMENTED INFORMATION The Company follows SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" with disclosure based upon the internal organization used by management for making operating decisions and assessing performance. SFAS No. 131 also requires disclosures as to products and services, geographic areas and major customers. The Company's reportable segments are Sequencing Systems, Genotyping Kits and Other Consumables, and Testing Services. The accounting F-23 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 13 - CONTINUED policies of the segments are the same as those described above in Note 2, "Summary of significant accounting policies."
2001 GENOTYPING KITS SEQUENCING AND OTHER TESTING RECONCILING SYSTEMS CONSUMABLES SERVICES ITEMS TOTAL ---------- -------------- -------- ----------- ----- Revenues.................... $ 2,667,994 $ 10,662,352 $ 249,568 $ - $ 13,579,914 Depreciation and amortization.............. (1,932,063) (5,151,120) (703,580) - (7,786,763) Loss from operations before interest........... (8,714,785) (34,316,948) (127,296) - (43,159,029) Additions to fixed assets... 568,102 12,483,334 140,601 - 13,192,037 Total assets................ 3,049,353 35,717,218 1,407,653 53,194,851(1) 93,369,075 2000 GENOTYPING KITS SEQUENCING AND OTHER TESTING RECONCILING SYSTEMS CONSUMABLES SERVICES ITEMS TOTAL ---------- --------------- -------- ----------- ----- Revenues.................... $ 4,522,661 $ 8,137,122 $ 412,780 $ - $ 13,072,563 Depreciation and amortization.............. (1,512,839) (3,507,732) (411,398) - (5,431,969) Loss from operations before interest........... (12,023,931) (24,089,606) (124,652) - (36,238,189) Additions to fixed assets... 2,079,845 5,543,748 1,645,452 - 9,269,045 Total assets................ 3,254,096 24,356,264 2,166,347 80,398,990(1) 110,175,697 1999 GENOTYPING KITS SEQUENCING AND OTHER TESTING RECONCILING SYSTEMS CONSUMABLES SERVICES ITEMS TOTAL ---------- ----------- -------- ----------- ----- Revenues.................... $ 7,725,910 $ 4,729,865 $ 1,171,145 $ - $ 13,626,920 Depreciation and amortization.............. (1,184,981) (999,571) (383,398) - (2,567,950) Profit (loss) from operations before interest................. (13,889,277) (10,099,584) 4,939 - (23,983,922) Additions to fixed assets... 697,030 849,144 372,918 - 1,919,092 Total assets................ 7,466,062 6,724,730 1,760,794 42,687,963(1) 58,639,549
Reconciling items consist of: (1) Cash, cash equivalents and short-term investments F-24 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 13 - CONTINUED
GEOGRAPHIC INFORMATION REVENUES, BY CUSTOMER LOCATION YEARS ENDED DECEMBER 31 ------------------------------ -------------------------------------------------------------- 2001 2000 1999 ---- ---- ---- Canada $ 357,495 $ 822,568 $ 468,535 United States 6,239,804 5,798,864 4,686,868 ------------- ------------ ------------ North America 6,597,299 6,621,432 5,155,403 ------------- ------------ ------------ France 855,379 760,742 1,252,222 Italy 1,295,486 839,243 602,484 Other Europe 3,217,229 3,371,016 3,696,261 ------------- ------------ ------------ Europe 5,368,094 4,971,001 5,550,967 ------------- ------------ ------------ Japan 1,195,099 927,644 1,609,799 Other Asia and Latin America 419,422 552,486 1,310,751 ------------- ------------ ------------ Asia and Latin America 1,614,521 1,480,130 2,920,550 ------------- ------------ ------------ $ 13,579,914 $ 13,072,563 $ 13,626,920 ============= ============ ============ GEOGRAPHIC INFORMATION FIXED ASSETS DECEMBER 31 ------------ -------------------------------------------------------------- 2001 2000 1999 ---- ---- ---- Canada $ 1,790,281 $ 2,614,017 $ 2,530,222 United States 14,710,160 6,486,653 955,161 Europe 2,156,554 1,191,612 687,952 ------------- ------------ ----------- $ 18,656,995 $ 10,292,282 $ 4,173,335 ============= =========== ============
In 2001, one customer accounted for 9% of sales, of which 8% comprised Sequencing Systems and 1% comprised Genotyping Kits and Other Consumables. (2000 - one customer accounted for 11% of sales, of which 10% comprised Sequencing Systems and 1% comprised Genotyping Kits and Other Consumables; 1999 - one customer accounted for 21% of sales, of which 19% comprised Sequencing Systems and 2% comprised Genotyping Kits and Other Consumables). F-25 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 14 - COMMITMENTS AND CONTINGENCIES COMMITMENTS The Company is committed to make payments under a license agreement of $5,000,000 per year in each of the years 2002 and 2003. The Company has collaborative arrangements with certain third parties that provide for royalty payments (see Note 3). The Company has entered into operating leases for premises and equipment as follows: 2002 $ 1,803,010 2003 1,030,443 2004 926,480 2005 1,077,553 2006 and thereafter 6,088,748 ----------------- $ 10,926,234 =================
Rent expense was $2,329,495 in 2001 (2000 - $1,768,346; 1999 - $851,876). CONTINGENCIES During 2000 and 2001 the Company sub-leased certain facilities it had vacated (see Note 11). In the event of default by the sub-lessees the Company remains contingently liable for remaining future lease commitments of approximately $1,568,000 related to these sub-leases. In September 2001, a lawsuit was filed in the United States District Court for the Northern District of California against the Company by The Board of Trustees of the Leland Stanford Junior University claiming that the Company's TRUGENE HIV-1 Genotyping Kit infringes patents owned by the university. The Company has received an attorney opinion that it does not infringe any claim of the patents-in-suit. No amount has been provided in these consolidated financial statements in respect of these allegations, as the amount of loss, if any, cannot be determined and the results of such allegations cannot be predicted with certainty. NOTE 15 - RELATED PARTY TRANSACTIONS During 2001, the Company incurred consulting fees to a director of the Company in the amount of $13,283 (2000 and 1999 - nil). During 2000, the Company incurred consulting fees to a firm, of which the president was a director of the Company, in the amount of $64,487 (1999 - $291,115). During 2000, the Company incurred legal fees to a law firm, in which a partner was a former director of the Company, in the amount of $10,939 (2001 - nil; 1999 - $246,210). During 2000, the Company also incurred consulting fees to a former director of the Company, in the amount of $28,250 (2001 - nil; 1999 - $58,269). NOTE 16 - COMPARATIVE FIGURES Certain comparative figures have been reclassified to conform to the financial statement presentation adopted in the current year. F-26 VISIBLE GENETICS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 17 - SUBSEQUENT EVENT On February 27, 2002, the Company received notice of a lawsuit that has been filed in Milan, Italy against Visible Genetics Inc. and two of the Company's wholly-owned subsidiaries by Nuclear Laser Medicine Srl. The lawsuit seeks unspecified damages and specific performance relating to an alleged distribution agreement pertaining to the Company's Hepatitis C and HIV products in Italy. No amount has been provided in these consolidated financial statements in respect of these allegations, as the amount of loss, if any, cannot be determined and the results of such allegations cannot be predicted with certainty. F-27 EXHIBIT INDEX
EXHIBITS NUMBER DESCRIPTION OF DOCUMENT PAGE ------ ----------------------- ---- 8 See Item 4. Information on the Company-Organizational Structure 10.27 Common Shares Purchase Agreement, dated December 24, 2001, by and among Visible Genetics Inc. and the Investors who are signatories thereto. 10.28 Registration Rights Agreement, dated December 24, 2001, by and among Visible Genetics Inc. and the Investors who are signatories thereto. 10.29 Amended and Restated Employment Agreement, dated as of February 1, 2002, among Visible Genetics Corporation, Visible Genetics Inc. and Richard T. Daly. 10.30 Amended and Restated Employment Agreement, dated as of February 1, 2002, among Visible Genetics Inc., Visible Genetics UK Ltd. and Arthur Cole. 10.31 Employment Agreement, dated as of February 1, 2002, among Visible Genetics Inc., Visible Genetics Corporation and Thomas J. Clarke. 10.32 Employment Agreement, dated as of February 1, 2002, among Visible Genetics Inc., Visible Genetics Corporation and Tim Ellis. 10.33 Employment Agreement, dated as of February 1, 2002, between Visible Genetics Inc. and Marguerite Ethier. 10.34 Service Agreement, dated December 15, 2001, between Visible Genetics UK Ltd. and Brendan Larder. 10.35 Deed, dated September 12, 2001, by and among Visible Genetics Inc., Visible Genetics UK Ltd., Virco U.K. Limited and Tibotec-Virco N.V. 10.36 Licence to Assign, dated October 10, 2001, by and among Visible Genetics Inc., Visible Genetics UK Ltd., Virco UK Limited and The Master Fellows and Scholars of Trinity College Cambridge, including that certain Lease, dated January 19, 1999, by and among The Master Fellows and Scholars of Trinity College Cambridge, Virco U.K. Limited and Virco NV, attached as Schedule A thereto.