-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, HpYNYOFAyJBD9P/44Q51doG98fUpAlfLK2kqORaIlTexy9ojqdjXpAx2+zGxVyVK CUc5uVNxK84HyN7V99DeuQ== 0001072613-07-002313.txt : 20071005 0001072613-07-002313.hdr.sgml : 20071005 20071005164446 ACCESSION NUMBER: 0001072613-07-002313 CONFORMED SUBMISSION TYPE: 10KSB PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 20070630 FILED AS OF DATE: 20071005 DATE AS OF CHANGE: 20071005 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PACIFIC BIOMETRICS INC CENTRAL INDEX KEY: 0001020475 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-COMMERCIAL PHYSICAL & BIOLOGICAL RESEARCH [8731] IRS NUMBER: 931211114 STATE OF INCORPORATION: DE FISCAL YEAR END: 0630 FILING VALUES: FORM TYPE: 10KSB SEC ACT: 1934 Act SEC FILE NUMBER: 000-21537 FILM NUMBER: 071159882 BUSINESS ADDRESS: STREET 1: 220 WEST STREET 2: HARRISON STREET CITY: SEATTLE STATE: WA ZIP: 98119 BUSINESS PHONE: 2062980068 10KSB 1 form10ksb_15449.txt FORM 10-KSB FOR 6-30-07 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-KSB [X] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended June 30, 2007 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________ to __________ Commission File Number 0-21537 PACIFIC BIOMETRICS, INC. - -------------------------------------------------------------------------------- (Name of small business issuer in its charter) DELAWARE 93-1211114 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 220 WEST HARRISON STREET SEATTLE, WASHINGTON 98119 ---------------------------------------- (Address of principal executive offices) (206) 298-0068 --------------------------- (Issuer's telephone number) Securities registered under Section 12(b) of the Exchange Act: (none) Securities registered under Section 12(g) of the Exchange Act: COMMON STOCK, $0.01 PAR VALUE PER SHARE Check whether the issuer is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act. [ ] Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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. [X] Yes [ ] No Check if no disclosure of delinquent filers in response to Item 405 of Regulation S-B is contained in this form, and no disclosure will be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). [ ] Yes [X] No Issuer's revenue for its most recent fiscal year: $8,480,330 As of September 28, 2007, there were 18,720,147 shares of the Company's common stock issued and outstanding, and the aggregate market value of the shares of common stock held by non-affiliates was approximately $12,513,843, based on the average bid and ask price of $0.70 of such stock on that date. DOCUMENTS INCORPORATED BY REFERENCE: The Company's definitive proxy statement for the annual meeting of stockholders for fiscal year ended June 30, 2007, which will be filed with the Securities and Exchange Commission within 120 days after the close of the fiscal year 2007, is incorporated by reference in Part III hereof. Transitional Small Business Disclosure Format (Check one): Yes [ ] No [X] ================================================================================ PACIFIC BIOMETRICS, INC. Form 10-KSB Annual Report Table of Contents Page ---- PART I Item 1. Description of Business...........................................2 Item 2. Description of Property..........................................21 Item 3. Legal Proceedings................................................22 Item 4. Submission of Matters to a Vote of Security Holders..............22 PART II Item 5. Market for Common Equity, Related Stockholder Matters and Small Business Issuer Purchases of Equity Securities.............22 Item 6. Management's Discussion and Analysis or Plan of Operations.......23 Item 7. Financial Statements.............................................31 Item 8. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.........................................31 Item 8A. Controls and Procedures..........................................31 Item 8B. Other Information................................................32 PART III Item 9. Directors, Executive Officers, Promoters, Control Persons and Corporate Governance; Compliance with Section 16(a) of the Exchange Act..............................................32 Item 10. Executive Compensation...........................................35 Item 11. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.......................39 Item 12.** Certain Relationships and Related Transactions and Director Independence............................................41 Item 13. Exhibits.........................................................41 Item 14.** Principal Accountant Fees and Services...........................43 SIGNATURES...................................................................44 ** Information contained in Items 12 and 14 of Part III is incorporated by reference from the definitive proxy statement for our 2007 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission within 120 days after the close of the 2007 fiscal year. -i- CAUTIONARY NOTICE REGARDING FORWARD LOOKING STATEMENTS This Annual Report on Form 10-KSB contains certain forward-looking statements, including statements about o our existing working capital and cash flows and whether and how long these funds will be sufficient to fund our operations, o the success of our business development efforts and our ability to enter into work orders for laboratory services and generate revenue, o the development of new services and products and the expansion of the market for our current services and products, o implementing aspects of our business plan and strategies, o financing goals and plans, and o our raising of additional capital through future equity and debt financings. The forward-looking statements in this Annual Report reflect management's current views and expectations with respect to our business, strategies, products, future results and events and financial performance. All statements other than statements of historical fact, including future results of operations or financial position, made in this Annual Report on Form 10-KSB are forward looking. In particular, the words "believe," "expect," "intend," "anticipate," "estimate," "desire," "goal," "may," "will," variations of such words, and similar expressions identify forward-looking statements, but are not the exclusive means of identifying such statements and their absence does not mean that the statement is not forward-looking. These forward-looking statements are subject to certain risks and uncertainties, including those discussed below. Our actual results, performance or achievements could differ materially from historical results as well as those expressed in, anticipated or implied by these forward-looking statements. We do not undertake any obligation to revise these forward-looking statements to reflect any future events or circumstances. For a discussion of some of the factors that may affect our business, results and prospects, see "ITEM 1. - DESCRIPTION OF BUSINESS - Risk Factors Affecting the Business of the Company" beginning on page 11. Readers are urged to carefully review and consider the various disclosures made by us in this Report and in our other reports previously filed with the Securities and Exchange Commission, including our periodic reports on Forms 10-KSB, 10-QSB and 8-K, and those described from time to time in our press releases and other communications, which attempt to advise interested parties of the risks and factors that may affect our business, prospects and results of operations. -1- PART I ITEM 1. DESCRIPTION OF BUSINESS. GENERAL We provide specialty central laboratory services to support pharmaceutical and laboratory diagnostic manufacturers in the conduct of human clinical research, for use in their drug and diagnostic product development efforts. Our clients include a number of the world's largest multi-national pharmaceutical, biotechnology and diagnostic companies. Our well-recognized specialty areas include cardiovascular disease (dyslipidemia, atherosclerosis, and coronary heart disease), diabetes (and obesity), and bone and joint diseases (osteoporosis as well as osteo and rheumatoid arthritis). Coupled with our specialty testing, we also have central laboratory capability and provide full-service central laboratory support for multi-center clinical trials, including routine safety lab tests (general chemistry, hematology, and urinalysis). Our company is a Delaware corporation, incorporated in May 1996, and we conduct our operations primarily through our wholly-owned subsidiary, Pacific Biometrics, Inc., a Washington corporation. BUSINESS STRATEGY Specialty reference and central laboratory service companies like ours typically derive substantially all of their revenue from the research, development and marketing expenditures of the pharmaceutical, biotechnology, and diagnostic industries. Participants in the pharmaceutical, biotechnology, and diagnostic industries typically outsource a significant quantity of these services to both central labs and specialty reference labs. In addition, central laboratories outsource to specialty reference labs some of the specialty testing where the central laboratory lacks expertise. We believe that such outsourcing will continue and may increase in the future because of many factors, including continuing pressures on the pharmaceutical and biotechnology industries to contain costs, limitations on pharmaceutical companies' internal capacity, a need for faster development time for new drugs, research in multiple countries simultaneously, stringent government regulation, and the difficulty in developing expertise in specialty testing areas internally within pharmaceutical companies or central labs. We believe the investment and amount of time required to develop new drugs and diagnostic products has been increasing, and that these trends create opportunities for companies like ours to provide our expertise and services to help reduce the time in the drug development and laboratory diagnostic product development processes and make the processes more efficient. Our strategy is to meet the needs for outsourcing by pharmaceutical, biotechnology, and diagnostic companies and other central laboratories, and to assist in enhancing the drug and diagnostic development processes by developing and delivering innovative services that apply science and technology in the provision of high quality service within our areas of specialty. Our primary business strategy is to continue our focus on providing high quality specialty central laboratory services in our core areas, including cardiovascular disease and bone and joint diseases because of active drug development activities. In addition, we also intend to pursue other strategies identified below to further our business. However, because of the significant expense associated with some of these strategies, we may not pursue some of these strategies unless our revenue increases significantly or we are able to raise equity or debt financing to adequately fund these strategies. There can be no assurance that we will pursue any or all of the strategies below or, if pursued, that any of such strategies will be successful. DIVERSIFY CLIENT BASE We have a goal to continue to diversify our client base, both in terms of the number of clients and the number of contracts within any particular client. In fiscal 2005 we adopted a new corporate visual identity and are using this to integrate all of our marketing efforts and advertising. We have also increased our visibility at industry trade shows and in industry publications through print advertisements and publicity campaigns. Historically, our largest two clients in any individual fiscal year have represented in excess of 50% of our revenue. This trend did not continue in the fiscal year ended June 30, 2007, in which our top two clients represented 33% of our revenue compared to 50% during the fiscal year ended June 30, 2006. As a result of ongoing business development and client diversification efforts, we have added 12 new clients to our client base during the fiscal year ended June 30, 2007, compared to 10 -2- new clients in fiscal 2006, and we continue to diversify the total number and types of study contracts. During fiscal 2007, the Company held a total of 100 active contracts, compared to 76 active contracts in fiscal 2006, a 32% increase. Management believes, therefore, that as a result of these continuing business development activities, we will incrementally diversify our client base and spread our revenues across a larger number of clients and a larger number of individual study contracts. Despite our efforts to expand our client base, a substantial portion of our revenues are generated through five large clients. Revenue from our five largest clients represented approximately 65% and 74% of total revenue in fiscal 2007 and 2006, respectively. Our largest client in fiscal 2007 individually accounted for approximately 17% of our total revenue in fiscal 2007, while our largest client in fiscal 2006 accounted for approximately 36% of our total revenue in fiscal 2006. While on the one hand this reflects an improvement in terms of decreasing our revenue reliance on a single client, on the other hand it is important to note that our largest client in fiscal 2007 was not our largest client in fiscal 2006, which illustrates the risk of significant revenue variability that we face in our marketplace. Because our revenue has historically been concentrated in one or two large clients, we can be materially adversely impacted by any delays in undertaking clinical studies or submitting samples for testing services, including any early termination or reductions in work orders or clinical studies, or any decreases in the volume or timing of new work orders. In fiscal 2008 we will continue to actively pursue business development and marketing activities to broaden our client and revenue base. INCREASE SPECIALTY AREAS In addition to our core specialties of cardiovascular disease and bone and joint diseases, our goal is to further expand our specialty laboratory expertise within related areas where we have a competitive advantage of existing in-depth expertise. This includes diabetes, obesity, metabolic syndrome, rheumatoid and osteo arthritis, and related inflammatory diseases. GLOBAL CENTRAL LABORATORY CAPABILITY We believe that in the central laboratory services business it is important to provide a broad geographic base as most clinical drug development programs are global. Through partnering with Quintiles Transnational Corp., a major central laboratory with a large established client base and existing infrastructure for managing clinical studies globally, we believe that we can compete with other central laboratories that have offices, monitoring sites and laboratories in many countries around the globe. In fiscal 2007 we realized significant financial benefit from our relationship with Quintiles, a trend we expect to continue during fiscal 2008; although there is no guarantee that the relationship will generate revenues consistently going forward. In fiscal 2008 we expect to build on this relationship by expanding joint business development efforts and implementing operational integration in certain areas that will lead to streamlined services. We believe that this joint marketing relationship can provide a unique advantage of combining both scope and depth in quality specialty testing service. ACQUISITIONS AND STRATEGIC RELATIONSHIPS Our clients and our competitors have experienced significant consolidation over the last several years and we expect that trend to continue. The uncertainty caused by the consolidation trend may result in other companies in the industry seeking to form strategic relationships or joint ventures or to be acquired in order to stay competitive. This may make it possible for us to make strategic acquisitions that are complementary to our existing services and that expand our ability to serve our clients. We are also exploring other strategic alternatives for our business and operations, which may include joint ventures, co-marketing relationships, or other strategic relationships especially with diagnostic companies with emerging or proprietary technologies. Additionally, we will evaluate, as appropriate, any potential business combinations involving our company as a whole, or involving a portion of our assets. UPGRADING INFORMATION TECHNOLOGY AND BACK-UP SYSTEMS We are currently focusing a significant portion of our capital expenditures and investments in carefully selected hardware and software products, information technology systems and networks. During fiscal 2007, we invested in our laboratory information system, including the initial phase implementation of the Clinaxys II Laboratory -3- Information System. The installation of this new system should streamline and improve our project and data management capabilities. In fiscal 2008, we expect to complete the Clinaxys II Laboratory Information System implementation and will continue to invest in the improvement of our information systems. We believe capital improvements in these areas are important to meet the changing demands of drug development by improving and facilitating our data reporting, testing data capacity and efficiency and the overall service to and communications with our clients. In fiscal 2006 we acquired and have begun to use a back-up electrical generator to provide our clients with the confidence that we can minimize the impact of local power outages. SERVICES SPECIALTY REFERENCE LABORATORY SERVICES Our specialty reference laboratory in Seattle, Washington has established itself as a technical leader due to our strong expertise in certain core areas. Our three general areas of expertise include: o cardiovascular disease (dyslipidemia, atherosclerosis, and coronary heart disease), o diabetes, metabolic syndrome, and obesity, and o bone and joint diseases (osteoporosis as well as osteo and rheumatoid arthritis). Management believes that among prospective new drugs, these areas of expertise represent three of the top ten areas of focus by the pharmaceutical industry. With respect to cardiovascular disease, we are one of the leaders in lipid services for clinical drug development in the U.S. Our expertise is concentrated on the measurement of cardiovascular disease markers, especially cholesterol and lipoproteins, including HDL, LDL, HDL and LDL subfractions, remnant cholesterol, apolipoproteins, Lp(a), and lipoprotein fraction compositions. Furthermore, the Pacific Biometrics Research Foundation, a non-profit organization affiliated and co-located with PBI, is one of only three U.S. standardization centers in the Cholesterol Reference Method Laboratory Network sponsored by the Centers for Disease Control and the National Heart, Blood & Lung Institute. There are only ten such laboratories worldwide. We are enhancing our activities in the area of diabetes and related disorders, notably obesity and metabolic syndrome. Metabolic syndrome is a collection of abnormalities that include central obesity, dyslipidemia (low HDL cholesterol and high triglycerides), insulin resistance, pre-diabetes and pre-hypertension. In the U.S. the prevalence of metabolic syndrome is estimated at 47 million individuals (Heart Disease and Stroke Statistics - 2006 Update, American Heart Association). People with metabolic syndrome are at increased risk for cardiovascular disease and associated morbidity and mortality and as a result, this population is coming under increased scrutiny for pharmacological intervention. Because of our established strengths in testing for lipids, cardiovascular risk and diabetes, we believe we are well-positioned to take advantage of this emerging area of pharmaceutical drug development. Moreover, we are expanding our test menu in areas related to diabetes and metabolic syndrome, notably in testing for markers of inflammation. We are active in promoting the standardization of bone metabolism biomarkers, and are involved in technologies for monitoring treatment response in diseases such as osteoporosis. We have used our expertise in osteoporosis-indicating bone-biomarker assays to manage the first proficiency-testing programs for bone-resorption markers. In the areas of bone metabolism and women's health, we also specialize in the measurement of hormones, and our menu of biochemical markers includes pyridinolines, various C- and N- terminal telopeptides, procollagens, osteocalcin and bone-specific alkaline phosphatase. Moreover, in recent years we have actively expanded our test menu to include biochemical markers of cartilage turnover as relating to drug development for arthritis, and we have performed specialty testing to support clinical drug development of drugs for rheumatoid arthritis and osteoarthritis. In connection with these stated areas of expertise, we offer a variety of services through our specialty reference laboratory, including o clinical study testing services, -4- o development of laboratory reference methods, o development of clinical trial protocols, and o contract research and development. Our involvement with clients frequently begins at the protocol design stage. Clinical trial support includes coordinating the collection and receipt of specimens from investigative sites, processing the samples, generating test databases and reporting the consolidated data to study sites and sponsors. The extensive knowledge we have in test development and our close collaboration with diagnostic manufacturers, frequently allow us to offer novel tests to our clinical research clients before such tests are commercially available. CENTRAL LABORATORY SERVICES Coupled with our expertise in specialty testing we also provide central laboratory services. The full-service central laboratory support for multi-center clinical trials includes project management and routine safety lab tests (general chemistry, hematology and urinalysis). Our operations support clinical trials by producing study-specific specimen collection supplies, coordinating collection and the receipt of specimens from clinical sites, processing the samples, generating test databases, and reporting data to sites and sponsors. We generally provide full-service central laboratory services in support of Phase I and Phase II FDA clinical trials. These trials are typically smaller and more geographically focused than Phase III trials. Through our joint marketing relationship with Quintiles Laboratories in providing centralized specialty lab testing services, we intend to compete with other central laboratories that have offices, monitoring sites and laboratories in countries around the globe, both for Phase I and Phase II trials, as well as Phase III and Phase IV trials. In fiscal 2007, we expect to build on this relationship with Quintiles by expanding joint business development efforts and implementing operational integration in certain areas that will lead to streamlined services. In fiscal 2006, we did not realize significant financial benefit from our relationship with Quintiles and there is no guarantee that the relationship will successfully generate expected revenue. TECHNOLOGIES AND PRODUCTS During fiscal 2004, we formed a new wholly owned subsidiary, PBI Technology, Inc., for the purpose of holding, developing and seeking commercialization of certain of our technologies and intellectual property portfolio, including our isothermal DNA amplification method (LIDA), our Cell Viability technology, and our Osteopatch(TM) and Saliva Sac(R) diagnostic devices. These technologies are described in more detail below. MOLECULAR TECHNOLOGIES PBI Technology owns DNA-based proprietary technologies, processes and equipment. This novel intellectual property (patented and patent-pending) includes a proprietary isothermal DNA amplification method (LIDA) and a genetic method for distinguishing live from dead cells (Cell Viability). During fiscal 2007, we ceased further research and development expenditures on these assets. As of June 30, 2007, these technology assets still require additional development prior to commercialization and their future value, as well as timing of their ongoing development, is dependent upon additional capital being available to fund continuing research and development. We expect to need additional capital to fund continuing research and development efforts related to these technologies, and there are no assurances that such funds will be available to us. We are actively seeking commercial partners interested in co-development or licensing of our technologies. If we are unable to find commercial partners or to obtain suitable financing to continue research and development efforts, commence the regulatory approval process (where applicable) and commercialization of the technologies, we are unlikely to continue pursuing development efforts related to these technologies. While we intend to continue to pursue development efforts, partnership, licensing or other means to realize the value of these intangible assets, in fiscal 2004 we determined that the value of these assets may not be recoverable over their remaining useful lives and that the value of these assets should be written off on our financial statements. Accordingly, we wrote off the entire balance ($476,874) of technology assets as of June 30, 2004. -5- Although we believe these technologies are valuable assets, we may not be able to successfully develop these technologies and they may not generate revenue. In addition, even if we are ultimately successful in developing products from these technologies, some of those products would likely be subject to regulatory approval, and could always be the subject of litigation or other claims from competitors or others with respect to such products or the patents and methodologies upon which they are based. DIAGNOSTIC DEVICE TECHNOLOGIES During the 1990's, we developed an intellectual property position in sweat and saliva collection technologies. In 1998, due to lack of funding and our failure to obtain FDA approval for resultant products, we suspended all further development efforts relating to these technologies and products. We subsequently wrote off the value of these assets on our balance sheet in 1999. We believe there may be potential commercial application for some of these technologies, and we have recently engaged outside consultants to resume business development efforts related to the saliva and sweat collection technologies. OTHER INTELLECTUAL PROPERTY In addition to the patented technologies, we have developed certain computer software and internal procedures and products intended to enhance the quality and effectiveness of our services. Although our intellectual property rights are important to our results of operations, we believe that such factors as the technical expertise, knowledge, ability and experience of our laboratory professionals are more important, and that, overall, these technological capabilities provide significant benefits to our clients. CLIENTS / MARKETING We provide specialty reference and central laboratory services to, among others, the pharmaceutical, biotechnology, and laboratory diagnostic industries. We also act as a subcontractor for large central laboratories for our specialty reference laboratory services. In fiscal years 2007 and 2006, our clients included companies ranging from the world's largest pharmaceutical companies and biotechnology companies to small and start-up organizations. Historically, our largest two clients in any individual fiscal year have represented in excess of 50% of our revenue. During the fiscal year ended June 30, 2007, our top two clients represented 33% of our revenue as compared to 50% during the fiscal year ended June 30, 2006. Our largest client in fiscal 2007 individually accounted for approximately 17% of our total revenue in fiscal 2007, while our largest client in fiscal 2006 accounted for approximately 36% of our total revenue in fiscal 2006. Revenue from our five largest clients represented approximately 65% and 74% of total revenue in fiscal 2007 and 2006, respectively. Our scientific expertise is an integral and interrelated part of our marketing and sales process. Our Chief Scientific Officer and our Chief Medical Officer are directly involved in sales and marketing through company capability and scientific presentations as well as consultation with pharmaceutical clinical teams beginning at the protocol design stage. Our extensive knowledge in test development and our close collaboration with diagnostic manufacturers frequently allow us to offer novel tests to our clinical research clients before such tests are commercially available. Additionally, our affiliation with the Centers for Disease Control through Pacific Biometrics Research Foundation, which allows us to participate in the development of reference methods, creates further expertise that we can bring to bear on our clients' testing needs. By marketing and selling our expertise, we believe we have a competitive advantage over our competitors. CONTRACTUAL ARRANGEMENTS Our contracts with clients are, for the most part, either fixed price or fee-for-service with a cap. To a lesser extent, contracts are fee-for-service without a cap. In cases where the contracts are fixed price, we generally bear the cost of overruns, but we benefit if the costs are lower than we anticipated. In cases where our contracts are fee-for-service with a cap, the contracts contain an overall budget for the trial based on time and cost estimates. If our costs are lower than anticipated, the client generally benefits from the savings. If our costs are higher than estimated, we bear the responsibility for the overrun unless the increased cost is a result of a change requested by the client, such as an increase in the number of patients to be enrolled or the type or amount of data to be collected. Contracts may -6- range from a few months to several years depending on the nature of the work performed. For most contracts, a portion of the contract fee is paid at the time the study or trial is started with the balance of the contract fee payable in installments upon the progress of the work completed or achievement of milestones over the study or trial duration. We recognize revenue in the period that we perform the related services. As of June 30, 2007, we have master contract service agreements with ten of our largest clients. Under these master service agreements, we perform laboratory research services based on work orders submitted to us by the client. There is no guaranteed minimum number of work orders or revenue to us under either agreement. Each work order is separately negotiated with the client and is usually limited to a specific project with limited duration. Most of our contracts may be terminated at any time by the client either immediately or upon notice. Our contracts typically entitle us to receive payment for services performed by us up to the time of termination and reimbursement for out-of-pocket costs incurred prior to termination. In certain limited instances, our contracts also entitle us to a termination fee or payment for the costs of winding down the terminated projects. Most of our contracts also provide for the client to indemnify us for any third party damages and claims arising from our providing services under the contract. The typical exception to this is that no indemnification will be provided if the damage or claim results from our negligence or intentional misconduct. For the fiscal year ended June 30, 2007, Fixed Price Contracts amounted to 94% of revenue or $7,973,428; Contracts Priced as Fee-For-Service with a Cap amounted to 3% of revenue or $225,976; Contracts Priced as Fee-For-Service without a Cap amounted to 3% of revenue or $280,926. For the fiscal year ended June 30, 2006, Fixed Price Contracts amounted to 77% of revenue or $8,267,604; Contracts Priced as Fee-For-Service with a Cap amounted to 2% of revenue or $177,375; Contracts Priced as Fee-For-Service without a Cap amounted to 21% of revenue or $2,305,044. COMPETITION The specialty reference and central laboratory services industries have many participants ranging from small, limited-service providers to a limited number of full-service laboratories with global capabilities. For specialty reference laboratory services in our areas of expertise, we primarily compete against other full-service and limited service specialty and central laboratory services organizations and, to a lesser extent, laboratories in academic centers. Many of these organizations have significantly greater resources than we do with somewhat different focus and business targets. Our significant competitors in specialty reference laboratory services include Synarc, Inc., MRL/PPD, MedPace, NW Lipid Laboratory, Esoterix Inc., Linco Diagnostics, Liposcience, Atherotech, ARUP, and the Mayo Clinic. In the full-service central laboratory service area, we primarily compete with much larger full-service central laboratories with significantly greater resources than we do and many have international operations. Our significant competitors in central laboratory services include Covance Central Laboratory Services, Inc., ICON Laboratories, Quintiles Transnational Corp., CRL - Medinet, MDS Inc. and Quest Diagnostics Incorporated, and Lab Corp among others. In fiscal 2005 we entered into a joint marketing arrangement with Quintiles Transnational Corp., a major central laboratory with a large established client base and existing infrastructure for managing clinical studies globally, and through this relationship we believe that we can compete with other central laboratories that have offices, monitoring sites and laboratories in many countries around the globe. In fiscal 2007 we realized significant financial benefit from our relationship with Quintiles, a trend we expect to continue during fiscal 2008; although there is no guarantee that the relationship will generate revenues consistently going forward. There is significant competition for clients on the basis of many factors for both specialty reference and full-service central laboratory services, including o technological expertise and efficient drug development processes, o financial stability, o reputation for on-time quality performance, o strengths in various geographic markets and global reach, -7- o ability to manage large-scale clinical trials both domestically and internationally, o expertise and experience in specific areas, o scope of service offerings, o price, o ability to acquire, process, analyze and report data in a timely and accurate manner, o size, and o expertise and experience in health economics and outcomes services. While size and global reach are more important competitive factors in the central laboratory services business, we believe that technological expertise is more important for specialty reference laboratory services. Except as to size and international capacity, where we know certain other competitors have an advantage, we believe we compete very favorably in a majority of these areas, particularly with respect to our technical expertise in our three specialty areas. GOVERNMENT REGULATION Our laboratory services are subject to various regulatory requirements designed to ensure the quality and integrity of our laboratory testing in support of clinical trials. The industry standards for conducting clinical laboratory testing are embodied in the Clinical Laboratory Improvement Amendments of 1988 ("CLIA"). As a medical test site in the State of Washington, we have established quality assurance programs at our laboratory facilities which monitor ongoing compliance with CLIA. In addition, we are a College of American Pathologists ("CAP") or CAP-certified test site. This certification provides monitoring for CAP and CLIA compliance by CAP on a yearly basis. The industry standards for conducting preclinical laboratory testing are embodied in the Good Laboratory Practices ("GLP") regulations as defined by the FDA. Although we do not perform testing related to preclinical research, we do comply with specific sections of the GLP regulations, at our discretion, when it is either important to our clients or is determined by management as advantageous to our quality assurance program. Our clinical laboratory services are subject to industry standards for the conduct of clinical research and development of studies that are embodied in the regulations for Good Clinical Practice ("GCP"). The FDA requires that test results submitted to such authorities be based on studies conducted in accordance with GCP. Noncompliance with GCP can result in the disqualification of some or all of the data collected during the clinical trial, as well as precipitate a full investigation of all previous and current regulatory submissions. We are subject to licensing and regulation under federal, state and local laws relating to workplace hazard communications and employee right-to-know regulations, the handling and disposal of medical specimens and hazardous waste and radioactive materials, as well as the safety and health of laboratory employees. Our laboratory is subject to applicable federal, state and local laws and regulations relating to the storage and disposal of all laboratory specimens including, but not limited to, the regulations of the Environmental Protection Agency, the Nuclear Regulatory Commission, the Department of Transportation, the National Fire Protection Agency and the Resource Conservation and Recovery Act. Although we believe that we are currently in compliance in all material respects with such federal, state and local laws, failure to comply could subject us to denial of the right to conduct business, fines, criminal penalties and other enforcement actions. In addition to its comprehensive regulation of safety in the workplace, the Occupational Safety and Health Administration has established extensive requirements relating to workplace safety for health care employers whose workers may be exposed to blood borne pathogens such as HIV and the hepatitis B virus, as well as radiation. Our employees receive initial and periodic training focusing on compliance with applicable hazardous materials regulations and health and safety guidelines. In the past few years, both the United States and foreign governments have become more concerned about the disclosure of confidential personal data. The European Union prohibits the disclosure of personal confidential information, including medical information, to any entity that does not comply with certain security safeguards. The U.S. Department of Health and Human Services recently promulgated final regulations under the Health Insurance Portability and Accountability Act of 1996 ("HIPAA") that will govern the disclosure of confidential medical -8- information in the United States. We do not process IIHI (Individually Identifiable Health Information) during any phase of our business practices related to clinical testing. We therefore are currently exempt from HIPAA regulations. The regulations of the U.S. Department of Transportation, the U.S. Public Health Service and the U.S. Postal Service apply to the surface and air transportation of laboratory specimens. We also comply with the International Air Transport Association regulations, which govern international shipments of laboratory specimens. Furthermore, when materials are sent to a foreign country, the transportation of such materials becomes subject to the laws, rules and regulations of such foreign country. LAURUS DEBT INVESTMENTS In fiscal 2004 and 2005, we entered into two financing arrangements with Laurus Master Fund, Ltd. ("Laurus"), a New York City based investment fund, for a total of $4 million of secured convertible debt financing. In fiscal 2005, we amended the terms of these financing arrangements to extend and defer principal payments and to waive certain defaults. We have described the complete terms, modifications and accounting treatment below. TERMS OF SECURED CONVERTIBLE NOTES Effective May 28, 2004, we entered into our first debt financing arrangement with Laurus, consisting of a $2.5 million secured convertible note with a term of three years (the "2004 Note"). Effective January 31, 2005, we entered into our second debt financing arrangement with Laurus, consisting of $1.5 million secured convertible note with a term of three years (the "2005 Note"). The terms of the 2005 Note are similar to the terms of the 2004 Note. The Notes bear interest at an initial rate equal to the prime rate plus two percent (2%). This is a variable interest rate that was 10.25% and 10.25% for fiscal years ending June 30, 2007 and 2006, respectively. Under the terms of the 2004 Note, we started making monthly payments of accrued interest only beginning on July 1, 2004. Under the terms of the 2005 Note, we started making monthly payments of accrued interest only beginning on March 1, 2005. Laurus has the option at any time to convert any or all of the outstanding principal and accrued and unpaid interest on the Notes into shares of our common stock. The initial conversion price is $1.06 per share for the 2004 Note and $1.17 per share for the 2005 Note. The conversion price for the Notes is subject to certain antidilution adjustments, including full ratchet antidilution if we issue convertible or equity securities at a price per share less than the conversion price. For each monthly payment under the Notes, Laurus will be obligated to convert a portion of the monthly payment into common stock at the applicable conversion price, when certain conditions are present. For any cash payments of principal we are required to make, the agreement requires an amount equal to 102% of the principal amount due. In addition, we can prepay either Note at any time upon payment of an amount equal to 130% of the then-outstanding principal balance, plus accrued and unpaid interest. As security for the obligation to Laurus, we and each of our subsidiaries granted Laurus a blanket security interest in all of our assets, and we entered into a stock pledge with Laurus for the capital stock in all of our subsidiaries. In addition, we registered with the SEC for resale the shares of common stock that are issuable upon conversion of the Notes and upon exercise of the warrants. We are obligated to maintain the effectiveness of the registration statement through January 2008. If we fail to comply with the registration obligations, Laurus will be entitled to certain specified remedies, including monetary liquidated damages. WARRANTS In connection with the 2004 Note financing, we issued to Laurus a warrant to purchase up to 681,818 shares of common stock at an exercise price of $1.25 per share exercisable at any time prior to May 28, 2011. For the 2005 -9- Note financing, we issued to Laurus a warrant to purchase up to 326,087 shares of common stock at an exercise price of $1.37 per share exercisable at any time prior to January 31, 2010. In consideration for the principal payment deferral and the waiver on the 2004 Note, on January 31, 2005 we issued an additional common stock purchase warrant to Laurus to purchase up to 200,000 shares of common stock at an exercise price of $1.48. The warrant expires on January 31, 2009. For the additional principal payment deferral and the extension of the 2004 and 2005 Notes, on May 6, 2005 we issued an additional common stock purchase warrant to Laurus to purchase up to 1,000,000 shares of our common stock at an exercise price of $1.05. The warrant expires on May 6, 2010. See "Note 12 to Notes to Consolidated Financial Statements." FINANCING COSTS In conjunction with the financing for both Notes, we paid fees and expenses of approximately $301,500 in cash and reserved $160,000 for potential payments due to Source Capital, our broker, upon the conversion of principal to common stock. The total amount of $293,500 expense for the 2004 Note has been amortized to other expense at the rate of approximately $8,153 per month over the 36-month life of the Note, beginning June 2004. The total amount of $168,000 expense for the 2005 Note was added to the amount of the 2004 Note. Furthermore, commencing as of May 31, 2005 deferral and extension of both Notes, we adjusted the amortization schedules for the 2004 Note and 2005 Note related to the deferred finance costs. Deferred finance costs are now being amortized at $5,509 and $3,422 per month for the 2004 and 2005 Notes, respectively. The unamortized balance as of June 30, 2007 was approximately $107,000. In addition, we issued to our broker a five-year warrant, exercisable as and to the extent that amounts owing under the 2004 Note are converted into common stock, for up to 181,818 shares of common stock at an exercise price of $1.25 per share. For the 2005 Note we issued to our broker a five-year warrant, exercisable as and to the extent that amounts owing under the 2005 Note are converted into common stock, for up to 105,263 shares of common stock at an exercise price of $1.37 per share. CONVERSION AND PRINCIPAL PAYMENTS Through June 30, 2007, Laurus has converted a total of $710,200 in principal on the 2004 Note, leaving $1,416,667 remaining principal balance, net of conversions and principal payments. There have been no conversions of principal on the 2005 Note, leaving a remaining principal balance of $950,000, net of principal payments. For any cash payments we are required to make on the Notes (e.g., any amounts due that are not converted into common stock), the agreement provides for monthly payments of principal in the amount of $83,333 for the 2004 Note and $50,000 for the 2005 Note. With principal conversions and note deferrals and extensions, repayments of principal on the 2004 Note were deferred. We began scheduled principal payments beginning in February 2007 with the first partial payment of approximately $41,000 and $85,000 for each month thereafter for the 2004 Note. Principal payments on the 2005 Note of $51,000 per month commenced August 2006. We are required to pay an amount equal to 102% of the principal amount due (i.e., a payment of $85,000 reduces the principal balance by $83,333 and a payment of $51,000 reduces the principal balance by $50,000). Any future conversions of principal by Laurus on either Note will further reduce our repayment obligations and defer future payments due. WAIVER, DEFERRAL AND EXTENSION Prior to December 1, 2004, we initiated discussions with Laurus for a six-month deferral on all principal payments and we did not make the principal payments on either December 1, 2004, due date for the first payment on the 2004 Note, or January 1, 2005. On January 31, 2005 Laurus formally agreed to the six-month deferral and also waived all events of default, including the failure by us to make our scheduled payments in December and January. Deferred principal amounts would be due on May 1, 2007, the maturity date of the 2004 Note. There was no change in the interest rate charged by Laurus on the unpaid principal. On May 6, 2005, we amended the terms of the 2004 Note and the 2005 Note with Laurus' approval to provide for a one year principal payment deferral and extension of both Notes. With respect to the 2004 Note, Laurus agreed to extend the term to be due in full on May 28, 2008, and principal payments to be paid monthly beginning June 1, -10- 2006. With respect to the 2005 Note, Laurus agreed to extend the term to be due in full on January 31, 2009, and principal payments to be paid monthly beginning August 1, 2006. There was no change in the interest rate charged by Laurus on the unpaid principal. Furthermore, commencing as of May 31, 2005 we adjusted the accretion schedules for the 2004 Note and 2005 Note related to the conversion feature and stock purchase warrants. The conversion feature and the warrants are being accreted at $30,858 and $26,625 per month for the 2004 and 2005 Notes, respectively. FINANCIAL DERIVATIVES - EMBEDDED CONVERSION, OTHER FEATURES AND WARRANTS In fiscal years 2004 and 2005, we estimated the valuation of the conversion and other features and the warrants for the Notes in accordance with EITF 00-27 and EITF 98-5, using the Black-Scholes pricing model and other assumptions deemed reasonable by management. We changed our accounting for derivative financial instruments, for the Notes, to conform to the requirements of Statements of Accounting Standards No. 133, as amended, and Financial Accounting Standards Board Emerging Issues Task Force (EITF) No. 00-19. Embedded conversion and other features that meet the definition of derivative financial instruments have, where applicable, been bifurcated from host instruments, the May 2004 and January 2005 Notes, and, in all instances derivative financial instruments have been recorded as assets or liabilities and are carried at fair value. EMPLOYEES At September 28, 2007, we had 54 full-time employees, 1 part-time employee, 3 temporary or contract and 1 inactive employee, for a total of 59 employees, 40 of whom were employed in laboratory operations, laboratory administration and client services (including our Chief Scientific Officer), 5 were employed in sales, marketing and business development (including our Chief Medical Officer), and 9 were employed in administrative capacities. One of our employees holds an M.D. degree, six others hold Ph.D. degrees, and two others hold masters degrees or other postgraduate degrees. None of our employees are represented by labor unions. We believe that our relationships with our employees are good. AVAILABLE INFORMATION We make available free of charge on our website at www.pacbio.com, our Annual Report on Form 10-KSB, Quarterly Reports on Form 10-QSB, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the SEC. RISK FACTORS AFFECTING OUR BUSINESS THE FOLLOWING DISCUSSION IN THIS ANNUAL REPORT ON FORM 10-KSB CONTAINS FORWARD-LOOKING STATEMENTS REGARDING OUR COMPANY, OUR BUSINESS, PROSPECTS AND RESULTS OF OPERATIONS THAT INVOLVE RISKS AND UNCERTAINTIES. OUR ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE RESULTS THAT MAY BE ANTICIPATED BY SUCH FORWARD-LOOKING STATEMENTS AND DISCUSSED ELSEWHERE IN THIS REPORT. FACTORS THAT COULD CAUSE OR CONTRIBUTE TO SUCH DIFFERENCES INCLUDE, BUT ARE NOT LIMITED TO, THOSE DISCUSSED BELOW, AS WELL AS THOSE DISCUSSED UNDER THE CAPTIONS "BUSINESS" AND "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" AS WELL AS THOSE DISCUSSED ELSEWHERE IN THIS REPORT. IN EVALUATING OUR BUSINESS, PROSPECTS AND RESULTS OF OPERATIONS, READERS SHOULD CAREFULLY CONSIDER THE FOLLOWING FACTORS IN ADDITION TO OTHER INFORMATION PRESENTED IN THIS REPORT AND IN OUR OTHER REPORTS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION THAT ATTEMPT TO ADVISE INTERESTED PARTIES OF THE RISKS AND FACTORS THAT MAY AFFECT OUR BUSINESS, PROSPECTS AND RESULTS OF OPERATIONS. SEE "CAUTIONARY NOTICE REGARDING FORWARD LOOKING STATEMENTS." RISKS RELATING TO OUR COMPANY AND OUR BUSINESS DURING EACH OF OUR PAST FISCAL YEARS, WE HAVE DEPENDED ON ONE OR TWO CLIENTS FOR A SIGNIFICANT PORTION OF OUR REVENUE. ANY DECREASE IN REVENUE FROM THESE CLIENTS COULD MATERIALLY ADVERSELY AFFECT US. Historically, our largest two clients in any individual fiscal year have represented in excess of 50% of our revenue. During the fiscal year ended June 30, 2007, however, our top two clients represented 33% of our revenue as compared to 50% during the fiscal year ended June 30, 2006. Our largest client in fiscal 2007 individually -11- accounted for approximately 17% of our total revenue in fiscal 2007, while our largest client in fiscal 2006 accounted for approximately 36% of our total revenue in fiscal 2006. While on the one hand this reflects an improvement in terms of decreasing our revenue reliance on a single client, on the other hand it is important to note that our largest client in fiscal 2007 was not our largest client in fiscal 2006, which illustrates the risk of significant revenue variability that we face in our marketplace. Revenue from our five largest clients represented approximately 65% and 74% of total revenue in fiscal 2007 and 2006, respectively. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" and see "DESCRIPTION OF BUSINESS - Clients/Marketing" above. Because our revenue has been concentrated in one or two large clients, we can be materially adversely impacted by decreases in work generated from these clients, including any delays in undertaking clinical studies or submitting samples for testing services, any early termination or reductions in work orders or clinical studies, or any decreases in the volume or timing of new work orders. We have expanded our business development efforts and have continued to submit bids and proposals to these and other companies for our services, to increase our revenue and to diversify our client base. Although we believe that we have good relations with all of our large clients and other companies in the industry, and we expect to receive additional work orders in the future, we cannot predict the timing or amount of any such additional work or whether we will be successful in further diversifying our client base. If we are unsuccessful in our sales and business development efforts with our existing clients and potential clients, our revenue for the fiscal year ending June 30, 2008 may be less than our revenue for the fiscal year ended June 30, 2007. In addition, unless we are able to attract additional clients for medium to large studies, we will continue to be dependent on one or two large clients for a substantial majority of our revenue. OUR ABILITY TO ATTRACT AND RETAIN CLIENTS DEPENDS IN LARGE PART ON OUR REPUTATION. IF OUR REPUTATION IS HARMED, OUR REVENUE, BUSINESS DEVELOPMENT, GROWTH AND OPERATING RESULTS MAY SUFFER. We compete with other specialty laboratories and central laboratories in large part on the basis of our reputation for providing quality results in a timely manner. Accordingly, timely, effective and quality service is essential to establishing and maintaining our reputation, as well as to generating clients and revenue. Our reputation may suffer damage, whether from actions outside or within our control. If our reputation is harmed, our revenue, business development, growth and operating results may suffer. IF WE DO NOT GAIN NEW CLIENTS AND NEW PROJECTS FROM OUR BUSINESS DEVELOPMENT EFFORTS, OUR GROWTH MAY BE LIMITED, SALES OF OUR SERVICES MAY DECREASE AND OUR OPERATING RESULTS MAY SUFFER. We generally do not have long-term contracts with clients for our services. In addition, any project we undertake may generally be terminated at any time by the client on short notice. As a result, it is difficult for us to forecast future sales, and our future revenue depends on our ability to generate new clients and new projects. During fiscal 2008, we are planning on making additional investments in our business development, technology infrastructure, operations and other areas of our business in an effort to become more competitive and to increase our revenue. These efforts will use significant amounts of time, effort and funding. Our business development efforts are substantially dependent on our ability to effectively manage our time, personnel and resources. In particular, our Chief Science Officer and Chief Medical Officer are often heavily involved in the marketing and business development process, and time that they spend in this area detracts from their available time for laboratory and development work. Our success in business development depends in part on our reputation in the industry and client perceptions (including as to our laboratory capacity and financial health), and also to a degree on personal relationships between us and the client. With the significant consolidation in the pharmaceutical industry, it is often a long and complex process in finding and meeting with the right person within the client company. We also understand that some companies in the pharmaceutical industry have "preferred vendor" lists, such that a vendor cannot participate in requests for proposal or contract with the company unless the vendor is pre-approved on the list. We are attempting to expand our efforts in this area. If a client or prospective client has negative perceptions about our capabilities, our laboratory capacity or our financial health, this may affect our ability to develop new clients or projects. If our business development efforts are not successful, our revenue and cash flow may decrease and our operating results may suffer. -12- WE MAY BEAR FINANCIAL LOSSES BECAUSE MOST OF OUR CONTRACTS ARE OF A FIXED PRICE NATURE AND MAY BE DELAYED, TERMINATED OR REDUCED IN SCOPE FOR REASONS BEYOND OUR CONTROL. Many of our contracts provide for services on a fixed price or fee-for-service with a cap basis and they may be terminated, delayed or reduced in scope by the other party either immediately or upon notice. See "DESCRIPTION OF BUSINESS - Contractual Arrangements" above. Contract termination, delay or reduction in scope may occur for a variety of reasons, most of which are beyond our control, including: o the failure of the client's products to satisfy safety requirements; o unexpected or undesired results of the client's products; o insufficient patient enrollment by the client; o insufficient investigator recruitment by the client; o the client's decision to terminate the development of a product or to end a particular study; and o our failure to perform properly our duties under the contract. Because we primarily receive revenue on the basis of the number of clinical samples we test and process, the loss, reduction in scope or delay of a large contract or the loss or delay of multiple contracts could materially adversely affect our business, results of operations, financial condition and cash flows. Our contracts typically entitle us to receive payment for fees earned by us up to the time of termination and reimbursement for out-of-pocket costs incurred prior to termination. In certain limited instances, our contracts also entitle us to a termination fee or payment for the costs of winding down the terminated projects. WE MAY BEAR FINANCIAL RISK IF WE UNDERPRICE OUR CONTRACTS OR OVERRUN COST ESTIMATES. Since our contracts are often structured as fixed price or fee-for-service with a cap, we bear the financial risk if we initially under price our contracts or otherwise overrun our cost estimates. Such under pricing or significant cost overruns could have a material adverse effect on our business, results of operations, financial condition and cash flows. OUR ABILITY TO PROTECT OUR INTELLECTUAL PROPERTY IS ESSENTIAL TO THE GROWTH AND DEVELOPMENT OF OUR PRODUCTS AND SERVICES. We rely, in part, on patents, trade secrets and know-how to develop and maintain our competitive position and technological advantage on our existing intellectual property and any future intellectual property we develop. See "DESCRIPTION OF BUSINESS - Technologies and Products" above. We protect our intellectual property through a combination of license agreements, trademark, service mark, copyright, trade secret laws and other methods of restricting disclosure and transferring title. We have and intend to continue entering into confidentiality agreements with our employees, consultants and vendors; entering into license agreements with third parties; and generally seeking to control access to and distribution of our intellectual property. RISKS RELATING TO OUR INDUSTRY FAILURE TO KEEP PACE WITH CHANGES IN THE MARKETPLACE MAY CAUSE US TO LOSE MARKET SHARE AND OUR REVENUE MAY DECREASE. The market for specialty reference and central laboratory services is subject to rapid technological change and innovation. In particular, laboratories are regularly developing new assays to incorporate into clinical testing and have to maintain up-to-date laboratory equipment to stay competitive. In developing and enhancing our services, we have made, and will continue to make, assumptions about which features, standards and performance criteria will be attractive to, or demanded by, our clients. If we implement features, standards and performance criteria that are different from those required by our clients or if our competitors introduce products and systems that better address these needs, market acceptance of our offerings may suffer or may become obsolete. In that event, our market share and revenue would likely decrease. In addition, clients are requiring that laboratories maintain secure and sophisticated information technology systems, as a means for storing data and facilitating communication between the laboratory and the client. Although we continue to expend efforts and resources in these areas, we may not be -13- successful in keeping up with client needs or expectations. In addition, if a client or prospective client has negative perceptions about our abilities based on our financial strength, this may affect our ability to develop new clients or projects. Many of our competitors have greater resources than we do. We are also exploring additional financing to be used to continue to update our laboratory service capability. If we are unsuccessful in raising funds as and when needed, we may, or it may be perceived, that we are less efficient and less economical than our competitors and we may lose business to our competitors. If this occurs, it would have a material adverse effect on our revenue and financial performance. WE DEPEND ON THE PHARMACEUTICAL AND BIOTECHNOLOGY INDUSTRIES. Our revenue depends greatly on the outsourcing expenditures made by the pharmaceutical and biotechnology industries in research and development. Accordingly, economic factors and industry trends that affect our clients in these industries also affect our business. If companies in these industries were to reduce the number of research and development projects they outsource, our business could be materially adversely affected. Our clients in the pharmaceutical and biotechnology industries have experienced significant consolidation over the last several years and we expect that trend to continue. The uncertainty caused by consolidation, before, during and after a business combination can result in product delays, changes in strategy, and consolidation and/or elimination of research and development efforts. Any of these effects can have a materially adverse affect on us if it results in testing delays, sample volume reductions or termination of tests. WE HAVE SEEN RECENT CHANGES IN OUR MARKETPLACE. Management has reviewed recent developments in the dyslipidemia drug development market that provides a substantial portion of our revenues. These changes - specifically, the late-stage withdrawal of the HDL-raising drug torcetrapib by Pfizer in December 2006 - have the potential to significantly impact our future revenues. We have not experienced a significant impact on current revenues for the period ended June 30, 2007 from these developments. A limited number of current studies have been postponed, suspended or terminated. Because of current uncertainty about the significance of these developments, potential effects on our future business and revenues, as well as on drug development activities by other pharmaceutical companies in the lipid / cholesterol market in general, are unclear. Even if the withdrawal of torcetrapib results in the cessation of similar drug programs (CETP inhibitors) at other pharmaceutical companies, we believe we are well positioned in the lab services market for the dyslipidemia therapeutic area to take advantage of other drug classes coming into the pipeline. Indeed, we are involved with many top pharmaceutical companies in providing testing services for drugs related to but distinct from the CETP inhibitors. Several factors may adversely affect our future revenues, including the recent announcements by Pfizer to halt further testing of torcetrapib, the lead compound in the CETP inhibitor drug class, due to specific safety issues, Pfizer's plans for cost reductions and layoffs and other large pharmaceutical companies' cost reduction announcements. We are not certain how the current issues will affect the clinical development of CETP inhibitors at other pharmaceutical companies, or the effect on other drug classes currently being evaluated for their favorable effects on HDL ("good") cholesterol levels and on reverse cholesterol transport. In a recent press release (April 20, 2007) Pfizer announced that it is putting a hold on all drugs in the same class as torcetrapib. There have been no public announcement by other major pharmaceutical companies about discontinuing development of related drugs, but we intend to monitor the situation and assess any potential impacts should they arise. WE MAY NOT BE ABLE TO SUCCESSFULLY DEVELOP AND MARKET NEW SERVICES. We may seek to develop and market new services that complement or expand our existing business. If we are unable to develop new services and or create demand for those newly developed services, our future business, results of operations, financial condition and cash flows could be adversely affected. -14- WE OPERATE IN A HIGHLY COMPETITIVE INDUSTRY, AND WE MAY LOSE OR FAIL TO ATTRACT CLIENTS FOR OUR SERVICES TO OUR COMPETITORS. Competitors in the specialty reference and central laboratory industry range from small, limited-service providers to full service global contract research organizations. Our main competition consists of in-house departments of pharmaceutical companies, full-service contract research organizations, and, to a lesser degree, universities. See "DESCRIPTION OF BUSINESS - Competition" above. We compete on a variety of factors, including o technological expertise and efficient drug development processes, o reputation for on-time quality performance, o price, o expertise and experience in specific areas, o strengths in various geographic markets and global reach, o ability to manage large-scale clinical trials both domestically and internationally, o scope of service offerings, o ability to acquire, process, analyze and report data in a time-saving and accurate manner, and o expertise and experience in health economics and outcomes services. Many of our competitors have greater resources than we do, have global operations and greater name recognition. If we experience significant competition which is based on factors which we do not have in our business, such as global management of projects or size, our business could be materially adversely affected. Although we have entered into a joint marketing arrangement with Quintiles in an attempt to improve our competitive position, in fiscal 2007, we did not realize significant financial benefit from this relationship and this arrangement may not be successful in generating revenue for us or improving our competitive position. DURING FISCAL 2007, WE HAVE EXPERIENCED A SIGNIFICANT DECREASE IN REVENUE. IN FISCAL 2006 WE EXPERIENCED A SIGNIFICANT INCREASE IN REVENUE FROM PRIOR YEARS. OUR REVENUE IS UNPREDICTABLE AND VARIES SIGNIFICANTLY FROM QUARTER TO QUARTER AND YEAR TO YEAR. We have experienced significant quarterly fluctuations in revenue during fiscal 2007 and fiscal 2006. For fiscal 2007 compared to fiscal 2006, our revenue decreased 21% to approximately $8,480,000 from approximately $10,750,000, and we incurred a net loss for fiscal 2007 and net income for fiscal 2006. The impact of quarterly fluctuations is clearly observed in the first fiscal quarter of 2007 where revenue increased 42% compared to the comparable period in fiscal 2006. While, for the last nine months of fiscal 2007, our revenue was 34% lower than for the comparable period of fiscal 2006. The following table shows the significant swings in our quarterly revenue for each quarter in the current fiscal year and the past two fiscal years: (DOLLARS IN THOUSANDS, FISCAL YEAR ROUNDED TO NEAREST THOUSAND) 2005 2006 2007 Q1, ended September 30................ $ 434 $1,834 $2,605 Q2, ended December 31................. 1,009 3,113 2,219 Q3, ended March 31.................... 1,048 3,110 1,755 Q4, ended June 30..................... 739 2,693 1,901 Our revenue depends in large part on receiving new clinical or diagnostic studies from our clients, and we cannot predict the timing or amount of revenue we may recognize from quarter to quarter. During fiscal 2006, we had two large studies totaling in excess of $2,600,000 that raised revenues to record levels during Q2, ended December 31 and Q3 ended March 31 as illustrated in the table above. During fiscal 2008, we are planning to make additional investments in our business development, technology infrastructure, operations and other areas of our business in an effort to become more competitive and to increase our revenue. These efforts will use significant amounts of time, effort and funding. These efforts may not be successful in generating additional revenue. -15- WE HAVE HISTORICALLY HAD WORKING CAPITAL DEFICITS. IF OUR REVENUE DOES NOT INCREASE, OUR LOSSES, CASH AND WORKING CAPITAL POSITION MAY WORSEN. Although we received gross proceeds of approximately $4,300,000 in a private placement of our common stock and warrants in March and April 2006, we have had cash flow shortages and deficiencies in working capital in previous fiscal years. At June 30, 2007, we had approximately $4,220,000 in cash and a positive working capital position of approximately $$827,000, both representing a significant decrease from the previous fiscal year; we also had significant amounts of debt, including secured convertible notes, the derivative liabilities associated with the notes and notes payable of approximately $3,577,000 and other liabilities of approximately $2,282,000 and stockholders' equity of approximately $1,513,000. For the last fiscal year ended June 30, 2007 we had an operating loss of approximately $565,000. For the previous fiscal year ended June 30, 2006 we had an operating income of approximately $1,846,000. At June 30, 2007, we had an accumulated deficit of approximately $27,133,000. Previously, our cash, cash equivalents, and accounts receivable have been used to fund our operating losses and investments in capital expenditures. However, unless revenue remains at the current level or continues to increase, we will likely experience losses and our cash and working capital positions may be adversely impacted through fiscal 2008. To improve our cash position, we are actively seeking to increase revenue and improve operating income. As noted above, we raised gross proceeds of approximately $4,300,000 in a private placement of our common stock and warrants in March and April 2006. This private placement has improved our cash position and reduced the risk associated with our revenue fluctuations and growth. However, our continuing efforts to improve our cash position, reduce expenses and generate revenue may not be successful. Our future capital requirements depend upon many factors, including, but not limited to: o the timing and number of clinical trials by clients, the number of samples submitted to us for testing, and the amount of revenue generated from these tests; o our ability to enter into and build relationships with new clients, and obtain additional projects from existing clients; o capital expenditure requirements, including for research and development efforts, upgrading or replacing laboratory equipment and making investments in information technology; o delays or early terminations of clinical testing agreements with clients; o our plans to pursue additional business strategies; o our ability to manage our cash flow, including by managing or reducing our expenses, such as insurance and professional fees of our accountants and attorneys associated with being a public company; and o other business and economic factors that may occur from time to time. None of these factors can be predicted with certainty. Additionally, if we desire to invest in our laboratory technology or research and development, we may require additional financing. OUR ABILITY TO MAKE REQUIRED PAYMENTS OF PRINCIPAL AND INTEREST ON OUR SENIOR SECURED DEBT DEPENDS PRIMARILY ON AVAILABLE CASH BALANCES, CASH FLOW FROM OPERATIONS, FUNDS FROM FINANCING EFFORTS AND EARLY CONVERSION OF THE DEBT, ALL OF WHICH MAY NOT BE SUFFICIENT TO SERVICE THE DEBT. In fiscal 2004 and 2005, we closed on two debt financings with Laurus Master Funds Ltd., consisting of $2.5 million effective May 28, 2004 and an additional $1.5 million effective January 31, 2005. See "DESCRIPTION OF BUSINESS - Laurus Debt Investments" above. Through June 30, 2007, Laurus has converted a total of $710,200 in principal on the 2004 Note and we made payments totaling $373,133 leaving a remaining principal balance on the 2004 Note of $1,416,667. Through June 30, 2007, no conversion of principal has taken place on the 2005 Note and we have made payments totaling $550,000 leaving a remaining principal balance of $950,000. On the 2005 Note we paid a reduced initial payment of approximately $41,000 for March 2006 and approximately $85,000 per month of which $83,000 applies to the principal net of interest, for each month thereafter. Payments on the 2005 Note of approximately $51,000 per month, of which $50,000 applies to the principal net of interest, commenced in August 2006. Any future additional conversions of principal by Laurus on either Note will further reduce our repayment -16- obligations. Our actual required cash payments on the two notes will vary depending on interest rates and whether amounts under the notes are converted into our common stock. Our ability to make scheduled monthly payments under the two notes primarily depends on our current cash balance, future performance and working capital, including our ability to increase revenue and improve cash flows. We currently have other fixed monthly commitments under various notes payable, equipment and facility leases. See "Notes 8 and 9 to Notes to Consolidated Financial Statements" for the fiscal year ended June 30, 2007 included in this Annual Report on Form 10-KSB. To a certain extent our ability to increase revenue and control costs are subject to a number of economic, financial, competitive, regulatory and other factors beyond our control. However, if our cash flow is insufficient to enable us to service our debt, we may have to utilize the funds raised from our private placement of common stock and warrants, be forced to find alternative sources of financing, or to take further measures, including significantly reducing expenses or scope of operations. Any future alternative sources of debt or equity financing may not be available to us when needed or in amounts required. Although we obtained a new non-revolving line of credit with Franklin Funding in November 2005 for an aggregate amount of up to $500,000 for equipment financing, of which we have borrowed $350,000 as of June 30, 2006 and we raised gross proceeds of approximately $4,300,000 in a private placement of our common stock and warrants in March and April 2006, we do not have available to us another bank line of credit or other general borrowing facility. Alternatively, we may be forced to attempt to negotiate with our debt holders on our payment terms, which may not be successful or may be on terms onerous to us. WE GRANTED A BLANKET SECURITY INTEREST IN ALL OF OUR ASSETS TO THE HOLDER OF OUR SECURED CONVERTIBLE DEBT. IF WE ARE UNABLE TO MAKE OUR REQUIRED MONTHLY PAYMENTS ON THE DEBT, OR ANY OTHER EVENT OF DEFAULT OCCURS, IT COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS AND OPERATIONS, AND THE DEBT HOLDER MAY FORECLOSE ON OUR ASSETS. As part of our two debt financings with Laurus, we granted to Laurus a blanket security interest in all of our assets, including assets of our subsidiaries. See "DESCRIPTION OF BUSINESS - Laurus Debt Investments" above. In the event we default in payment on the debt, or any other event of default occurs under the financing documents, 130% of the outstanding principal amount and accrued interest will accelerate and be due and payable in full. The cash required to pay such accelerated amounts on the notes following an event of default would most likely come out of our working capital. As we rely on our working capital for our day to day operations, such a default could have a material adverse effect on our business, operating results, or financial condition to such extent that we are forced to restructure, file for bankruptcy, sell assets or cease operations. In addition, upon an event of default, the holders of the secured debt could foreclose on our assets or exercise any other remedies available to them. If our assets were foreclosed upon, or if we were forced to file for bankruptcy or cease operations, stockholders may not receive any proceeds from disposition of our assets and may lose their entire investment in our stock. EVEN WITH OUR PRIVATE PLACEMENT OF COMMON STOCK AND WARRANTS IN MARCH AND APRIL 2006, WE MAY NEED TO RAISE ADDITIONAL CAPITAL TO FUND OPERATIONS IN THE FUTURE. IF OUR FINANCING EFFORTS ARE NOT SUCCESSFUL, WE WILL NEED TO EXPLORE ALTERNATIVES TO CONTINUE OPERATIONS, WHICH MAY INCLUDE A MERGER, ASSET SALE, JOINT VENTURE, LOANS OR EXPENSE REDUCTIONS. We have been successful in achieving our second highest revenue level in the company's history for the fiscal year ended June 30, 2007, although this result was 21% below the revenue level for the fiscal year ended June 30, 2006. Our efforts to continue revenue increases and control expenses may not be successful. If we continue to experience significant quarterly fluctuations in our revenue or if our revenue does not continue to increase, we may need to raise additional capital through equity or debt financing or through the establishment of other funding facilities in order to keep funding operations. Even with our recent private placement in March and April 2006, in the current market condition, raising capital has been, and may continue to be difficult, and we may not receive sufficient funding. Any future financing that we seek may not be available in amounts or at times when needed, or, even if it is available, may not be on terms acceptable to us. Also, if we raise additional funds by selling equity or equity-based securities, the ownership of our existing stockholders will be diluted. -17- We continually evaluate various other alternatives to enable us to fund continuing operations, which may or may not occur, including, but are not limited to, any one or more of the following: o engaging a financial advisor to explore strategic alternatives, which may include a merger, asset sale, joint venture or other similar transaction; o forming a joint venture with one or more strategic partners to provide additional capital resources to fund operations. These potential alternatives may not be open to us, or may only be available on unfavorable terms. If we are unable to obtain sufficient cash either to continue to fund operations or to locate a strategic alternative, we may be forced to seek protection from creditors under the bankruptcy laws or cease operations. Any inability to obtain additional cash as needed could have a material adverse effect on our financial position, results of operations and ability to continue in existence. During fiscal 2008, we are planning to make additional investments in our business development, technology infrastructure, operations and other areas of our business in an effort to become more competitive and to increase our revenue. These efforts will use significant amounts of time, effort and funding. THE LOSS OF OUR KEY PERSONNEL, INCLUDING OUR CHIEF SCIENTIFIC OFFICER AND CHIEF MEDICAL OFFICER, COULD ADVERSELY AFFECT OUR BUSINESS. Our success depends to a significant extent upon the efforts of our senior management team and other key personnel, and in particular Dr. Elizabeth Leary, our Chief Scientific Officer, and Dr. Mario Ehlers, our Chief Medical Officer. In addition to the services they provide in our laboratory services, Drs. Leary and Ehlers are also important to our business development efforts, both due to their reputations and skills, as well as their contacts and relationships with clients and prospective clients. The loss of the services of such personnel could adversely affect our business. Also, because of the scientific and technical nature of our business, our success is dependent upon our ability to attract and retain technologically qualified personnel. There is substantial competition for qualified personnel, and an inability to recruit or retain qualified personnel may impact our ability to grow our business and compete effectively in our industry. OUR OBLIGATIONS UNDER OUR SECURED DEBT TO LAURUS MAY ADVERSELY AFFECT OUR ABILITY TO ENTER INTO POTENTIAL SIGNIFICANT TRANSACTIONS WITH OTHER PARTIES. As a result of our debt financings with Laurus in May 2004 and January 2005, we incurred significant repayment obligations, we granted a blanket security interest in our assets, and we agreed to certain restrictive covenants. In particular, for so long as 25% of the original principal is outstanding under either note, we will need Laurus' consent before we can take certain actions, including the following: o pay any dividends; o merge, effect a material reorganization, liquidate or dissolve; o materially change the scope of our business; or o create, incur or assume any debt (other than certain trade debt, equipment financings and debt for the purchase of assets in the ordinary course of business). Accordingly, unless we obtain Laurus' consent, we may not be able to enter into certain transactions. In addition, in connection with any potential significant transaction (such as a merger, sale of substantially all our assets, joint venture, or similar transaction), it is likely that we would have to pay off the debt obligations to Laurus and have the security interests released. Although we have the right at any time to prepay our secured debt obligations, we can only do so upon payment of 130% of the then principal balance, plus all other amounts owing under the notes. See "DESCRIPTION OF BUSINESS - Laurus Debt Investments" above. Based on a total principal balance of approximately $2,367,000 under both notes as of June 30, 2007, prepayment would require a cash payment of approximately $3,077,000, plus accrued interest. These provisions could have the practical effect of increasing the costs of any potential significant transaction, and restrict our ability to enter into any such transaction. -18- CHANGES IN GOVERNMENT REGULATIONS COULD DECREASE THE NEED FOR OUR SERVICES. Governmental agencies throughout the world, but particularly in the United States, highly regulate the drug development and approval process. See "DESCRIPTION OF BUSINESS - Government Regulation" above. Our business involves performing safety and efficacy laboratory testing during clinical trials of new pharmaceutical drugs. Clinical trial laboratory data is used by pharmaceutical and biotechnology companies in the submission process to the FDA for the marketing approval of a new drug. Changes in regulations, such as a relaxation in regulatory requirements or the introduction of simplified drug approval procedures or an increase in regulatory requirements that we have difficulty satisfying, could eliminate or substantially reduce the need for our services. Also, government efforts to contain drug costs and pharmaceutical and biotechnology company profits from new drugs may have an impact on the drug development and approval process, and our clients may spend less, or reduce their growth in spending, on research and development. FAILURE TO COMPLY WITH EXISTING GOVERNMENT REGULATIONS COULD RESULT IN A LOSS OF REVENUE OR EARNINGS FROM A PROJECT. Any failure on our part to comply with applicable government regulations could result in the termination of on-going research or sales and marketing projects or the disqualification of data for submission to regulatory authorities. For example, if we failed to validate analytical test methods performed on samples collected during and in support of a trial or if we fail to comply with GCP (Good Clinical Practice) regulations, the generated test data could be disqualified. If this were to happen, we could be contractually required to repeat the trial at no further cost to our client, but at substantial cost to us. WE MUST MAINTAIN CERTIFICATIONS FROM OUR CLIENTS IN ORDER TO BE ELIGIBLE TO BID ON PROJECTS. Many of our clients require our laboratories to be tested from time to time for certification that we comply with their internal requirements. If we fail to comply, we will probably be terminated from existing contracts and we will not be eligible to bid on that client's future projects. While generally we have been very successful in maintaining certifications and in gaining new certifications, if we fail certification tests, especially for our major clients, our business would be materially adversely affected. WE MAY EXPAND OUR BUSINESS THROUGH ACQUISITIONS. We may review acquisition opportunities. Factors which could affect our ability to grow successfully through acquisitions include o difficulties and expenses in connection with integrating the acquired companies and achieving the expected benefits, o diversion of management's attention from current operations, o the possibility that we may be adversely affected by risk factors facing the acquired companies, and o acquisitions could be dilutive to earnings, or in the event of acquisitions made through the issuance of our common stock to the stockholders of the acquired company, dilutive to the percentage of ownership of our existing stockholders. WE MAY BE AFFECTED BY POTENTIAL HEALTH CARE REFORM. In recent years, governments of the United States, Europe and Asia have considered various types of health care reform in order to control growing health care costs. We are unable to predict what legislative proposals will be adopted in the future, if any. Implementation of health care reform legislation that contains costs could limit the profits that can be made from the development of new drugs. This could adversely affect research and development expenditures by pharmaceutical and biotechnology companies which could in turn decrease the business opportunities available to us. In addition, new laws or regulations may create a risk of liability, increase our costs or limit our service offerings. -19- SPECIAL REFERENCE AND CENTRAL LABORATORY SERVICES CREATE A RISK OF LIABILITY. In contracting to work on drug development trials, we face a range of potential liabilities, including o errors or omissions in laboratory data being generated relating to the safety and efficacy of the drug, that could affect the regulatory approval of the drug, and o errors and omissions during a trial that may undermine the usefulness of a trial or data from the trial. While we maintain what we believe is adequate insurance coverage and obtain contractual indemnifications protecting us against liability arising from our own actions (other than negligence or intentional misconduct), we could be materially and adversely affected if we were required to pay damages or bear the costs of defending any claim which is not covered by a contractual indemnification provision or which is beyond the level of our insurance coverage. Due to the rising costs of insurance, we may not be able to maintain such insurance coverage at levels or on terms acceptable to us. RISKS RELATED TO OUR COMMON STOCK OUR COMMON STOCK IS TRADED ON THE OTC BULLETIN BOARD AND IS CONSIDERED A "PENNY STOCK". OUR STOCKHOLDERS' ABILITY TO SELL SHARES IN THE SECONDARY TRADING MARKET MAY BE LIMITED. Our common stock is currently quoted for trading on the OTC Bulletin Board. As a result, the liquidity of our common stock is limited, not only in the number of shares that are bought and sold, but also through delays in the timing of transactions, and the lack of coverage by security analysts and the news media of our company. In addition, because our stock is quoted on the OTC Bulletin Board, our common stock is subject to certain rules and regulations relating to "penny stock." A "penny stock" is generally defined as any equity security that has a price less than $5.00 per share and that is not quoted on the NASDAQ Stock Market or a national securities exchange. Being a penny stock generally means that any broker who wants to trade in our shares (other than with established clients and certain institutional investors) must comply with certain "sales practice requirements," including delivery to the prospective purchaser of the penny stock a risk disclosure document describing the penny stock market and the risks associated therewith. In addition, broker-dealers must take certain steps prior to selling a "penny stock," which steps include: o obtaining financial and investment information from the investor; o obtaining a written suitability questionnaire and purchase agreement signed by the investor; and o providing the investor a written identification of the shares being offered and the quantity of the shares. If these penny stock rules are not followed by the broker-dealer, the investor has no obligation to purchase the shares. The application of these comprehensive rules will make it more difficult for broker-dealers to sell our common stock, and as a practical matter, these requirements may mean that brokers are less likely to make recommendations on our shares to its general clients. As a result, for as long as our common stock is quoted on the OTC Bulletin Board and subject to these penny stock rules, our stockholders may have difficulty in selling their shares in the secondary trading market. In addition, prices for shares of our common stock may be lower than might otherwise prevail if our common stock were quoted on the NASDAQ Stock Market or traded on a national securities exchange, like The New York Stock Exchange or American Stock Exchange. This lack of liquidity may also make it more difficult for us to raise capital in the future through the sale of equity securities. -20- RISKS RELATED TO OUR COMMON STOCK INCLUDE, BUT ARE NOT LIMITED TO THE FOLLOWING: o Our quarterly operating results may vary, and these fluctuations could affect the market price of our stock. o Our stock price is volatile and a stockholder's investment in our common stock could suffer a decline in value. o The market for our stock has not been liquid. AS WE ISSUE ADDITIONAL EQUITY SECURITIES IN THE FUTURE, INCLUDING UPON CONVERSION OF ANY OF OUR SECURED CONVERTIBLE DEBT, THE OWNERSHIP OF OUR EXISTING STOCKHOLDERS WILL BE DILUTED. IN PARTICULAR, THE SECURED CONVERTIBLE DEBT HAS A FULL RATCHET ANTI-DILUTION PROVISION THAT COULD SIGNIFICANTLY DILUTE THE OWNERSHIP OF OUR STOCKHOLDERS. In connection with our two debt financings with Laurus, we issued a $2.5 million secured convertible note, a $1.5 million secured convertible note and warrants to Laurus. See "DESCRIPTION OF BUSINESS - Laurus Debt Investment" above. The $2.5 million note is convertible into shares of our common stock at an initial conversion price of $1.06 per share, and the $1.5 million note is convertible at an initial conversion price of $1.17 per share. At these initial conversion rates, for example, we would issue approximately 2,148,000 shares upon conversion of the $2,367,000 million owed under the notes at June 30, 2007. The actual number of shares to be issued will depend on the actual dollar amount of principal and interest being converted. In addition, each note carries a full ratchet anti-dilution provision, such that if we issue in the future convertible or equity securities (subject to certain exceptions, including stock option grants and issuances in connection with certain acquisition transactions) at a price less than the initial conversion price, the note conversion price will be automatically adjusted down to that lesser price. In addition to the conversion rights of the convertible debt, as we issue stock or convertible securities in the future, including for any future equity financing or upon exercise of any of the outstanding stock purchase warrants and stock options, those issuances would also dilute our stockholders. If any of these additional shares are issued and are sold into the market, it could decrease the market price of our common stock and could also encourage short sales. Short sales and other hedging transactions could place further downward pressure on the price of our common stock. WE DO NOT INTEND TO PAY CASH DIVIDENDS, SO ANY RETURN ON INVESTMENT MUST COME FROM APPRECIATION. We have not declared dividends on our common stock in the past, and do not intend to declare dividends on our common stock in the foreseeable future. In addition, pursuant to our financing agreements with Laurus, for as long as 25% of the original principal amount is outstanding under the either secured convertible note to Laurus, we may not declare or pay any dividends without Laurus' consent. As a result, any investment return in our common stock must come from increases in the fair market value and trading price of our common stock. ITEM 2. DESCRIPTION OF PROPERTY. We lease approximately 15,000 square feet of office and laboratory space in Seattle, Washington for our executive offices and laboratory. In April 2007 we entered into an amendment to the lease to extend its term through October 31, 2012. The current monthly rent under the lease is $19,513. Effective November 1, 2007, the monthly rental rate will increase to $20,361, with an increase of approximately three percent on each November 1 thereafter for the remainder of the term. We believe the leased premises are suitable and adequate for their current intended use. In the opinion of management, the leased premises are adequately covered by insurance. We do not own any real property. We do not have a policy pertaining to investments in real estate. Our current practice is to invest solely in short-term money market securities. -21- ITEM 3. LEGAL PROCEEDINGS. We are not a party to any pending material legal proceedings. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended June 30, 2007. PART II ITEM 5. MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES. COMMON STOCK Our common stock is currently quoted for trading on the OTC Bulletin Board under the symbol "PBME." The following table shows, for each quarter of fiscal 2007 and 2006, the high and low closing sales prices as reported by the OTC Bulletin Board. The quotations from the OTC Bulletin Board reflect inter-dealer prices without retail mark-up, mark-down, or commissions and may not represent actual transactions. OTC BULLETIN BOARD High Low FISCAL 2007: Fourth quarter, ended June 30, 2007............. $0.90 $0.42 Third quarter, ended March 31, 2007............. 1.07 0.75 Second quarter, ended December 31, 2006......... 1.16 0.90 First quarter, ended September 30, 2006......... 1.23 0.85 FISCAL 2006: Fourth quarter, ended June 30, 2006............. $1.46 $1.03 Third quarter, ended March 31, 2006............. 1.98 1.15 Second quarter, ended December 31, 2005......... 1.20 0.90 First quarter, ended September 30, 2005......... 1.01 0.77 HOLDERS As of September 28, 2007, there were 18,720,147 shares of common stock issued and outstanding, held by approximately 214 holders of record. DIVIDENDS We have never declared or paid any cash dividends with respect to our common stock, and do not plan to do so in the foreseeable future. We anticipate that we will retain future earnings for use in the operation and expansion of our business and do not anticipate paying cash dividends on our equity in the foreseeable future. Any future determination with regard to the payment of dividends will be at the discretion of our board of directors and will be dependent upon our future earnings, financial condition, applicable dividend restrictions and capital requirements and other factors deemed relevant by the board of directors. -22- ISSUER REPURCHASES OF COMMON STOCK On August 25, 2006, our board of directors authorized the repurchase of shares of common stock of the Company up to an aggregate value of $500,000 for shares at a maximum price of $1.17 per share. The repurchase plan expired on August 31, 2007. Under this repurchase program, we repurchased 187,200 shares for a total of $201,544. No purchases of shares of common stock were made during the fourth quarter of the fiscal year ended June 30, 2007. Shares purchased through June 30, 2007 are represented in the following table: Period Total number Average price Total value of shares paid per of shares purchased share purchased August 25, 2006 - October 31, 2006 -- -- -- November 1, 2006 - November 30, 2006 59,900 $1.12 $67,032 ===== December 1, 2006 - December 31, 2006 127,300 $1.06 $134,512 ===== January 1, 2007 - June 30, 2007 -- -- -- - -------------------------------------------------------------------------------- Total 187,200 $201,544 ======= ======== ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS. YOU SHOULD READ THE FOLLOWING DISCUSSION AND ANALYSIS IN CONJUNCTION WITH OUR CONSOLIDATED AUDITED FINANCIAL STATEMENTS AND RELATED NOTES FOR THE FISCAL YEAR ENDED JUNE 30, 2007, INCLUDED ELSEWHERE IN THIS REPORT. EXCEPT FOR HISTORICAL INFORMATION, THE FOLLOWING DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS. SEE "CAUTIONARY NOTICE REGARDING FORWARD LOOKING STATEMENTS" AND "RISK FACTORS." OVERVIEW We provide specialty central laboratory services to support pharmaceutical and laboratory diagnostic manufacturers in the conduct of human clinical research, for use in their drug and diagnostic product development efforts. Our clients include a number of the world's largest multi-national pharmaceutical, biotechnology and diagnostic companies. Our well-recognized specialty areas include cardiovascular disease (dyslipidemia, atherosclerosis, and coronary heart disease), diabetes (and obesity), and bone and joint diseases (osteoporosis as well as osteo and rheumatoid arthritis). Coupled with our specialty testing, we also have central laboratory capability and provide full-service central laboratory support for multi-center clinical trials, including routine safety lab tests (general chemistry, hematology, and urinalysis). Our company is a Delaware corporation, incorporated in May 1996, and we conduct our operations primarily through our wholly-owned subsidiary, Pacific Biometrics, Inc., a Washington corporation. CRITICAL ACCOUNTING ESTIMATES AND POLICIES The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates including, among others, those affecting revenue, the allowance for doubtful accounts, and the useful lives of tangible and intangible assets. The discussion below is intended as a brief discussion of some of the judgments and uncertainties that can impact the application of these policies and the specific dollar amounts reported on our financial statements. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form our basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions, or if management made different judgments or utilized different estimates. Many of our estimates or judgments are based on anticipated future events or performance, and as such are forward-looking in nature, and are subject to many risks and uncertainties, including those discussed below and elsewhere in -23- this Report. We do not undertake any obligation to update or revise this discussion to reflect any future events or circumstances. We have identified below some of our accounting policies that we consider critical to our business operations and the understanding of our results of operations. This is not a complete list of all of our accounting policies, and there may be other accounting policies that are significant to our company. For a detailed discussion on the application of these and our other accounting policies, see Note 2 to the Consolidated Financial Statements included in this Report. REVENUE RECOGNITION Under fixed-price contracts, we recognize revenue as services are performed, with performance generally assessed using output measures, such as units-of-work performed to date compared to the total units-of-work contracted. Our client contracts may be delayed or cancelled at anytime. Uncertainty surrounding continuation of existing revenues during any period is high. We believe that recognizing revenue as services are performed is the most appropriate method for our business as it directly reflects services performed in the laboratory. We would expect material differences in reporting of our revenues to occur if we changed our assumptions for revenue recognition from services performed to other methods such as percent complete or completed contract methods. While both other methods are allowed under GAAP, they would introduce more variables and estimates into our revenue recognition process. The percent complete method introduces estimated costs early in the process that may drive revenues higher in early periods. The completed contract method may recognize revenues in future contract periods, such as the first quarter after a fiscal year close and subsequent to completion of the services rendered. USEFUL LIVES OF TANGIBLE AND INTANGIBLE ASSETS The assets we acquire are subject to our best estimates of useful lives of the asset for depreciation purposes. Due to the uncertainty of current studies which are subject to cancellation, which may occur at any time, as well as changes in scientific methods for our testing, we may no longer have use for certain tangible and intangible assets and may take a charge against current earnings should changes in our estimated asset lives occur. We depreciate equipment and computers over three to five years, while leasehold improvements are depreciated over the remaining life of the lease or ten years. This estimate of a three to five-year useful life on equipment and computers and a useful life based on the remaining years left on the building lease for leasehold improvements reflects management's judgment that these useful life periods reflect a reasonable estimate of the life over which the equipment, computers and leasehold improvements will be used by us. Software costs incurred in connection with obtaining and developing internal use software ("software costs"), are capitalized in accordance with Statement of Position (SOP) No. 98-1 ACCOUNTING FOR THE COSTS OF COMPUTER SOFTWARE DEVELOPED OR OBTAINED FOR INTERNAL USE. Software costs are amortized over a period not to exceed three years and are included in Property and Equipment (see Note 5). The amount of depreciation and amortization expense we record in any given period will change if our estimates of the useful life of our equipment, computers, software or leasehold interests were to increase or decrease. We use the discounted cash flow method according to SFAS 144 to test our assets for impairment. The current balance of our depreciable assets at June 30, 2007 is $835,934, net of depreciation and amortization. We currently do not carry material amounts of intangible assets on our balance sheet. FINANCIAL DERIVATIVES - CONVERSION, OTHER FEATURES AND WARRANTS Embedded conversion and other features that meet the definition of derivative financial instruments have, where applicable, been bifurcated from host instruments (secured convertible notes - see Note 8. Notes Payable) and, in all instances derivative financial instruments have been recorded as assets or liabilities and are carried at fair value, using the Black-Scholes pricing model. We record the value allocated to warrants issued with the convertible instruments, measured at fair value, using the Black-Scholes pricing model and recognized by allocating a portion of the proceeds to a derivative liability with an offset to discount on the convertible instrument. For convertible debt and related warrants, the recorded discount is accreted as interest expense using the effective interest method over the life of the debt. -24- STOCK-BASED COMPENSATION We have traditionally applied APB Opinion 25, "ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES," and related interpretations in accounting for our stock-based employee compensation plan. Beginning with the quarter ended March 31, 2006, we adopted the provisions of SFAS No. 123(R), "ACCOUNTING FOR STOCK-BASED COMPENSATION." For the fiscal year ended June 30, 2006 and June 30, 2005, we granted 125,000 (granted prior to March 31, 2006) and 253,000, respectively, of incentive-based stock options under incentive compensation plans. For prior reporting periods, had compensation cost been determined based on the fair value of stock options granted in a manner consistent with the method promulgated by SFAS No. 123, our net loss and loss per share would have been changed to the pro forma amounts as reported in our financial statements the fiscal year ended June 30, 2007 and June 30, 2006. We will continue to disclose on a pro forma basis according to SFAS No. 123 during the transition period to be in accordance with SFAS No. 123(R). ALLOWANCE FOR DOUBTFUL ACCOUNTS While the company has historically experienced very low levels of bad debt, we constantly monitor our current accounts receivable for past due accounts. If we have specific knowledge of a current account that may be uncollectible, we will add that amount to our allowance for doubtful accounts. We are susceptible to changes in the pharmaceutical market as well as changes in the overall economy. A downturn in the market or cost reductions and consolidation such as the market is currently experiencing, may change how we estimate our allowance. The company had not experienced any bad debt in the prior two fiscal years. We incurred one significant bad debt in the current fiscal year for approximately $24,000. However, based on the current changes in our marketplace, we may need to increase our bad debt allowance in future periods, which would reduce our operating and net profits. The balance of the bad debt allowance was approximately $29,000 and $32,000 for the fiscal year ended June 30, 2007 and June 30, 2006, respectively. OPERATING EXPENSES Historically, we have segregated our recurring operating expenses among three categories: laboratory and cost of goods sold; selling, general and administrative expenses; and research and development. Laboratory expenses and cost of goods sold consist of amounts necessary to complete the revenue and earnings process, and includes direct labor and related benefits, other direct costs, and an allocation of facility charges and information technology costs, and depreciation and amortization. Also, laboratory expenses and cost of goods sold include shipping and handling fees and reimbursable out-of-pocket costs. Laboratory expenses and cost of goods sold, as a percentage of net revenue, tends, and is expected, to fluctuate from one period to another, as a result of changes in labor utilization and the mix of service offerings involving studies conducted during any period of time. Selling, general and administrative expenses include business development activities, sales and marketing expenses and related commissions, and laboratory administration expenses. Selling, general and administrative expenses consist primarily of administrative payroll and related benefit charges, legal and accounting fees, advertising and promotional expenses, administrative travel and an allocation of facility charges, information technology costs, and depreciation and amortization. Research and development expenses consist of direct labor and related benefits, supplies, legal fees for patent applications, travel expenses, and depreciation and amortization. RESULTS OF OPERATIONS FOR THE FISCAL YEARS ENDED JUNE 30, 2007 AND 2006 REVENUE: - ------------------------------------------------------------------------------- YEARS ENDED JUNE 30, ------------------------------------------------ DOLLARS IN THOUSANDS, $ % ROUNDED TO NEAREST THOUSAND 2007 2006 Change Change - ------------------------------------------------------------------------------- REVENUE 8,480 10,750 (2,270) (21) - ------------------------------------------------------------------------------- Our revenue is primarily generated from clinical pharmaceutical trials testing services and from diagnostic services. The approximately 21% decrease in fiscal 2007 revenue from fiscal 2006 was primarily attributable to a decrease in -25- the size and number of clinical pharmaceutical trials testing and diagnostic testing services we performed. This decrease is contrary to the significant increases in revenue and open work orders we experienced in fiscal 2006. Over the last three fiscal years, we have made significant investments in our business development initiatives that have been responsible for a significant portion of the revenue increase in fiscal 2006. However, our quarterly and annual revenues are subject to fluctuations. The clinical pharmaceutical trials testing and diagnostic testing services that we provide are many times subject to setup and initiation delays, or early termination of studies, which impact our revenues. In particular, in fiscal 2007 we had expected a large prospective study contract to close for over $2,000,000 in the third quarter of fiscal 2007; however, this study was delayed until the fourth quarter and eventually cancelled before the end of the fiscal year 2007. The cancellation of this study had a significant impact on our revenue for fiscal 2007. We did not have a similar study cancellation during fiscal 2006. Also, in the second and third quarters of fiscal 2006, we recognized revenue in excess of $2,600,000 from several large studies; however, we did not have any comparable large studies in fiscal 2007. However, we did see a significant rebound in referral business from other laboratories during fiscal 2007, compared to fiscal 2006. The overall revenue decrease for the fiscal year ended June 30, 2007 reflects revenue decreases that occurred in the fiscal year after the first quarter. Combined revenue for the first quarter for the fiscal year ended June 30, 2007 showed an increase of approximately $770,000 over the comparable quarter in the prior fiscal year. Each successive quarter for fiscal 2007, second through fourth, showed a decrease in revenue of at least $790,000 over the comparable quarters in the prior fiscal year. We have previously experienced quarterly fluctuations in revenue that were above or below previous fiscal years' revenues. Typically our revenue fluctuations are primarily explained by the timing between our work on testing and open work orders, and prior work orders having been completed or terminated. Historically, our largest two clients in any individual fiscal year have represented in excess of 50% of our revenue. During the fiscal year ended June 30, 2007, our top two clients represented 33% of our revenue as compared to 50% during the fiscal year ended June 30, 2006. Our largest client in fiscal 2007 individually accounted for approximately 17% of our total revenue in fiscal 2007, while our largest client in fiscal 2006 accounted for approximately 36% of our total revenue in fiscal 2006. Revenue from our five largest clients represented approximately 65% and 74% of total revenue in fiscal 2007 and 2006, respectively. LABORATORY EXPENSE AND COST OF GOODS SOLD: - ------------------------------------------------------------------------------- YEARS ENDED JUNE 30, -------------------------------------------- DOLLARS IN THOUSANDS, $ % ROUNDED TO NEAREST THOUSAND 2007 2006 Change Change - ------------------------------------------------------------------------------- LABORATORY EXPENSES AND COST OF GOODS SOLD 5,153 5,161 (8) (0) - ------------------------------------------------------------------------------- PERCENTAGE OF REVENUE 61% 48% - ------------------------------------------------------------------------------- Laboratory expense and cost of goods sold consist primarily of payment of salaries and related benefits to employees performing analysis of clinical trial samples, the cost of supplies for analysis of clinical trial samples, payments to subcontractors of laboratory services, and other expenses such as payment of business and occupation taxes. For the comparable fiscal years ended June 30, 2007 and 2006, laboratory expense and cost of goods sold was essentially unchanged, primarily due to increases in salaries and benefits and rent expense, offset by a decrease in costs of supplies. As a percentage of revenue, laboratory expense and cost of goods sold increased in fiscal 2007 to approximately 61% from approximately 48% in fiscal 2006. The relative increase in laboratory expense and cost of goods sold as a percentage of revenue was primarily the result of the significant decrease in revenues over the comparable periods and the components of laboratory expense and cost of goods sold. The following table illustrates changes in Laboratory Expenses and Cost of Goods Sold in fixed and variable expense categories: -26-
- ---------------------------------------------------------------------------------------------------- YEARS ENDED JUNE 30, ------------------------------------------ DOLLARS IN THOUSANDS, % of % of $ % ROUNDED TO NEAREST THOUSAND 2007 revenue 2006 revenue Change Change - ---------------------------------------------------------------------------------------------------- FIXED COST DETAIL Rent, Utilities, Certain Taxes $ 503 6% $ 387 4% $ 116 30 VARIABLE COST DETAIL Wages, Taxes, Benefits 2,052 24% 1,791 17% 261 15 Reagent Chemicals 1,647 19% 2,153 20% (506) (24) Other Variable Costs 951 11% 830 8% 121 15 Total 4,650 55% 4,774 44% (124) (3) TOTAL COST OF GOODS SOLD $ 5,153 61% $ 5,161 48% $ (8) (0) - ----------------------------------------------------------------------------------------------------
The largest component of laboratory expense during fiscal 2007 was salaries and related benefits. During the fiscal years ended June 30, 2007 and 2006, respectively, salaries and related benefits accounted for approximately 40% and 35% of total laboratory expense and cost of goods sold. Laboratory salaries and related benefits increased approximately 15% to $2,052,000 from $1,791,000 for the fiscal years ended June 30, 2007 and 2006, respectively. The majority of hiring in the laboratory area began in fiscal 2006, for laboratory technicians, data managers, and project managers to address the significant increase in testing volume and clinical studies during fiscal 2006, which we expected to continue into fiscal 2007. At the beginning of fiscal 2006 we had a staff of 25 FTE in the Laboratory and Project Management areas. By the end of fiscal 2006, we had increased staff to 36 FTE, and by the end of fiscal 2007 we had 39 FTE in this area. During fiscal 2007, as our clinical studies declined from 2006, including due to unanticipated cancellation of studies, we did not reduce our laboratory staff. Our highly skilled laboratory technical people are difficult to find, and once hired, we train our staff extensively on our proprietary methods. The other primary component of laboratory expense is the cost of supplies for analysis of clinical trial samples. During the fiscal years ended June 30, 2007 and 2006, respectively, lab supplies were approximately 32% and 42%, and outside services were approximately 9% and 6%. The 24% decrease in laboratory supplies expense resulted directly from the decrease in number of studies during fiscal 2007compared to fiscal 2006, which reduced our costs for reagent chemicals. SELLING, GENERAL AND ADMINISTRATIVE EXPENSE: - ------------------------------------------------------------------------------- YEARS ENDED JUNE 30, --------------------------------------------- DOLLARS IN THOUSANDS, $ % ROUNDED TO NEAREST THOUSAND 2007 2006 Change Change - ------------------------------------------------------------------------------- SELLING, GENERAL AND ADMINISTRATIVE EXPENSE 3,892 3,696 196 5 - ------------------------------------------------------------------------------- PERCENTAGE OF REVENUE 46% 34% - ------------------------------------------------------ Our selling, general and administrative expense consists primarily of compensation for our executive officers, board members and other selling, general and administrative personnel, compensation income (expense) on our stock options, legal and accounting fees, and payments under consulting arrangements. For the comparable years ended June 30, 2007 and 2006, respectively, selling, general and administrative expense increased approximately 5% to approximately $3,892,000 from $3,696,000. As a percentage of revenue, selling, general and administrative expenses were approximately 46% and 34%, respectively, for the comparable fiscal years ended June 30, 2007 and 2006. The dollar increase in our selling, general and administrative expenses for the comparable periods is due in large part to salaries and benefits for management, sales and administrative personnel, which increased approximately $702,000. The majority of this increase is attributable to approximately $555,000 of share-based compensation expense for stock awards granted in the first quarter of fiscal 2007. We issued 125,000 -27- stock options as share-based compensation in fiscal 2006; however, they were issued before implementation of SFAS 123(R) and did not result in compensation expense. We also added additional staff to laboratory management, science and technology and accounting, increasing headcount to 17 FTE in fiscal 2007 from 14 FTE in fiscal 2006. Another factor impacting salaries and benefits, all senior managers and executive officers took a voluntary 10% pay cut effective March 15, 2007, due to the reduced clinical study revenue experienced during fiscal 2007. During fiscal 2007, we had increases in advertising, trade show and travel expenses for business development activities. We reduced expenses for legal, recruiting, consulting, other outside services, insurance and employee bonuses during fiscal 2007. We suspended our investor relations program starting December 1, 2006 to further reduce expenses. RESEARCH AND PRODUCT DEVELOPMENT: - ------------------------------------------------------------------------------- YEARS ENDED JUNE 30, ------------------------------------------- DOLLARS IN THOUSANDS, $ % ROUNDED TO NEAREST THOUSAND 2007 2006 Change Change - ------------------------------------------------------------------------------- RESEARCH AND PRODUCT DEVELOPMENT -- 46 (46) (100) - ------------------------------------------------------------------------------- PERCENTAGE OF REVENUE 0% 0% - -------------------------------------------------------- Research and development expenses consist mainly of our expenditures incurred in connection with development of our LIDA and cell viability technology that is held by our subsidiary, PBI Technology, Inc. For the comparable fiscal years ended June 30, 2007 and 2006, research and product development expenses decreased to zero from approximately $46,000. The decrease was primarily the result of ending further expenditures in this area. For the fiscal year ended June 30, 2006, the research and product development expenses consisted of depreciation charges for laboratory instruments. For the fiscal year ended June 30, 2007, we moved those laboratory instruments to general use in the laboratory. We anticipate that we will no longer incur research and development expenses related to the technology held by PBI Technology. These technology assets held by PBI Technology were written off as of June 30, 2004. OTHER EXPENSE: - ------------------------------------------------------------------------------- YEARS ENDED JUNE 30, -------------------------------------------- DOLLARS IN THOUSANDS, $ % ROUNDED TO NEAREST THOUSAND 2007 2006 Change Change - ------------------------------------------------------------------------------- OTHER EXPENSE 648 1,667 (1,019) (61) - ------------------------------------------------------------------------------- PERCENTAGE OF REVENUE 8% 16% - -------------------------------------------------------- Total other expense decreased 61% to approximately $648,000 from expense of approximately $1,667,000 during the fiscal years ended June 30, 2007 and 2006, respectively. There were three major components of other expense in the year ended June 30, 2007 associated with the Laurus 2004 and 2005 Notes. First, we recorded cash interest expense, approximately $322,000 and $339,000, paid on the 2004 and 2005 Notes, and we recorded approximately $886,000 and $771,000 of non-cash expense related to the accretion of the intrinsic value of the conversion feature and warrants associated with both notes. -28- The second component is net fair value adjustments included in earnings related to these instruments amounted to approximately $694,000 and $299,000 for the fiscal year ending June 30, 2007 and 2006, respectively. The third major component of other expense associated with Laurus related to the approximately $293,500 in fees and expenses related to the 2004 Note, and approximately $168,000 in fees and expenses in the fiscal year ended June 30, 2006, related to the 2005 Note. We are amortizing these fees to deferred financing costs over the amended 48-month life of each note, resulting in approximately $107,000 of expense recognized for the fiscal years ended June 30, 2007 and June 30, 2006. For fiscal 2007, we expect to continue to amortize these expenses at the rate of approximately $9,000 per month, or $27,000 per quarter. Another major component of other expense for fiscal 2006 was approximately $978,000 of warrant expense associated with our private placement of common stock and warrants in March and April 2006, for which we had no comparable expense in fiscal 2007. This warrant expense was a one-time charge in the fiscal year ended June 30, 2006, without any remaining amounts to be amortized in future periods. During the fiscal year ended June 30, 2007, we paid other expense - for settlement charges totaling $50,000. This sum represents our pro rata share of a promissory note in principal amount of $50,000 issued jointly by us and Saigene Corporation in connection with our prior asset purchase agreement dated August 28, 2002. While we and Saigene Corporation were each obligated for $25,000 of the $50,000 promissory note, Saigene was unable to satisfy its portion of the note guarantee for $25,000, which we subsequently paid. See Note 13. Commitments and Contingencies in the financial statement notes. For fiscal 2006, our net "other expense" also included approximately $261,000 in Washington state sales and business and occupation tax refunds (which accrued from a review of past years tax remittances and application of new apportionment rules where we incurred approximately $171,000 of expense for the audit). The State of Washington has subsequently performed an audit of our documentation supporting the refund during fiscal 2007. However, we have not had notification of any changes to this amount to be refunded and continue to carry the balance as "other receivable". NET INCOME (LOSS): - ------------------------------------------------------------------------------- YEARS ENDED JUNE 30, -------------------------------------------- DOLLARS IN THOUSANDS, $ % ROUNDED TO NEAREST THOUSAND 2007 2006 Change Change - ------------------------------------------------------------------------------- NET INCOME (LOSS) (1,213) 179 (1,392) (777) - ------------------------------------------------------------------------------- PERCENTAGE OF REVENUE (14)% 2% - --------------------------------------------------------- We had a loss of approximately $(1,213,000) in fiscal 2007 compared to net income of approximately $179,000 in fiscal 2006. This change to a loss, from net income, is principally due to a significant decrease in revenue during fiscal 2007 and a lesser extent our share-based compensation expense. We experienced a major decrease in gross margin due to the decrease in revenue, increase in costs due to increased staffing in the laboratory and an increase in referral business that included subcontracted testing services. Our selling, general and administrative expenses rose due to increased staffing in business development and accounting. As a percentage of revenue, all expense categories increased. Some offset to the decrease in revenue and increases to expense was provided by and our net income position was favorably impacted by a large gain from adjustment to fair value of the derivative instruments during fiscal 2007 and higher interest income from our positive cash position. LIQUIDITY AND CAPITAL RESOURCES: We had a significant decrease in revenues and a net operating loss for the fiscal year ended June 30, 2007, compared to record revenues and significant net operating income for the fiscal year ended June 30, 2006. By comparison, revenues for the fiscal year ended June 30, 2006 were significantly higher than those in the comparable prior fiscal years and for the fiscal year ended June 30, 2007. While revenues have decreased from a record level for fiscal -29- 2006, we experienced the second highest revenue in our history for fiscal 2007. We have continued to experience significant volatility in our revenues over the past several years. We may experience significant losses and our cash and working capital position will be adversely impacted if our revenues continue to decrease significantly in future periods. Our operations historically have been funded through revenues generated from operations and from the sale and issuance of our common stock, preferred stock and debt. At June 30, 2007, our cash and cash equivalents were approximately $4,220,000, compared to approximately $5,498,000 at June 30, 2006. The decrease in our cash and equivalents is primarily attributable to principal payments on our secured Laurus convertible debt, reduced profitability, and our repurchases of shares of common stock. While cash flow from operations was down approximately $518,000 from fiscal 2006, we maintain a cash balance that we believe will fund our current operating needs through fiscal 2008. The placement of common stock and warrants in March and April 2006 which produced a net cash inflow of approximately $3,963,000 is the main reason for our current cash position. The net decrease in our cash and cash equivalents from the prior fiscal year is the result of: (a) payments on our accounts payable, (b) payments on our accrued liabilities, (c) increases in inventory. These items were more than offset as a the result of: (i) collections on accounts receivable, (ii) increases in advances from customers, (iii) decreases in prepaid expenses. At June 30, 2007, we had approximately $1,659,000 in accounts receivable, compared to approximately $1,978,000 as of June 30, 2006, reflecting the decrease in revenue and timing of revenues billed and collected. We generally have a high collectibility rate on our accounts receivable, however, we experienced our first significant bad debt in the last three fiscal years where we wrote off approximately $24,000. Our allowance for doubtful accounts is $29,300 which we believe is reasonable based on our past experience. Our accounts receivable generally reflect our billings, and may include one or several individually large customer receivables from time to time. Total liabilities recorded on our balance sheet as of June 30, 2007 were approximately $5,859,000 compared to approximately $6,668,000 as of June 30, 2006. The significant decrease in liabilities was the result of decreases in our other notes payable, accounts payable and capital lease obligations, and a large decrease in our overall secured Laurus convertible debt. This was offset only by increases in customer advances. Significant components of our liabilities include the 2004 and 2005 Notes with Laurus, and, to a lesser degree, our prior $350,000 in borrowings in fiscal 2006 under our credit facility with Franklin Funding. As required by U.S. generally accepted accounting principles, the liability we recorded for the 2004 and 2005 Notes reflected a discount from the face value of the secured Laurus convertible notes by approximately $877,000, related to the valuation of the conversion features and the warrants. Those conversion features and warrants are bifurcated from the convertible notes and reported as derivative liabilities. During the fiscal year ended June 30, 2007, Laurus did not convert any portion of the principal amount due on the 2004 Note, compared to $646,600 of the principal amount converted during the fiscal year ended June 30, 2006. As of June 30, 2007 the remaining principal balance on the 2004 Note was $1,416,667. No amounts of the 2005 Note have been converted, and as of June 30, 2007 the remaining principal balance on the 2005 Note was $950,000. Accordingly, if the discount to face value is disregarded, our total liabilities as of June 30, 2007 and June 30, 2006, respectively, would be approximately $6,620,000 and $5,763,000. At June 30, 2007, we had positive working capital of approximately $827,000, compared to approximately $1,904,000 at June 30, 2006. The approximately $1,077,000 decrease in working capital is attributable to several changes in the components of working capital. Changes providing negative impact include decreases in cash, accounts receivable, prepaid expenses and accounts payable. Changes providing positive impact include increases in inventory, customer advances, capital lease obligations, current balances and derivative liability related to the 2004 and 2005 Notes, and other notes payable. The 2004 and 2005 Notes can be converted to common stock at any time if certain conditions are met. The Notes are classified as short-term liabilities on this basis. This classification creates a reduction in working capital. Should the Notes be converted, the effect would increase working capital by the amount converted. The transaction settlement in common stock would increase equity and decrease short-term liabilities. Net cash provided in operating activities was approximately $164,000 for the fiscal year ended June 30, 2007. For the fiscal year ended June 30, 2007, net cash used in operations included the effect of approximately $886,000 of accretion related to the 2004 and 2005 Notes, approximately $290,000 in depreciation and amortization. Our investing activities used approximately $329,000 for the fiscal year ended June 30, 2007 primarily for the repurchase of shares of common stock and capital equipment related to our laboratory. On August 25, 2006, our -30- board of directors authorized the repurchase of shares of common stock up to an aggregate value of $500,000 for shares at a maximum price of $1.17 per share, and under this repurchase program, we repurchased 187,200 shares for a total of $201,544. See "ITEM 5 - Issuer Repurchases of Common Stock" above. Cash flows used in financing activities included approximately $1,112,000 consisting primarily of approximately $1,056,000 in payments on our 2004 and 2005 Notes with Laurus, and payments of approximately $56,000 on capital lease obligations. As described above, we experienced a significant decrease in revenue for the year ended June 30, 2007, and we incurred a net loss. We have realized a decline in our cash and working capital position from operations, and we expect these trends will continue during fiscal 2008, at approximately the same rate due to principal payments for the 2004 and 2005 Notes with Laurus, note payable with Franklin Funding, and capital lease obligations. In fiscal 2008 we will continue to actively pursue business development and marketing activities to broaden our client and revenue base, and we anticipating make additional investments from time to time in our technology infrastructure, operations and other areas of our business. These efforts will use significant amounts of time, effort and funding. Our efforts to improve our operations and increase revenue may not be successful. We expect that our current cash, current assets and any cash flows from operations will be sufficient to fund operations through fiscal 2008. (See "Note 8 to Consolidated Financial Statements" included in this Report). However, any decreases in future revenue would adversely affect our financial condition, and we may need to seek additional capital before fiscal 2009. We may not be able to raise sufficient financing, whether debt or equity. We have no additional amounts available to us under our Franklin Funding credit facility, and we do not have any other credit facility in place. In addition, based on the terms of the Laurus debt financings, raising additional capital may be difficult or highly dilutive to existing stockholders. ITEM 7. FINANCIAL STATEMENTS. Financial Statements are listed in the Index to Financial Statements and filed and included elsewhere herein as a part of this Annual Report on Form 10-KSB, beginning at page F-1. ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. ITEM 8A. CONTROLS AND PROCEDURES. We maintain disclosure controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 is (a) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms and (b) accumulated and communicated to management, including our Chief Executive Officer and Vice President of Finance, as appropriate, to allow timely decisions regarding required disclosure. As of the end of the period covered by this Annual Report on Form 10-KSB, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and Vice President of Finance, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, management and our Chief Executive Officer and Vice President of Finance concluded that our disclosure controls and procedures are effective. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems no evaluation of controls can provide absolute assurance that all control issues if any, within a company have been detected. There has been no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the fourth quarter of fiscal 2007 that has materially affected, or -31- is reasonably likely to materially affect, our internal control over financial reporting. In response to the Sarbanes-Oxley Act of 2002, we are continuing a comprehensive review of our disclosure procedures and internal controls and expect to make minor modifications and enhancements to these controls and procedures. Management continually reviews, modifies and improves its systems of accounting and controls in response to changes in business conditions and operations and in response to recommendations in reports prepared by the independent registered public accounting firm and outside consultants. ITEM 8B. OTHER INFORMATION. Not applicable PART III ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS, CONTROL PERSONS AND CORPORATE GOVERNANCE; COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT. The following list identifies the members of our Board of Directors and our executive officers as of September 28, 2007, and sets forth certain biographical information regarding each person. DIRECTORS AND EXECUTIVE OFFICERS Our directors and executive officers as of September 28, 2007 were as follows: NAME AGE POSITION - --------------------------- ---- ----------------------------------------------- Ronald R. Helm 56 President, Chief Executive Officer and Director Dr. Elizabeth Teng Leary 59 Chief Scientific Officer Dr. Mario Ehlers 48 Chief Medical Officer John P. Jensen 51 Vice President of Finance and Controller Michael P. Murphy 52 Senior Vice-President, Operations Terry M. Giles 59 Director Paul G. Kanan 61 Director Richard W. Palfreyman(1)(2) 65 Director Curtis J. Scheel (1)(2) 48 Director - ---------- (1) Member of Audit Committee (2) Member of Compensation Committee Our Board of Directors currently consists of five directors. Currently, two directors are considered "independent" within the meaning of the listing standards of The NASDAQ Stock Market. Officers are appointed by the Board of Directors. Each executive officer named above will serve until his or her successor is appointed or until his or her earlier death, resignation or removal. RONALD R. HELM has served as our Chairman, Chief Executive Officer and a Director since August 28, 2002. From 1996 to August 28, 2002, Mr. Helm served as the Chairman and CEO of Saigene Corporation, and served on the board of directors of Saigene until January 2004. Mr. Helm was previously in a private law practice with the California law firm of Helm, Purcell & Wakeman. Mr. Helm was a Senior Vice-President and General Counsel for ComputerLand Corporation and also served as the Managing Director of ComputerLand Europe. Prior to that, Mr. Helm was the Associate Dean for Development and a Professor of Law at Pepperdine University School of Law. He received his B.S.Ed from Abilene Christian University and his J.D. from Pepperdine University School of Law. ELIZABETH TENG LEARY, Ph.D, DABCC, has served as our Chief Scientific Officer since 2000, prior to which Dr. Leary was our Vice President of Laboratory Services from 1998. Dr. Leary co-founded Pacific Biometrics Inc., a Washington corporation (PBI-WA), in 1989 and from 1989 to 1998, she was Vice President and Director of the -32- Laboratory Division of PBI-WA. In l989, Dr. Leary also co-founded the Pacific Biometrics Research Foundation (PBRF), a non-profit corporation affiliated with us, and currently serves as the director of the CDC Cholesterol Reference Network Laboratory at PBRF (one of eleven such reference laboratories in the world). Prior to joining Pacific Biometrics, Dr. Leary served as a director of clinical chemistry and industry consultant for 13 years. She is a diplomat of the American Board of Clinical Chemistry. She is past chair of the Pacific Northwest chapter of American Association for Clinical Chemistry (AACC) and the Lipids and Vascular Disease Division of AACC, and past president of the North America Chinese Clinical Chemist Association. She has published over 80 articles in peer-reviewed journals and books and is a recipient of several grants and awards. Dr. Leary received her B.A. from the University of California at Berkeley and her Ph.D. in Biochemistry from Purdue University. She is a graduate of the post-doctoral training program in clinical chemistry at the University of Washington Department of Medicine. MARIO R. EHLERS, M.D., PH.D., has served as our Chief Medical Officer since September 2002. From June 1998 to September 2002, Dr. Ehlers was the Vice President and Chief Medical Officer of Restoragen, Inc., a privately-held biotechnology company. Subsequently, in December 2002, Restoragen, Inc. filed for chapter 11 reorganization and bankruptcy protection. Prior to 1998, Dr. Ehlers has 11 years of experience in academic research. He was formerly chairman of an academic department at the University of Cape Town Medical School in South Africa and an instructor in biochemistry at Harvard Medical School. He is author to over 40 publications, two patents and two additional patent applications, with an international reputation in research on ACE and related proteases and in mycobacterial infectious diseases. Dr. Ehlers received both his MBChB (M.D. equivalent) and Ph.D. from the University of Cape Town in South Africa. JOHN P. JENSEN has served as our Vice President of Finance and Controller since July 1, 2007 and as our Controller since May 2005. From May 2002 to March 2005, Mr. Jensen was Vice President, Operations for Utility, Inc., a privately-held manufacturing company. From June 2000 to March 2002, Mr. Jensen was Director of Operations for Seattle Lab, Inc., a wholly-owned subsidiary of BVRP, Inc., a French public company. Prior to 2000, Mr. Jensen has 22 years of experience in financial management in the manufacturing, professional service and retail medical supply sectors, holding senior management positions at Mountain Safety Research, Inc., a wholly owned subsidiary of REI, Inc., and Karr, Tuttle, Campbell, P.S. Mr. Jensen holds a B.B.A. with a Minor in Mathematics from Eastern Washington University. MICHAEL P. MURPHY, PH.D., has served as our Senior Vice-President, Operations since May, 2005. From June 1999 to May 2005, Dr. Murphy served as Director, Laboratory Operations, Regional CMBP Account Executive, and Technical Director of Laboratory Corporation of America. He served as Director of Laboratory Services from 1998 -1999 at Pacific Biometrics, Inc. before returning to the commercial clinical diagnostic laboratory industry. From November 1993 through November 1997, Dr. Murphy was Technical Director for Laboratory Corporation of America. Prior to 1993 he served as Laboratory Director for Eastern Maine Medical Center and Director, Professional Services at Compulab Corporation. His experience includes various environments such as clinical diagnostic, commercial reference, and clinical trial and research laboratories. His areas of expertise include technical and administrative laboratory operations, method standardization and quality assurance, laboratory consultation and support, information systems and laboratory automation. Research and clinical areas of interest include diabetes, infectious diseases, cardiovascular and oncology testing. Dr. Murphy received his B.S. from Xavier University and Ph.D. from The Ohio State University. He is a Diplomat of the American Board of Clinical Chemistry. TERRY M. GILES was elected to the Board of Directors in September 2003. Mr. Giles previously served on our Board of Directors from 1995 to 2001. Mr. Giles currently is in private law practice in California, and is also an adjunct professor with the Pepperdine University School of Law. Mr. Giles currently also serves as Chairman of Giles Enterprises, a private holding company for various business enterprises, as Chairman of the Board of Landmark Education Corporation, a private company providing seminars on personal growth and responsibility, as Chairman of Mission Control Productivity, Inc., a private company, and as the owner of GWE, LLC, a private company specializing in lender financing. Mr. Giles serves on the Pepperdine University Board of Regents and is a member of the Board of Visitors for the Pepperdine University School of Law. Mr. Giles also serves on the board of directors of The Terry M. Giles Foundation, a charitable foundation. Mr. Giles received his B.A. from California State University at Fullerton and his J.D. from Pepperdine University School of Law. -33- PAUL G. KANAN has served as a Director since July 1996, and previously served as President and Chief Executive Officer from October 1996 through August 2002. Mr. Kanan served as President and Chief Executive Officer of our wholly owned subsidiary, Pacific Biometrics, Inc., a Washington corporation, from October 1996 through August 2002, and as President and a director of BioQuant from October 1993 through August 2002. Since May 2001, Mr. Kanan has served as Vice President of Operations and Chief Financial Officer of Agensys, Inc., a biotechnology firm in California. Mr. Kanan is also an officer and director of CEO Advisors, a health care consulting firm that he co-founded in 1992. Mr. Kanan received his B.S.E. from the University of Michigan and an M.B.A. from Harvard University Graduate School of Business. RICHARD W. PALFREYMAN became a Director on August 28, 2002, and currently serves on our Audit Committee and Compensation Committee. Mr. Palfreyman is currently the President, CEO and Director of the Relax the Back Corporation, serving since November 2001. Mr. Palfreyman's prior business positions include serving as President and Chief Executive Officer of BackSaver Acquisitions Corporation from November 2001 to October 2002, as Chief Operating Officer and Chief Financial Officer of Spafinder, Inc. from October 2000 to August 2001, as Chief Operating Officer of Spectra Entertainment Corporation from October 1996 to June 2000. He has also served as President and Chief Executive Officer of the Photo & Sound Corporation and as the Chief Financial Officer of ComputerLand Corporation. Mr. Palfreyman holds a B.S. in Economics and an M.B.A. from the University of Utah. CURTIS J. SCHEEL became a Director on January 1, 2006, and currently serves on our Audit Committee and Compensation Committee. Mr. Scheel currently serves as the Chief Operating Officer of Ritz Camera Centers, serving since January 2003. Mr. Scheel's prior business positions include President and Chief Financial Officer of Cameraworld.com from December 1999 to May 2002 and Director of National Marketing, Technology Division, Deutsche Financial Services Corp. from July 1996 to December 1999. He has also served as Vice President and Chief Financial Officer at Artisoft, Inc. from September 1995 to June 1996 and Vice President and Treasurer at Microage, Inc. from September 1989 to 1995. Mr. Scheel holds a B.B.A. and an M.B.A. from the University of Wisconsin-Madison. None of the persons specified above share any familial relationship. Other that the persons specified above, there are currently no significant employees expected to make a significant contribution to the business. SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE Section 16(a) of the Securities Exchange Act of 1933, as amended, requires our executive officers and directors, and persons who own more than 10% of our outstanding Common Stock, to file reports of ownership and change in ownership with the Securities and Exchange Commission. Officers, directors and greater than 10% stockholders are required by SEC regulations to furnish us with copies of all such ownership reports they file. Based solely on our review of the copies of such reports we received, or written representations from certain reporting persons, we believe that, during the 2007 fiscal year, all such filing requirements applicable to our executive officers, directors and greater than 10% beneficial owners were complied with, except that the following filings were not made on a timely basis: Terry Giles, one of our directors, filed a Form 4 reporting 5 late transactions. CODE OF ETHICS We have adopted a Code of Ethics applicable to our principal executive officer, principal financial officer, and other employees performing similar functions. We filed a copy of the Code of Ethics as an exhibit to our annual report on Form 10-KSB for the 2004 fiscal year, which may be accessed through the SEC's website at www.sec.gov. AUDIT COMMITTEE The Audit Committee assists the Board in fulfilling its responsibilities to provide oversight with respect to our financial statements and reports, our independent auditors, the system of internal controls and the audit process. Its primary duties include reviewing the results and scope of the audit and other services provided by our independent auditors, and reviewing and evaluating our internal control functions. The Audit Committee also has authority for -34- selecting and engaging our independent auditors and approving their fees. During the 2007 fiscal year, the Audit Committee met 4 times. The Audit Committee currently consists of two directors, Richard Palfreyman (Chairman) and Curtis J. Scheel. Mr. Palfreyman is financially literate, and the Board has determined that Mr. Palfreyman is qualified as an "audit committee financial expert" within the meaning of SEC regulations based on his accounting and related financial management expertise. In addition, Mr. Palfreyman and Mr. Scheel is each considered an "independent director" within the meaning of the listing standards of The NASDAQ Stock Market. POLICY ON STOCKHOLDER NOMINATION OF DIRECTORS There have been no material changes to the procedures by which stockholders may recommend nominees for election to our Board of Directors. ITEM 10. EXECUTIVE COMPENSATION. COMPENSATION OF EXECUTIVE OFFICERS The following table shows for each of the two fiscal years ended June 30, 2007 and 2006 , respectively, compensation awarded or paid to, or earned by, the following persons (collectively, the "NAMED EXECUTIVE OFFICERS"): o Ronald R. Helm, our Chief Executive Officer and Chairman; o Elizabeth T. Leary, Ph.D., our Chief Scientific Officer; and o Mario R. Ehlers, Ph.D., our Chief Medical Officer. SUMMARY COMPENSATION TABLE
STOCK ALL OTHER SALARY BONUS AWARDS COMP. TOTAL NAME AND PRINCIPAL POSITION YEAR ($) ($) ($) ($) ($) - ------------------------------------------------------------------------------------------------------------- Ronald R. Helm (1) 2007 $233,000 $34,500 $396,000 $6,341(1) $669,841 CHIEF EXECUTIVE OFFICER 2006 225,000 90,000 -- 7,339 322,339 AND CHAIRMAN Elizabeth T. Leary (2) 2007 184,458 4,750 17,820 6,736(2) 213,764 CHIEF SCIENTIFIC OFFICER 2006 190,000 53,468 -- 4,874 248,342 Mario R. Ehlers (3) 2007 194,166 5,000 18,810 5,869(3) 223,845 CHIEF MEDICAL OFFICER 2006 192,667 38,585 -- 8,557 240,068
(1) Mr. Helm became a Director, Chairman and Chief Executive Officer on August 28, 2002. The amounts listed under "All Other Compensation" in fiscal 2007 include $1,959 in life insurance premiums paid by us for Mr. Helm's benefit and $4,640 in company-contributions for Mr. Helm's account in the 401(k) plan. (2) Dr. Leary became Chief Scientific Officer in 2000. The amounts in the Bonus column in fiscal year 2007 consist of payouts under the employee bonus program. The amounts in the Bonus column in fiscal year 2006 consist of payouts under the senior manager and employee bonus programs $38,000 and sales commissions paid of $15,468. The amounts listed under "All Other Compensation" in fiscal 2007 include $1,959 of life insurance premiums paid by us for Dr. Leary's benefit and $5,035 in company-contributions for Dr. Leary's account in the 401(k) plan. -35- (3) Dr. Ehlers became Chief Medical Officer on September 30, 2002. The amounts listed under "All Other Compensation" in fiscal 2006 include $1,959 in life insurance premiums paid by us for Dr. Ehlers' benefit and $4,000 in company-contributions for Dr. Ehlers' account in the 401(k) plan. NARRATIVE DISCUSSION OF SUMMARY COMPENSATION TABLE INFORMATION The following provides a narrative discussion of the material factors which we believe are necessary to understand the information disclosed in the foregoing Summary Compensation Table. The following narrative disclosure is separated into sections, with a separate section for each of our Named Executive Officers. RONALD R. HELM, CHIEF EXECUTIVE OFFICER AND CHAIRMAN CASH COMPENSATION. Mr. Helm was awarded total cash compensation for his services to us for fiscal 2007 in the amount of $267,500. Of this sum, $233,000 represents his base salary and $34,500 for cash bonuses. As of the 2007 fiscal year end, Mr. Helm's employment agreement was in process of renegotiation with the Compensation Committee of the Board of Directors. The base salary represents an adjustment to $240,000 from $225,000 in fiscal year 2006; due to the reduced revenue experienced in fiscal 2007, all senior managers including executive officers took a 10 percent pay cut effective March 15, 2007. The Compensation Committee plans to reevaluate Mr. Helm's base salary and long-term incentive awards on an annual basis. In determining Mr. Helm's base salary for the 2007 fiscal year, the Compensation Committee considered Mr. Helm's managerial and executive experience and the level of compensation paid to the highest paid executives at comparable public companies. The Committee also considered competitive trends, our overall financial performance and resources, our operational performance, general economic conditions as well as a number of factors relating to Mr. Helm, including the performance of Mr. Helm, and level of his experience, ability and knowledge of the job. LONG-TERM INCENTIVE AWARDS. On August 25, 2006, the Board awarded Mr. Helm 400,000 shares of restricted stock, at a market price of $.99 per share, fully vested on the date of the grant. In connection with the restricted stock award, Mr. Helm surrendered 160,000 stock options previously granted to him in fiscal 2005 (these options were not valued as compensation as the grant was made in fiscal 2005 under SFAS 123) to obtain 200,000, or half, of the restricted stock award. The amount included under the column "Stock Awards" in the Summary Compensation Table for Mr. Helm represents the dollar amount recognized as compensation expense with respect to the restricted stock award to Mr. Helm of $396,000, as reflected in our audited financial statements for the 2007 fiscal year in accordance with Statement of Financial Accounting Standards Statement No. 123(R), SHARE-BASED PAYMENT (SFAS No. 123(R)), disregarding, however, the estimate of forfeitures related to service-based vesting conditions included in such financial statements and required by SFAS No. 123(R). FRINGE BENEFITS AND PERQUISITES. During fiscal 2007, we provided fringe benefits to Mr. Helm in an amount of $6,341, related to short-term, long-term disability and life insurance and company match on our 401(k) plan. EMPLOYMENT AGREEMENT. On June 1, 2005, as amended August 30, 2006, we entered into an employment agreement with Ronald R. Helm. The employment agreement provides for a base salary of $240,000 per year, with potential bonuses of 20% in year one and 30% in year two based on criteria determined by our board of directors. For the 2006 fiscal year, we paid to Mr. Helm bonuses for achievement of certain performance milestones: (a) 2.5% bonus paid quarterly upon achievement of revenue targets of $2,500,000 for each fiscal quarter; (b) 10% bonus paid upon achievement of a positive operating income and backlog targets; (c) 10% bonus paid upon closing of the PIPE financing in April 2006; and (d) 10% bonus paid upon achievement of overall company performance targets of $10,000,000 in revenue and backlog targets. Pursuant to the amendment in August 2006, Mr. Helm agreed to surrender all of his stock options specified in the original employment agreement in exchange for an award of 200,000 shares of restricted common -36- stock. In addition, Mr. Helm received 200,000 additional shares of restricted stock for meeting fiscal 2006 performance milestones of $10,000,000 in revenue and backlog targets. The term of the employment agreement continues through June 30, 2008, renewable upon mutual agreement of us and Mr. Helm. If we terminate the employment agreement without cause, Mr. Helm will be entitled to receive the unpaid salary and vacation for the remaining term of the agreement, plus any bonus earned as of the date of termination. In the event our company is sold, is the non-surviving party in a merger or completes a sale of substantially all its assets, Mr. Helm will be entitled to receive an amount equal to two times his base annual salary, less any money that he receives from the buyer or surviving entity. Mr. Helm may terminate the agreement upon 30 days' notice. ELIZABETH T. LEARY, CHIEF SCIENTIFIC OFFICER CASH COMPENSATION. Dr. Leary was awarded total cash compensation for her services to us for fiscal 2007 in the amount of $189,208. Of this sum, $184,458 represents her base salary and $4,750 for cash bonuses. The base salary represents an adjustment to $184,458 from $190,000; due to the reduced revenue experienced in fiscal 2007, all senior managers including executive officers took a 10 percent pay cut effective March 15, 2007. The Compensation Committee plans to reevaluate Dr. Leary's base salary and long-term incentive awards on an annual basis. In determining Dr. Leary's base salary for the fiscal year 2007, the Compensation Committee considered Dr. Leary's managerial and executive experience and the level of compensation paid to the highest paid executives at comparable public companies. The Committee also considered competitive trends, our overall financial performance and resources, our operational performance, general economic conditions as well as a number of factors relating to Dr. Leary, including the performance of Dr. Leary, and level of her experience, ability and knowledge of the job. LONG-TERM INCENTIVE AWARDS. On August 25, 2006, the Board awarded Dr. Leary 18,000 shares of restricted stock, at a market price of $.99 per share, fully vested on the date of the grant. The amount included under the column "Stock Awards" in the Summary Compensation Table for Dr. Leary represents the dollar amount recognized as compensation expense with respect to the restricted stock award to Dr. Leary of $17,820, as reflected in our audited financial statements for the 2007 fiscal year in accordance with Statement of Financial Accounting Standards Statement No. 123(R), SHARE-BASED PAYMENT (SFAS No. 123(R)), disregarding, however, the estimate of forfeitures related to service-based vesting conditions included in such financial statements and required by SFAS No. 123(R). FRINGE BENEFITS AND PERQUISITES. During fiscal 2007, we provided fringe benefits to Dr. Leary in an amount of $6,736, related to short-term, long-term disability and life insurance and company match on our 401(k) plan. EMPLOYMENT AGREEMENT. As of the 2007 fiscal year end the employment agreement from 2004 with Dr. Leary remained in force. It specifies a base salary of $190,000 per year, with potential bonuses of 2.5% paid quarterly and 10% annual bonus based on criteria determined by our board of directors. For the 2006 fiscal year, we paid to Dr. Leary bonuses for achievement of certain performance milestones: (a) 2.5% bonus paid quarterly upon achievement of revenue targets of $2,500,000 for each fiscal quarter; (b) 10% bonus paid upon achievement of revenue and backlog targets. MARIO R. EHLERS, CHIEF MEDICAL OFFICER CASH COMPENSATION. Dr. Ehlers was awarded total cash compensation for his services to us for fiscal 2007 in the amount of $199,166. Of this sum, $194,166 represents his base salary and $5,000 for cash bonuses. The base salary represents an adjustment to $194,199 from $200,000; due to the reduced revenue experienced in fiscal 2007, all senior managers including executive officers took a 10 percent pay cut effective March 15, 2007. The Compensation Committee plans to reevaluate Dr. Ehlers's base salary and long-term incentive awards on an annual basis. -37- In determining Dr. Ehlers's base salary for the 2007 fiscal year, the Compensation Committee considered Dr. Ehlers's managerial and executive experience and the level of compensation paid to the highest paid executives at comparable public companies. The Committee also considered competitive trends, our overall financial performance and resources, our operational performance, general economic conditions as well as a number of factors relating to Dr. Ehlers, including the performance of Dr. Ehlers, and level of his experience, ability and knowledge of the job. LONG-TERM INCENTIVE AWARDS. On August 25, 2006, the Board awarded Dr. Ehlers 19,000 shares of restricted stock, at a market price of $.99 per share, fully vested on the date of the grant. The amount included under the column "Stock Awards" in the Summary Compensation Table for Dr. Ehlers represents the dollar amount recognized as compensation expense with respect to the restricted stock award to Dr. Ehlers of $18,810, as reflected in our audited financial statements for the 2007 fiscal year in accordance with Statement of Financial Accounting Standards Statement No. 123(R), SHARE-BASED PAYMENT (SFAS No. 123(R)), disregarding, however, the estimate of forfeitures related to service-based vesting conditions included in such financial statements and required by SFAS No. 123(R). FRINGE BENEFITS AND PERQUISITES. During fiscal 2007, we provided fringe benefits to Dr. Ehlers in an amount of $5,869, related to short-term, long-term disability and life insurance and company match on our 401(k) plan. EMPLOYMENT AGREEMENT. As of the 2007 fiscal year end, we did not have a written employment agreement with Dr. Ehlers. OUTSTANDING EQUITY AWARDS AT FISCAL YEAR-END The following table presents information about unexercised stock options held by each of the Named Executive Officers as of June 30, 2007. As of the end of the 2007 fiscal year, none of the Named Executive Officers held any stock awards that had not vested.
OPTION AWARDS ----------------------------------------------------------------------- EQUITY INCENTIVE PLAN AWARDS: NUMBER OF NUMBER OF NUMBER OF SECURITIES SECURITIES SECURITIES UNDERLYING UNDERLYING UNDERLYING UNEXERCISED UNEXERCISED UNEXERCISED OPTION OPTION OPTIONS OPTIONS UNEARNED EXERCISE EXPIRATION NAME EXERCISABLE UNEXERCISABLE OPTIONS PRICE DATE - ------------------------------------------------------------------------------------------ (#) (#) (#) ($) Ronald R. Helm 340,000 -- -- $0.81 01/30/2014 4,049 -- -- 0.81 01/30/2014 Elizabeth T. Leary 21,922 -- -- 0.51 08/27/2012 157,887 -- -- 0.81 01/30/2014 Mario R. Ehlers 117,391 -- -- 0.81 01/30/2014 3,787 -- -- 0.81 01/30/2014
POTENTIAL PAYMENTS UPON RESIGNATION, RETIREMENT, OR CHANGE OF CONTROL Other than an employment agreement with Mr. Helm (as described above), we do not have any plans or agreements that are specific and unique to executive officers regarding termination of employment or a change of control of the company. However, our 2005 Stock Incentive Plan provides for accelerated vesting of all unvested stock options and unvested stock awards upon a change of control (as defined in the plan), irrespective of the scheduled vesting date for these awards. -38- COMPENSATION OF DIRECTORS We use a combination of cash and stock-based incentive compensation to attract and retain qualified candidates to serve on the Board. The following table presents information about compensation paid to our non-employees directors during fiscal 2007. DIRECTOR COMPENSATION TABLE FEES EARNED OR NAME PAID IN CASH STOCK AWARDS OPTION AWARDS TOTAL - -------------------------------------------------------------------------------- ($) ($) ($) ($) - -------------------------------------------------------------------------------- Terry M. Giles $ 25,000 $12,375(1) -(1) $37,375 Paul G. Kanan 25,000 12,375(2) -(2) 37,375 Richard W. Palfreyman 32,625 12,375(3) -(3) 45,000 Curtis J. Scheel 32,625 12,375(4) -(4) 45,000 - -------------- (1) Mr. Giles held an aggregate of 12,500 stock awards and 25,000 stock options at the end of fiscal 2007. (2) Mr. Kanan held an aggregate of 12,500 stock awards and 178,245 stock options at the end of fiscal 2007. (3) Mr. Palfreyman held an aggregate of 12,500 stock awards and 76,761 stock options at the end of fiscal 2007. (4) Mr. Scheel held an aggregate of 12,500 stock awards and 25,000 stock options at the end of fiscal 2007. NARRATIVE TO DIRECTOR COMPENSATION TABLE The Board grants directors an honorarium of $3,750 per meeting attended. In addition, Committee members receive $625 and Committee Chair receives $1,250 per meeting attended. The Chairman as an employee does not receive cash compensation for his board services. Each non-employee director received a discretionary bonus of $10,000 during fiscal 2007 based on the company's performance in fiscal 2006. ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT, AND RELATED STOCKHOLDER MATTERS. PRINCIPAL STOCKHOLDERS The following table sets forth as of September 28, 2007, certain information regarding the beneficial ownership of our common stock by the following persons or groups: o each person who, to our knowledge, beneficially owns more than 5% of our common stock; o each Named Executive Officer identified in the Executive Compensation table above; o each of our current directors, and o all of our directors and executive officers as a group. As of September 28, 2007, there were issued and outstanding 18,720,147 shares of common stock. -39- BENEFICIAL OWNERSHIP OF COMMON STOCK(2) --------------------------------------- NAME AND ADDRESS(1) NO. OF SHARES PERCENT - -------------------------------------------------------------------------------- OFFICERS AND DIRECTORS: Mario Ehlers, M.D., Ph.D.............. 140,178 (3) ** Terry M. Giles........................ 37,500 (4) ** Ronald R. Helm........................ 947,049 (5) 4.9% Paul G. Kanan......................... 279,269 (6) 1.5 Elizabeth T. Leary, Ph.D.............. 241,207 (7) 1.3 Richard W. Palfreyman ................ 84,261 (8) ** Curtis J. Scheel ..................... 37,500 (9) ** All current directors and executive officers as a group (9 persons)....... 1,766,964 (10) 9.0 5% OWNERS: Saigene Corporation .................. 2,537,057 (11) 13.6 2201 34th Avenue NW, Suite C Gig Harbor, WA 98335 EFG Bank S.A.......................... 1,491,907 8.0 24 Quai du Seujet 1211 Geneva 2, Switzerland Anthony Silverman..................... 1,126,600 (12) 6.0 2747 Paradise Road, #903 Las Vegas, NV 89109 - ------------------ **Less than one percent (1) Except as otherwise noted, the address of each of these stockholders is c/o Pacific Biometrics, Inc., 220 West Harrison Street, Seattle, WA 98119. (2) This table is based upon information supplied by executive officers, directors and principal stockholders. Unless otherwise indicated in the footnotes to this table and subject to community property laws where applicable, to our knowledge, each of the stockholders named in this table has sole voting and investment power with respect to the common stock shown as beneficially owned. (3) Includes 121,178 shares of common stock subject to outstanding stock options held by Dr. Ehlers that are exercisable within 60 days of September 28, 2007 ("Vested Options"). (4) Includes 25,000 shares of common stock subject to Vested Options held by Mr. Giles. (5) Includes 344,049 shares of common stock subject to Vested Options held by Mr. Helm. (6) Includes 88,524 shares of common stock held by the Kanan Living Trust dated May 15, 1990, of which Mr. Kanan is a co-trustee with his wife. Also includes 177,424 shares of common stock subject to Vested Options held by Mr. Kanan. (7) Includes 179,809 shares of common stock subject to Vested Options held by Dr. Leary. (8) Consists of 71,761 shares of common stock subject to Vested Options held by Mr. Palfreyman. (9) Consists of 25,000 shares of common stock subject to Vested Options held by Mr. Scheel. (10) Consists of Ronald R. Helm, Paul G. Kanan, Terry M. Giles, Richard W. Palfreyman, Curtis J. Scheel, Dr. Elizabeth T. Leary, Dr. Mario Ehlers, John P. Jensen and Michael Murphy. Includes an aggregate 945,042 shares of common stock subject to Vested Options held by such persons. (11) Includes an aggregate of 1,036,693 shares of common stock held of record by third parties, but over which Saigene has voting power pursuant to irrevocable proxies granted by such third parties. Also includes 1,350,000 shares of common stock pledged to certain third parties to secure debt obligations of Saigene, but over which Saigene currently retains voting power. (12) Includes 170,000 shares of common stock held by Katsinam Partners, LP, of which Mr. Silverman is the general partner. EQUITY COMPENSATION PLAN INFORMATION The following table gives information as of June 30, 2007, regarding our common stock that may be issued upon the exercise of options, warrants and other rights under our equity compensation plans. See also "Notes 12 and 13 to Consolidated Financial Statements" to our Consolidated Financial Statements for the fiscal year ended June 30, 2007 included in this report. -40-
(A) No. of Shares (B) (C) to be Issued Weighted Average No. of Shares Available Upon Exercise of Exercise Price of for Future Issuance, Outstanding Options, Outstanding Options, excluding securities Plan Category Warrants and Rights Warrants and Rights reflected in Column(a) - ------------- ------------------- ------------------- ---------------------- Equity Compensation Plans Approved by Stockholders (1) 1,353,907 $0.79 446,093 Equity Compensation Plans Approved 673,479 $0.99 2,326,521 by Stockholders (2) Equity Compensation Plans Not Approved by Stockholders 4,390,372 $1.23 - TOTAL 6,417,759 $1.11 2,772,614
- -------------- (1) Consists solely of the Pacific Biometrics, Inc. 1996 Stock Incentive Plan. (2) Consists solely of the Pacific Biometrics, Inc. 2005 Stock Incentive Plan. ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE. Certain information called for by Part III, Item 12, will be included in our proxy statement relating to our 2007 annual meeting of stockholders, and is incorporated here by reference. ITEM 13. EXHIBITS. EXHIBIT NO. DESCRIPTION - ------- ------------------------------------------------------------ 3.1 (1) Amended and Restated Certificate of Incorporation of the Company, as amended - includes (a) Amended and Restated Certificate of Incorporation dated July 9, 1996, (b) Certificate of Amendment to Certificate of Designation for Series A Convertible Preferred Stock, dated as of August 28, 2002, (c) Certificate of Amendment to Restated Certificate of Incorporation, dated February 14, 2003, and (d) Certificate of Designation for Series B Convertible Preferred Stock, dated as of March 6, 2003 3.2 (2) Amended and Restated By-Laws of the Company 4.1 (2) Specimen Stock Certificate 10.1A (3) 1996 Stock Incentive Plan, as amended 10.1B (11) Form of stock option agreement (for employees and officers) under 1996 Stock Incentive Plan 10.1C (11) Form of stock option agreement (for directors) under 1996 Stock Incentive Plan 10.2A (16) 2005 Stock Incentive Plan 10.2B (20) Form of stock option agreement under 2005 Stock Incentive Plan 10.2C (20) Form of restricted stock award agreement under 2005 Stock Incentive Plan 10.3A (15) Executive Employment Agreement, dated June 1, 2006, between Pacific Biometrics, Inc. and Ronald R. Helm 10.3B (17) First Amendment to Executive Employment Agreement, between Pacific Biometrics, Inc. and Ronald R. Helm 10.4++ (12) Employment Agreement, dated October 1, 2004, by and between the Company and Dr. Elizabeth Leary 10.5A (4) Office Lease, dated April 23, 1997, between Tom Kane and Elsa Kane and the Company 10.5B ** First Amendment to Office Lease, dated January 20, 1998 10.5C ** Second Amendment to Office Lease, dated April 20, 2007 10.6 (5) Asset Purchase Agreement, dated as of June 27, 2002, among the Company, PBI-WA and Saigene Corporation -41- 10.7 (6) Amendment Number One to Asset Purchase Agreement, dated as of August 28, 2002, among the Company, Saigene Corporation, and PBI-WA 10.8 (3) Option Agreement, dated August 28, 2002, between the Company and Saigene Corporation 10.9 (10) Common Stock Purchase Warrant issued by the Company in favor of Source Capital Group, Inc. 10.10 (7) Amended and Restated Financing Agreement, dated as of October 1, 2002, among the Company, Transamerica Technology Finance Corporation, successor in interest to Transamerica Business Credit Corporation, and Saigene Corporation 10.11 (7) Restructure Agreement, dated as of October 1, 2002, among the Company, Transamerica Technology Finance Corporation, successor in interest to Transamerica Business Credit Corporation, and Saigene Corporation 10.12 (7) Amendment to Warrant Agreements, dated as of October 1, 2002, among the Company, Transamerica Technology Finance Corporation, successor in interest to Transamerica Business Credit Corporation, and Saigene Corporation 10.13 (7) Investment Agreement, dated as of December 19, 2002, between Saigene Corporation and the Company 10.14 (8) Securities Purchase Agreement, dated May 28, 2004 between the Company and Laurus Master Fund, Ltd. 10.15 (8) $2.5 Million Secured Convertible Term Note, dated May 28, 2004, made by the Company in favor of Laurus Master Fund, Ltd. 10.16 (8) Master Security Agreement dated May 28, 2004, among the Company, BioQuant, Inc., Pacific Biometrics, Inc., a Washington corporation, PBI Technology, Inc., and Laurus Master Fund, Ltd. 10.17 (8) Registration Rights Agreement, dated May 28, 2004, between the Company and Laurus Master Fund, Ltd. 10.18 (8) Common Stock Purchase Warrant, dated May 28, 2004, issued by the Company in favor of Laurus Master Fund, Ltd. for 681,818 shares of common stock. 10.19 (8) Subsidiary Guaranty dated May 28, 2004, among Pacific Biometrics, Inc., a Washington corporation, BioQuant, Inc., and PBI Technology, Inc. 10.20 (8) Stock Pledge Agreement dated May 28, 2004, between the Company and Laurus Master Fund, Ltd. 10.21 (13) Amendment No. 1 and Waiver, dated January 31, 2005, between the Company and Laurus Master Fund, Ltd. 10.22 (13) Amendment No. 2, dated January 31, 2005, among the Company, Pacific Biometrics, Inc., a Washington corporation, BioQuant, Inc., PBI Technology, Inc. and Laurus Master Fund, Ltd. 10.23 (13) Securities Purchase Agreement, dated January 31, 2005 between the Company and Laurus Master Fund, Ltd. 10.24 (13) $1.5 Million Secured Convertible Term Note, dated January 31, 2005, made by the Company in favor of Laurus Master Fund, Ltd. 10.25 (13) Registration Rights Agreement, dated January 31, 2005, between the Company and Laurus Master Fund, Ltd. 10.26 (13) Common Stock Purchase Warrant, dated January 31, 2005, issued by the Company in favor of Laurus Master Fund, Ltd. for 326,087 shares of common stock. 10.27 (14) Amendment No. 1, dated May 6, 2005, between Pacific Biometrics, Inc. and Laurus Master Fund, Ltd. 10.28 (14) Amendment No. 2, dated May 6, 2005, between Pacific Biometrics, Inc. and Laurus Master Fund, Ltd. 10.29 (14) Common Stock Purchase Warrant, dated May 6, 2005, issued by Pacific Biometrics, Inc. in favor of Laurus Master Fund, Ltd. for 1,000,000 shares of common stock. 10.30 (18) Loan and Security Agreement, dated November 3, 2005, between Pacific Biometrics, Inc. and Franklin Funding, Inc. 10.31 (19) Form of Unit Subscription Agreement for March 2006 private placement 10.32 (19) Form of Common Stock Purchase Warrant for March 2006 private placement 14.1 (11) Code of Ethics for Financial Officers 21.1 (9) Subsidiaries of Pacific Biometrics, Inc. 23.1 ** Consent of Williams & Webster P.S. -42- 23.2 ** Consent of PMB Helin Donovan, LLP 31.1 ** Certification by Ronald R. Helm, Chief Executive Officer 31.2 ** Certification by John P. Jensen, Vice President of Finance and Controller 32.1 ** Certification by Ronald R. Helm, Chief Executive Officer and John P. Jensen, Vice President of Finance and Controller, of Pacific Biometrics, Inc., pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. - -------------- ** Filed herewith ++ Portions of the marked exhibit have been omitted pursuant to a request for confidential treatment filed with the SEC. (1) Incorporated by reference to Exhibits of Registrant's Quarterly Report on Form 10-QSB for the quarter ended March 31, 2003, filed on May 15, 2003. (2) Incorporated by reference to Exhibits of Registrant's Pre-Effective Amendment No. 1 to Registration Statement on Form SB-2, Registration No. 333-11551, filed on October 11, 1996. (3) Incorporated by reference to Exhibits of Registrant's Annual Report on Form 10-KSB for the fiscal year ended June 30, 2003, filed on September 29, 2003. (4) Incorporated by reference to Exhibits of Registrant's Annual Report on Form 10-KSB for the fiscal year ended June 30, 1997, filed on September 29, 1997. (5) Incorporated by reference to Exhibits of Registrant's Current Report on Form 8-K filed on July 3, 2002. (6) Incorporated by reference to Exhibits of Registrant's Current Report on Form 8-K filed on September 6, 2002. (7) Incorporated by reference to Exhibits of Registrant's Quarterly Report on Form 10-QSB for the quarter ended December 31, 2002, filed on February 14, 2003. (8) Incorporated by reference to Exhibits of Registrant's Current Report on Form 8-K filed on June 7, 2004. (9) Incorporated by reference to Exhibits of Registrant's Quarterly Report on Form 10-QSB for the quarter ended March 31, 2004, filed on May 14, 2004. (10) Incorporated by reference to Exhibits of Registrant's Registration Statement on Form SB-2, Registration No. 333-116968, filed on June 29, 2004. (11) Incorporated by reference to Exhibits of Registrant's Annual Report on Form 10-KSB for the fiscal year ended June 30, 2004, filed on September 23, 2004. (12) Incorporated by reference to Exhibits of Registrant's Quarterly Report on Form 10-QSB for the quarter ended September 30, 2004, filed on November 15, 2004. (13) Incorporated by reference to Exhibits of Registrant's Current Report on Form 8-K filed on February 1, 2006. (14) Incorporated by reference to Exhibit of Registrant's Current Report on Form 8-K filed on May 10, 2005. (15) Incorporated by reference to Exhibit of Registrant's Current Report on Form 8-K filed on June 7, 2005. (16) Incorporated by reference to Appendix A of Registrant's Definitive Proxy Statement on Schedule 14A filed on October 25, 2005. (17) Incorporated by reference to Exhibit of Registrant's Current Report on Form 8-K filed on September 5, 2006. (18) Incorporated by reference to Exhibit of Registrant's Current Report on Form 8-K filed on November 7, 2005. (19) Incorporated by reference to Exhibit of Registrant's Current Report on Form 8-K filed on March 13, 2006. (20) Incorporated by reference to Exhibits of Registrant's Annual Report on Form 10-KSB for the fiscal year ended June 30, 2006, filed on October 3, 2006. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES Information called for by Part III, Item 14, will be included in our proxy statement relating to our 2007 annual meeting of stockholders, and is incorporated herein by reference. -43- SIGNATURES In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on October 5, 2007. PACIFIC BIOMETRICS, INC. By: /s/ Ronald R. Helm --------------------------- Ronald R. Helm President and Chief Executive Officer In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. SIGNATURE CAPACITIES DATE /s/ Ronald R. Helm Chief Executive Officer, October 5, 2007 - -------------------------- President, and Director Ronald R. Helm (PRINCIPAL EXECUTIVE OFFICER) /s/ John P. Jensen Vice President of Finance October 5, 2007 - -------------------------- and Controller (PRINCIPAL John P. Jensen FINANCIAL OFFICER AND PRINCIPAL ACCOUNTING OFFICER) /s/ Terry M. Giles Director October 5, 2007 - -------------------------- Terry M. Giles /s/ Paul G. Kanan Director October 5, 2007 - -------------------------- Paul G. Kanan /s/ Richard W. Palfreyman Director October 5, 2007 - -------------------------- Richard W. Palfreyman /s/ Curtis J. Scheel Director October 5, 2007 - -------------------------- Curtis J. Scheel -44- PACIFIC BIOMETRICS, INC. Form 10-KSB Annual Report Index to Consolidated Financial Statements Page ---- Report of Independent Registered Public Accounting Firm F-2 Report of Independent Registered Public Accounting Firm F-3 Consolidated Financial Statements: Consolidated Balance Sheets as of June 30, 2007 and 2006 F-4 Consolidated Statements of Operations for the years ended June 30, 2007 and 2006 F-5 Consolidated Statements of Cash Flows for the years ended June 30, 2007 and 2006 F-6 Consolidated Statement of Stockholders' Equity for the years ended June 30, 2007 and 2006 F-7 Notes to Consolidated Financial Statements F-8 F-1 PMP Helin Donovan, LLP Certified Public Accountants & Business Consultants - -------------------------------------------------------------------------------- Pacific Biometrics, Inc. Seattle, WA REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We have audited the accompanying balance sheets of Pacific Biometrics, Inc. as of June 30, 2007 and the related statements of operations, stockholders' equity and cash flows for the year then ended. 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 audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Pacific Biometrics, Inc. as of June 30, 2007 and the results of its operations, stockholders' equity and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. /s/ PMB Helin Donovan LLP PMB Helin Donovan LLP Certified Public Accountants San Francisco, California September 20, 2007 50 Francisco Street, Suite 120 San Francisco, CA 94133 Phone (415) 399-1330- Fax (415) 399-9212- www.pmbhd.com F-2 Williams & Webster, P.S. Certified Public Accountants & Business Consultants - -------------------------------------------------------------------------------- Pacific Biometrics, Inc. Seattle, WA REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We have audited the accompanying balance sheet of Pacific Biometrics, Inc. as of 2006, and the related statement of operations, stockholders' equity and cash flows for the year then ended. 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 audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Pacific Biometrics, Inc. as of June 30, 2006 and the results of its operations, stockholders' equity and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. /s/ Williams & Webster, P.S. Williams & Webster, P.S. Certified Public Accountants Spokane, Washington September 30, 2006 Members of Private Companies Practice Section, SEC Practice Section, AICPA and WSCPA Bank of America Financial Center - 601 W Riverside, Suite 1940 - Spokane, WA 99201 Phone (509) 838-5111 - Fax (509) 838-5114 - www.williams-webster.com F-3 PACIFIC BIOMETRICS, INC. CONSOLIDATED BALANCE SHEETS AS OF JUNE 30,
ASSETS 2007 2006 ------------ ------------ Current assets: Cash and cash equivalents $ 4,219,926 $ 5,497,737 Accounts receivable, net 1,659,483 1,977,589 Other receivables 261,753 258,263 Inventory 163,965 -- Prepaid expenses and other assets 104,825 363,966 Deferred financing cost on secured convertible note - current portion 107,170 107,170 ------------ ------------ Total current assets 6,517,122 8,204,725 Property and equipment, net 835,934 693,231 Other assets: Deferred financing cost on secured convertible note - long-term portion 18,447 125,617 ------------ ------------ Total assets $ 7,371,503 $ 9,023,573 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 482,058 $ 549,517 Accrued liabilities 478,794 499,858 Advances from customers 1,093,776 966,573 Capital lease obligation - current portion 58,841 51,994 Secured convertible note - current portion, net of unaccreted fair value assigned to conversion feature and warrants of $761,907 and $1,684,210 respectively 1,604,761 1,641,590 Embedded derivative liability - current portion 1,047,492 1,391,463 Freestanding derivative liability relating to secured convertible note - current portion 811,536 1,161,770 Other notes payable - current portion 113,339 38,148 ------------ ------------ Total current liabilities 5,690,597 6,300,913 Capital lease obligations - long - term portion 65,619 56,500 Other notes payable - long - term portion 102,467 310,938 ------------ ------------ Total liabilities 5,858,683 6,668,351 ------------ ------------ Stockholders' equity: Preferred stock, Series A convertible $0.01 par value, 5,000,000 shares authorized, 0 shares issued and outstanding for 2007and 2006 -- -- Common stock, $0.01 par value, 30,000,000 shares authorized, 18,720,147 and 18,336,884 shares issued and outstanding, respectively 360,803 355,098 Additional paid-in capital 28,288,347 27,921,488 Accumulated deficit (27,133,035) (25,919,941) Treasury stock (3,295) (1,423) ------------ ------------ Total stockholders' equity 1,512,820 2,355,222 ------------ ------------ Total liabilities and stockholders' equity $ 7,371,503 $ 9,023,573 ============ ============
The accompanying notes are an integral part of these consolidated financial statements. F-4 PACIFIC BIOMETRICS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED JUNE 30,
2007 2006 ------------ ------------ Revenues $ 8,480,330 $ 10,750,023 ------------ ------------ Laboratory expenses and cost of sales 5,153,039 5,161,011 ------------ ------------ Gross Profit 3,327,291 5,589,012 ------------ ------------ Operating expenses: Research and product development -- 46,283 Selling, general and administrative 3,892,054 3,696,284 ------------ ------------ Operating income (loss) (564,763) 1,846,445 ------------ ------------ Other income (expense): Interest expense (376,927) (402,072) Interest expense from accretion of conversion feature and warrants - secured convertible debt (886,304) (771,429) Gain on adjustment of embedded and freestanding derivatives to fair value 694,205 298,616 Amortization of deferred financing costs - secured convertible debt (107,170) (107,170) Interest income 88,343 18,275 Other income 1,346 321,378 Warrant expense for equipment lease and financing (11,820) (1,024,940) Other expense (50,000) -- ------------ ------------ Total other income (expense) (648,327) (1,667,342) Net earnings (loss) before tax expense (1,213,090) 179,103 ------------ ------------ Tax expense -- -- Net earnings (loss) $ (1,213,090) $ 179,103 ============ ============ Net earnings (loss) per share: Basic earnings (loss) per share $ (0.06) $ 0.01 ============ ============ Diluted earnings (loss) per share $ (0.06) $ 0.01 ============ ============ Weighted average common shares outstanding: Basic 18,720,147 13,295,169 ============ ============ Diluted 18,720,147 16,245,998 ============ ============
The accompanying notes are an integral part of these consolidated financial statements. F-5 PACIFIC BIOMETRICS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended June 30,
2007 2006 ------------ ------------ Cash flows from operating activities: Net earnings (loss) $ (1,213,090) $ 179,103 Reconciliation of net earnings (loss) to net cash provided by (used in) operating activities: Depreciation and amortization 290,222 256,889 Accretion of fair value assigned to conversion feature and warrants 886,303 771,429 Amortization of deferred financing costs on secured convertible note 107,170 107,170 Bad Debt Expense 23,909 -- Gain from embedded and freestanding derivative liabilities relating to secured convertible note (694,205) (298,616) Warrant expense for equipment lease and financing 11,820 1,024,940 Compensation expense (income) from restricted shares and options 560,415 944 Changes in assets and liabilities: ---------------------------------- Accounts receivable 294,197 (1,369,722) Other receivable (3,490) (256,243) Inventory (163,965) -- Prepaid expenses and other assets 25,664 231,645 Advances from customers 127,203 269,012 Accounts payable (67,459) 111,175 Accrued liabilities (21,064) (346,409) ------------ ------------ Net cash provided by operating activities 163,629 681,317 ------------ ------------ Cash flows from investing activities: Purchases of capital equipment (127,458) (512,684) Acquisition of Company common stock (201,544) -- ------------ ------------ Net cash used in investing activities (329,002) (512,684) ------------ ------------ Cash flows from financing activities: Payments on notes payable (1,056,414) (370,492) Net proceeds from loan and security agreement -- 350,000 Payments on capital lease obligations (56,024) (51,993) Net proceeds from private placement of common stock -- 3,963,045 ------------ ------------ Net cash provided by (used in) financing activities (1,112,438) 3,890,560 ------------ ------------ Net increase (decrease) in cash and cash equivalents (1,277,811) 4,059,193 Cash and cash equivalents, beginning of period 5,497,737 1,438,543 ------------ ------------ Cash and cash equivalents, end of period $ 4,219,926 $ 5,497,737 ============ ============ Supplemental Information: Cash paid during the period for interest $ 362,797 $ 408,311 Cash paid during the period for income taxes $ -- $ -- Non-cash investing and financing activities: Cashless exercise of stock options and warrants $ 272 $ 1,022 Warrants issued in consideration of issuance costs for private placement $ -- $ 300,154 Warrants issued to private placement investors $ -- $ 599,149 Warrants issued in conjuction with equipment financing $ -- $ 34,723 Common stock issued upon conversion of principal on Laurus convertible note $ -- $ 646,600
The accompanying notes are an integral part of these consolidated financial statements. F-6 PACIFIC BIOMETRICS, INC. CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
Series A Preferred Stock Common Stock Additional Total ---------------------- --------------------- Treasury Paid-in Accumulated Stockholders' Shares Amount Shares Amount Stock Capital Deficit Equity ---------- --------- ---------- -------- --------- ------------ ------------ ------------ Balance June 30, 2005 1,550,000 $ 15,500 13,325,705 $304,985 $ (1,423) $ 22,326,406 $(26,099,044) $ (3,453,577) Warrants issued in conjunction with private placement of common stock -- -- -- -- -- 978,137 -- 978,137 Fair value of warrants issued to lender in conjunction with non-revolving line of credit -- -- -- -- -- 7,142 -- 7,142 Fair value adjustment to stock options -- -- -- -- -- (79) -- (79) Common stock issued to Laurus Master Funds for note payment -- -- 610,000 6,100 640,500 -- 646,600 Fair value of warrants issued to placement agent - Laurus Master Funds note payment -- -- -- -- -- 39,661 -- 39,661 Common stock issued to investors - private placement of common stock and warrants -- -- 3,185,231 31,853 -- 3,931,192 -- 3,963,045 Cancellation of common stock released from escrow, previously held in trust as security for note payable -- -- (583,333) (5,833) -- -- -- (5,833) Common stock issued for conversion of preferred Series A shares -- -- 1,791,907 17,919 -- (17,919) -- -- Preferred Series A shares converted into common stock (1,550,000) (15,500) -- -- -- 15,500 -- -- Stock options exercised - cashless exercise -- -- 7,374 74 -- 948 -- 1,022 Net income for year ended June 30, 2006 -- -- -- -- -- -- 179,103 179,103 ---------- --------- ---------- -------- --------- ------------ ------------ ------------ Balance June 30, 2006 -- -- 18,336,884 355,098 (1,423) 27,921,488 (25,919,941) 2,355,221 Cashless exercise of stock options and warrants -- -- 27,229 272 -- (272) -- -- Warrants issued for equipment leasing -- -- -- -- -- 11,820 -- 11,820 Restricted shares issued -- -- 543,234 5,433 -- 532,369 -- 537,802 Stock options issued - compensation expense -- -- -- -- -- 22,615 -- 22,615 Common stock purchased -- -- (187,200) -- (1,872) (199,672) -- (201,544) Net loss for year ended June 30, 2007 -- -- -- -- -- -- (1,213,090) (1,213,090) ---------- --------- ---------- -------- --------- ------------ ------------ ------------ Balance June 30, 2007 -- $ -- 18,720,147 $360,803 $ (3,295) $ 28,288,347 ($27,133,035) $ 1,512,820 ========== ========= ========== ======== ========= ============ ============ ============
The accompanying notes are an integral part of these consolidated financial statements. F-7 PACIFIC BIOMETRICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND BASIS OF PRESENTATION Pacific Biometrics, Inc., a Delaware corporation ("PBI" or the "Company"), provides specialty reference laboratory services to the pharmaceutical and diagnostics industries. The Company was incorporated in Delaware in May 1996. The Company conducts its business primarily through its wholly owned subsidiary, Pacific Biometrics, Inc., a Washington corporation ("PBI-WA"). The Company's other wholly owned subsidiaries include PBI Technology, Inc., a Washington corporation, and BioQuant, Inc., a Michigan corporation. The Company had previously been engaged in the development and commercialization of non-invasive diagnostics to improve the detection and management of chronic diseases. Due to a lack of significant resources, the Company had suspended such activities. Laboratory services constitute the majority of the Company's commercial efforts. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION These consolidated financial statements include consolidated financial position, results of operations, and statements of stockholders' equity and cash flows of Pacific Biometrics, Inc. and its subsidiaries. All material intercompany balances and transactions have been eliminated in the accompanying consolidated financial statements. CASH AND CASH EQUIVALENTS Cash and cash equivalents consist of highly liquid investments with an original maturity of three months or less when purchased. ACCOUNTS RECEIVABLE Accounts receivable are stated at amounts billed to and due from clients net of an allowance for doubtful accounts. Credit is extended based on evaluation of a client's financial condition, and collateral is not required. In determining the adequacy of the allowance, management identifies specific receivables for which collection is not certain and estimates the potentially uncollectible amount based on the most recently available information. The Company writes off accounts receivable when they are determined to be uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts. For the year ended June 30, 2007 we had one account balance written off for $23,909. For the year ended June 30, 2006, the Company deemed no accounts receivable uncollectible. The balance of the bad debt allowance was approximately $29,000 and $32,000 for the fiscal year ended June 30, 2007 and June 30, 2006, respectively. INVENTORY Inventory is stated the lower of cost or market. Cost is determined on a first in, first out (FIFO) basis. Our inventory consists of reagent chemicals, which the Company began buying in bulk in 2007, which are used in our laboratory testing. LONG - LIVED ASSETS Property and equipment are recorded at cost. Depreciation is provided using the straight-line method over the useful lives of the related assets, which range from three to five years. Leasehold improvements are amortized over the shorter of the estimated useful life of the improvements or the remaining term of the lease. The cost and related accumulated depreciation of property or equipment sold or otherwise disposed of are removed from the accounts and the resulting gains or losses are included in the statement of operations. F-8 In accordance with the Financial Accounting Standards Board's Statements of Financial Accounting Standards Statement No. 144 - "ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS" ("SFAS 144"), all of the Company's long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount may not be recovered. If the sum of the expected future cash flows is less than the carrying amount of the asset, a loss is recognized. TECHNOLOGY ASSETS PBI Technology, Inc., a wholly owned subsidiary of the Company, has been established to hold certain technologies and intellectual property, including isothermal DNA amplification method (LIDA), Cell Viability technology, Osteopatch and Saliva Sac(R). The Company wrote off the entire balance of $476,874 related to the technology assets to operations as impairment of technology assets as of June 30, 2004. The Company did not allocate resources to business development activities for the technologies held by PBI Technology, Inc. during the fiscal year ended June 30, 2007. CLIENT ADVANCES The Company receives advances from certain clients to perform consulting, laboratory services, and clinical studies. These advances are applied as payments to invoices as work is completed until the amounts advanced are exhausted. Advances are also applied to invoices for setup and administrative fees, billed upon contract approval. These setup and administrative fees are deferred as unearned income when billed and amortized over the life of the project. INCOME TAXES The Company recognizes deferred tax assets and liabilities based on differences between the financial reporting and tax bases of assets and liabilities using the enacted tax laws and rates that are expected to be in effect when the differences are expected to be recovered. The Company provides a valuation allowance for deferred tax assets due to the uncertainty of realization. The Company follows SFAS 109, as amended, to prepare income tax reporting. FINANCIAL INSTRUMENTS The carrying amounts of cash, cash equivalents, and accounts receivable approximate fair value due to the short-term maturities of these instruments. The carrying value of the Company's secured convertible note is recorded net of the unaccreted fair value assigned to conversion feature and warrants, representing its estimated fair value. (See Note 8 Notes Payable) The carrying value of the Company's other debt approximates their estimated fair values due to the rates of interest on the debt approximate current interest rates for similar obligations with like maturities. DERIVATIVE FINANCIAL INSTRUMENTS The Company generally does not use derivative financial instruments to hedge exposures to cash-flow or market risks. However, certain other financial instruments, such as the embedded conversion features of debt instruments that are indexed to the Company's common stock, are classified as liabilities when either (a) the holder possesses rights to net-cash settlement or (b) physical or net share settlement is not within the control of the Company. In such instances, net-cash settlement is assumed for financial accounting and reporting, even when the terms of the underlying contracts do not provide for net-cash settlement. Such financial instruments are initially recorded at fair value and subsequently adjusted to fair value at the close of each reporting period. Fair value for option based derivative financial instruments is determined using the Black-Scholes pricing model. FINANCIAL DERIVATIVES - EMBEDDED FEATURES AND WARRANTS Embedded conversion and other features that meet the definition of derivative financial instruments have, where applicable, been bifurcated from host instruments (secured convertible notes - see Note 8. Notes Payable) and, in all instances derivative financial instruments have been recorded as assets or liabilities and are carried at fair value, using the Black-Scholes pricing model. The Company records the value allocated to warrants issued with the convertible instruments, measured at fair value, using the Black-Scholes pricing model and recognized by allocating a portion of the proceeds to derivative liabilities with an offset to discount on the convertible instrument. The recorded discount is accreted as interest expense using the effective interest method over the life of the debt. F-9 STOCK-BASED COMPENSATION The Company has traditionally applied APB Opinion 25, "ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES," and related interpretations in accounting for its stock-based employee compensation plan. On January 1, 2006, the Company adopted the provisions of SFAS No. 123(R), "SHARE-BASED PAYMENT", using the modified prospective transition method. Under the transition method, compensation cost recognized in the year ended June 30, 2006, includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123(R), and (b) compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). Results for prior periods have not been restated, in accordance with the modified prospective transition method. As a result of adopting SFAS No. 123(R) on January 1, 2006, the Company's net loss for the year ended June 30, 2006 is unchanged compared to if it had continued to account for share-based compensation under APB 25. The Company did not grant any share-based compensation after January 1, 2006 and before year end at June 30, 2006. SFAS No. 123(R) requires companies to estimate the fair value of equity-based payment awards on the date of grant using an option-priced model. The value of the portion of the award that is ultimately expected to vest is recognized as an expense over the requisite service periods in the Company's consolidated income statements. Prior to adoption of SFAS No. 123(R), the Company accounted for equity-based awards to employees and directors using the intrinsic value method in accordance with APB No. 25 as allowed under Statement of Financial Accounting Standards No. 123, "ACCOUNTING FOR STOCK-BASED COMPENSATION" SFAS NO. 123(R) and recognized compensation expenses, over the requisite service period of each of the awards. For the fiscal year ended June 30, 2007, the Company granted 130,245 incentive-based stock options and 543,234 incentive-based restricted shares. This was the first grant under the provisions of SFAS No. 123(R). For the fiscal year ended June 30, 2006, the Company granted 253,000 incentive-based stock options which were granted prior to March 31, 2006 and the adoption of the provisions of SFAS No. 123(R). Both grants of incentive-based stock options and restricted shares were under incentive compensation plans. For prior reporting period, had compensation cost been determined based on the fair value of stock options granted in a manner consistent with the method promulgated by SFAS No. 123, the Company's net loss and loss per share would have been changed to the pro forma amounts in the table below for the fiscal year ended June 30, 2006. 2006 ------------ Net income (loss) as reported $ 179,103 Adjust: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects 62,135 ------------ Pro forma net income (loss) $ 116,968 ============ Net loss per share: Basic - as reported $ 0.01 ============ Diluted - as reported $ 0.01 ============ Basic - pro forma $ 0.01 ============ Diluted - pro forma $ 0.01 ============ F-10 To estimate compensation expense, the Company uses the Black-Scholes pricing model and assumptions deemed reasonable by management. All options are valued as of the date of the grant period. The following assumptions were used to compute the fair value of option grants for the year ended June 30: 2007 2006 ---------- ---------- Expected volatility 105% 83% Expected dividend yield 0% 0% Risk-free interest rate 5.03% 5.05% Expected life 10 years 10 years The total equity-based compensation expense related to all of the Company's equity-based awards, recognized for the fiscal year ended June 30, 2007, was comprised as follows: Laboratory Expenses and Cost of Sales $ 13,582 Selling, general and administrative $ 546,833 ---------- Total equity-based compensation expense $ 560,415 Effect of equity-based compensation expenses, on basic and diluted loss per Ordinary share $ (0.03) REVENUE RECOGNITION The Company recognizes revenue in the period that the related services are performed and collectibility is reasonably assured. Currently, the Company derives substantially all of its revenues from laboratory services. Service contracts generally take the form of fixed-price contracts. Under fixed-price contracts, revenue is recognized as services are performed, with performance generally assessed using output measures, such as units-of-work performed to date as compared to the total units-of-work contracted. Changes in the scope of work generally result in a renegotiation of contract pricing terms and/or a contract amendment. Renegotiated amounts are not included in net revenues until earned, and realization is assured. Advance payments on service contracts are treated as a deposit and applied to periodic billing during the contract period. Setup and administrative fees are billed upon contract approval. Revenues from setup and administrative fees are amortized over the life of the contract. Historically, costs are not deferred in anticipation of work on contracts after they are awarded, but instead are expensed as incurred. All out-of-pocket costs are included in expenses. RESEARCH AND DEVELOPMENT EXPENSES Expenditures for research and development are expensed as incurred. We anticipate that we will no longer incur research and development expenses related to the technology held by PBI Technology, Inc. EARNINGS (LOSS) PER SHARE Basic net income (loss) per share is based upon the weighted average number of common shares outstanding. Diluted earnings per share is computed on the basis of the weighted average number of common shares outstanding plus the effect of outstanding stock options and warrants using the "treasury stock" method and the effect of preferred stock on an as-converted basis. All per share calculations exclude treasury shares. As of June 30, 2007, vested, in-the-money options to purchase 183,917 shares of common stock and in-the-money warrants to purchase 457,607 shares of common stock were outstanding and were not included in the computation of diluted loss per share because the effect would be antidilutive for fiscal 2007. As of June 30, 2006, vested, in-the-money options to purchase 1,175,101 shares of common stock and in-the-money warrants to purchase 1,775,727 shares of common stock were outstanding and were included in the computation of diluted earnings per share for fiscal 2006. In addition, 1,550,000 shares of Series A preferred convertible stock were not included in the computation of diluted loss per share because the shares of Series A preferred stock were converted into common stock during April of the fiscal year ended June 30, 2006. F-11 USE OF ESTIMATES In preparing financial statements in conformity with accounting principles generally accepted in the United States of America ("U.S. GAAP"), management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. NEW ACCOUNTING PRONOUNCEMENTS In February 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities--Including an amendment of FASB Statement No. 115". This statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This statement is expected to expand the use of fair value measurement, which is consistent with the Board's long-term measurement objectives for accounting for financial instruments. This statement is effective as of the beginning of an entity's first fiscal year that begins after November 15, 2007. Early adoption is permitted. Management has not determined the effect that adoption of this statement would have on the Company's financial condition or results of operations. In September 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans--an amendment of FASB Statements No. 87, 88, 106, and 132(R)". This statement requires an employer to recognize the overfunded or underfunded positions of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income of a business entity or changes in unrestricted net assets of a not-for-profit organization. This statement also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions. Management believes the adoption of this statement will have no immediate material effect on the Company's financial condition or results of operations. In September 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 157, "FAIR VALUE MEASUREMENTS". This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. Where applicable, SFAS No. 157 simplifies and codifies related guidance within GAAP and does not require any new fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Earlier application is encouraged. Management has not determined the effect that adoption of this statement would have on the Company's financial condition or results of operations. In June 2006, the Financial Accounting Standards Board issued FASB Interpretation No. 48 "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109," which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company does not expect the adoption of FIN 48 to have a material impact on its financial reporting. 3. CONCENTRATION OF CREDIT RISK The Company's largest client in fiscal 2007 individually accounted for approximately 17% of the Company's total revenues in fiscal 2007, while the Company's largest client in fiscal 2006 accounted for approximately 36% of the Company's total revenues in fiscal 2006. As of June 30, 2007 and 2006, respectively, approximately 54% and 27% of the Company's accounts receivable balance was from the two largest clients at that time. F-12 Clients of the Company represent many Fortune 500 pharmaceutical companies. The revenues from several pharmaceutical company divisions are aggregated as a single client for the Company's revenue calculations. Sixteen percent of the Company's revenue is derived from Fortune 500 clients for the year ended June 30, 2007. The percentage of revenue increases to 40% using the Fortune Global 500 list. The Company's exposure to concentration of credit risk is reduced considering the financial strength of the Company's clients. The Company maintains its cash in three insured commercial accounts and one uninsured investment account at major financial institutions. Although the financial institutions are considered creditworthy and have not experienced any losses on their deposits, the Company's cash balance exceeded Federal Deposit Insurance Corporation (FDIC) limits by $3,919,926 at June 30, 2007 and by $5,397,737 at June 30, 2006. 4. PREPAID EXPENSES AND OTHER ASSETS Prepaid expenses consisted of the following at June 30: 2007 2006 ---------- ---------- Laboratory Information System Software .......... $ -- $ 233,477 Investor Relations Consulting ................... -- 14,464 Insurance ....................................... 30,120 39,801 Property Taxes .................................. 13,795 12,402 Service Contracts ............................... 37,543 44,689 Trade Show and Conference Fees ....... .......... 12,813 6,750 Other ........................................... 10,554 12,383 ---------- ---------- $ 104,825 $ 363,966 ========== ========== 5. PROPERTY AND EQUIPMENT Property and equipment consisted of the following at June 30: 2007 2006 ---------- ---------- Laboratory equipment ............................ $1,099,878 $1,010,112 Computer equipment .............................. 368,258 357,345 Internal use software ........................... 233,417 -- Office furniture and equipment .................. 209,232 180,158 Leasehold improvements .......................... 238,262 168,507 ---------- ---------- Total property and equipment .................... 2,149,047 1,716,122 Less: accumulated depreciation and amortization.. 1,313,113 1,022,891 ---------- ---------- Net property and equipment ...................... $ 835,934 $ 693,231 ========== ========== At June 30, 2007 and 2006, respectively, these amounts included assets under capital leases of $434,056 and $358,856, and related accumulated amortization of $337,265 and $282,806. Depreciation expense for the fiscal years ended June 30, 2007 and 2006, respectively, was $290,222 and $256,889. 6. ACCRUED LIABILITIES Accrued liabilities consisted of the following at June 30: 2007 2006 ---------- ---------- Accrued Laurus note costs due to third party..... $ 131,592 $ 131,592 Accrued payroll and related payroll taxes ....... 135,304 136,060 Accrued vacation ................................ 64,649 82,556 Accrued audit fees .............................. 46,677 28,566 Accrued interest expense ........................ 18,500 27,840 Accrued 401(k) .................................. 2,550 19,449 Accrued board of directors fees ................. 18,750 20,135 Accrued fees due to PBRF ........................ 7,835 7,835 Other ........................................... 52,937 45,825 ---------- ---------- $ 478,794 $ 499,858 ========== ========== F-13 7. CAPITAL LEASE OBLIGATIONS The Company leases laboratory and other equipment under capital lease arrangements. The obligations under capital leases have interest rates ranging from approximately 6.5% to 17.64% and mature at various dates through 2009. Annual future minimum lease payments for years subsequent to June 30, 2007 are as follows: 2008 $ 69,660 2009 24,743 2010 17,652 2011 17,652 2012 13,239 Total minimum payments 142,947 Less: amount representing interest (18,487) ---------- Obligations under capital leases $ 124,460 ========== Total minimum payments $ 124,460 Less: current portion 58,841 ---------- Long-term portion $ 65,619 ========== 8. NOTES PAYABLE LAURUS DEBT Effective May 28, 2004, the Company entered into a financing arrangement with Laurus Master Fund, Ltd., a New York City based investment fund ("Laurus"). The financing consisted of a $2.5 million secured convertible note with a term of three years. In connection with the financing, the Company also issued Laurus a warrant to purchase up to 681,818 shares of common stock at an exercise price of $1.25, exercisable at any time prior to May 28, 2011. The note bears interest at an initial rate equal to the prime rate plus two percent (2%), subject to reduction on a month-to-month basis if certain specified conditions are met. The note interest rate was equal to 10.25% and 10.25% for the fiscal years ended June 30, 2007 and 2006, respectively. Under the original terms of the note, the Company was obligated to make monthly payments of accrued interest beginning July 1, 2004 and, commencing December 1, 2004, begin to make monthly payments of $85,000 to reduce the principal amount by $83,333. For any cash payments made on the note, the Company is required to pay an amount equal to 102% of the principal amount due as noted above. In addition, the Company can prepay the note at any time upon payment of an amount equal to 130% of the then-outstanding principal balance, plus accrued and unpaid interest. Laurus has the option at any time to convert any or all of the outstanding principal and accrued and unpaid interest on the note into shares of common stock at an initial conversion price of $1.06 per share. In addition, for each monthly payment under the note, Laurus will be obligated to convert a portion of the monthly payment into common stock at the applicable conversion price, if certain specified conditions are met. As of June 30, 2007, Laurus had converted $710,200 in principal into 696,800 shares of the Company's common stock. On June 30, 2007, the principal balance on this first note owing to Laurus was $1,416,667, net of principal payments. The initial note conversion price ($1.06 per share) is subject to certain anti-dilution adjustments, including full ratchet anti-dilution, if the Company issues convertible or equity securities at a price per share less than the conversion price. As security for the obligations to Laurus, the Company and each of its subsidiaries granted a blanket security interest in all of their respective assets to Laurus, and the Company entered into a stock pledge with Laurus for the capital stock in each of its subsidiaries. The Company was obligated to register with the SEC for resale the shares of common stock that are issuable upon conversion of the note and upon exercise of the warrant. The registration was deemed effective by the SEC on September 28, 2004. To date, the Company has maintained the effectiveness of the registration statement and is obligated to maintain it effective for up to three years from the closing date. If the Company fails to comply with the registration obligations, Laurus will be entitled to certain specified remedies, including monetary liquidated damages. F-14 In conjunction with the financing, the Company incurred and recorded fees of $293,500 as deferred financing costs, which are being amortized to other expense over the life of the note. This amount includes a potential payment to the Company's broker of up to $100,000 should Laurus convert all or a portion of the 2004 Note. At June 30, 2007, the unamortized balance of the deferred financing costs was $232,787. As of May 6, 2005, the Company modified the amounts being amortized to other expense to account for the extension of 12 months in the term of the 2004 Note. As of May 2004, the Company also recorded discounts to the secured convertible note in the amount of $683,962 and $573,266, respectively, representing the value of the conversion feature and value allocated to the warrant to purchase 681,818 shares. As of May 6, 2005, the Company modified the discount balance of the loan to account for the warrants issued as of January 31, 2005 for the postponement of principal payments due and for the warrants issued as of May 6, 2005 as consideration for the deferral and extension of the 2004 Note. In accounting for the issuance of the new warrants, the Company recorded discounts to the secured convertible note of $1,084,906, $452,076, $120,445 and $383,013, respectively, representing the value of the conversion feature, the value allocated to the warrant to purchase 681,818 shares issued on May 28, 2004, the value allocated to the warrant to purchase 200,000 shares issued on January 31, 2005, and the value allocated to the warrant to purchase 625,000 shares issued on May 6, 2005. The warrant to purchase 625,000 shares represents the pro-rata share of the May 2004 Note related to the warrant to purchase a total of 1,000,000 shares issued on May 6, 2005, with the balance allocated to the January 2005 Note. Upon conversion of any amounts owing under the note, the Company is obligated to issue warrants for up to a maximum of 181,818 shares of common stock to its broker, in the amount of 8% of amounts converted, at an exercise price of $1.25 per share, exercisable for five years. Effective January 31, 2005, the Company entered into a second financing arrangement with Laurus for a $1.5 million secured convertible note with a term of three years. In connection with the financing, the Company issued Laurus a warrant to purchase up to 326,087 shares of common stock at an exercise price of $1.37, exercisable at any time prior to January 31, 2012. The note bears interest under the same terms as the May 2004 Note as detailed above. The note interest rate was equal to 10.25% and 10.25% for the fiscal years ended June 30, 2007 and 2006, respectively. Under the original terms of the note, the Company was obligated to make monthly payments of accrued interest beginning March 1, 2005 and, commencing August 1, 2005, monthly payments of $51,000 to reduce the principal amount by $50,000. For the January 2005 the terms of cash payments and prepayments are the same as for the May 2004 Note as detailed above. Laurus has the option at any time to convert any or all of the outstanding principal and accrued and unpaid interest on the note into shares of common stock at an initial conversion price of $1.17 per share. In addition, for each monthly payment under the note, Laurus will be obligated to convert a portion of the monthly payment into common stock at the applicable conversion price, if certain specified conditions are met. The initial note conversion price ($1.17 per share) is subject to certain anti-dilution adjustments, including full ratchet anti-dilution if the Company issues convertible or equity securities at a price per share less than the conversion price. As security for the obligations to Laurus, the Company and each of its subsidiaries granted a blanket security interest in all of their respective assets to Laurus, and the Company entered into a stock pledge with Laurus for the capital stock in each of its subsidiaries. The Company was obligated to register with the SEC for resale the shares of common stock that are issuable upon conversion of the note and upon exercise of the warrant. The registration was deemed effective by the SEC on April 1, 2005. To date, the Company has maintained the effectiveness of the registration statement and is obligated to maintain it effective for up to three years from the closing date. If the Company fails to comply with the registration obligations, Laurus will be entitled to certain specified remedies, including monetary liquidated damages. F-15 In conjunction with the January 2005 financing, the Company incurred and recorded fees of $168,000 as deferred financing costs, which are being amortized to other expense over the life of the note. This amount includes a potential payment to the Company's broker of up to $60,000 should Laurus convert all or a portion of the 2005 Note. At June 30, 2006, the unamortized balance of the deferred financing costs was $147,156. As of May 6, 2005, the Company modified the amounts being amortized to other expenses to account for the extension of 12 months in the term of the 2004 Note. As of January 2005, the Company also recorded discounts to the secured convertible note of $397,436 and $279,191, respectively, representing the value of the conversion feature and value allocated to the warrant to purchase 326,087 shares. As of May 6, 2005, the Company modified the discount balance of the loan to account for the warrants issued as of January 31, 2005 for the warrants issued as of May 6, 2005 for the deferral and extension of the 2005 Note. In accounting for the issuance of the new warrants, the Company recorded discounts to the secured convertible note of $589,743, $229,898, and $244,356, respectively, representing the value of the conversion feature, the value allocated to the warrant to purchase 326,087 shares issued on January 31, 2005, and the value allocated to the warrant to purchase 375,000 shares issued on May 6, 2005. The warrant to purchase 375,000 shares represents the pro-rata share of the January 2005 Note related to the warrant to purchase a total of 1,000,000 shares issued on May 6, 2005. Upon conversion of any amounts owing under the note, the Company is obligated to issue warrants for up to a maximum of 105,263 shares of common stock to its broker, in the amount of 8% of amounts converted, at an exercise price of $1.37 per share, exercisable for five years. LAURUS WAIVER -- MAY 2004 $2.5 MILLION SECURED CONVERTIBLE NOTE On January 31, 2005, Laurus formally agreed that the Company would not be required to pay the principal portion of any monthly amount due for the six-month period from December 2004 through May 2005, and instead such deferred principal amounts would be due on May 1, 2007, the maturity date of the 2004 Note. There was no change in the interest rate charged by Laurus on the unpaid principal. In consideration for the principal payment deferral and the waiver, the Company issued a warrant to Laurus to purchase up to 200,000 shares of the common stock of the Company at an exercise price of $1.48. The warrant expires on January 31, 2010. The cost to the Company associated with the issuance of this warrant was attributed to the discount balance on the May 2004 Note. LAURUS DEFERRAL AND EXTENSION -- MAY 2004 $2.5 MILLION AND JANUARY 2005 $1.5 MILLION SECURED CONVERTIBLE NOTES On May 6, 2005, Laurus and the Company amended the terms of the 2004 Note and the 2005 Note, to provide for a twelve-month deferral and extension of both. With respect to 2004 Note, Laurus agreed to (a) extend the term for an additional year, to be due in full on May 28, 2008, and (b) defer 12 months of principal payments (originally due June 1, 2005 through May 1, 2006) to be paid monthly beginning June 1, 2007 through May 1, 2008. With respect to the 2005 Note, Laurus agreed to (a) extend the term for an additional year, to be due in full on January 31, 2009, and (b) defer 12 months of principal payments (originally due August 1, 2005 through July 1, 2006) to be paid monthly beginning February 1, 2008 through January 1, 2009, with the balance on the 2005 Note to be paid in full on January 31, 2009. As a result of these amendments, the first repayments of principal owed to Laurus on the 2004 and 2005 Notes became due on June 1, 2006 and August 1, 2006, respectively, and the maturity dates for the 2004 and 2005 Notes are now May 1, 2008 and January 1, 2009, respectively. There was no change in the interest rate charged by Laurus on the unpaid principal. Furthermore, commencing as of May 31, 2005, the Company adjusted the amortization schedules for the 2004 Note and 2005 Note related to the conversion feature, stock purchase warrants and deferred finance costs. In consideration for the principal payment deferral and the extension of the 2004 and 2005 Notes, the Company issued an additional common stock purchase warrant to Laurus to purchase up to 1,000,000 shares of the Company's common stock at an exercise price of $1.05. The warrant expires on May 6, 2010. The cost to the Company associated with the issuance of this warrant was attributed to the discount balances of the May 2004 and January 2005 Notes based on the pro-rata amounts of the respective Notes. F-16 Through June 30, 2007, Laurus has converted a total of $710,200 in principal on the 2004 Note, leaving a remaining principal balance on the 2004 Note of $1,416,667, net of conversions and principal payments. There have been no conversions of principal on the 2005 Note, leaving a remaining principal balance of $950,000 net of principal payments. With these principal conversions, repayments of principal on the 2004 Note were scheduled to begin in February 2007 at a rate of approximately $40,000 for the first month and approximately $85,000 for each month thereafter, per the 102% payment of principal requirement that applies to both notes. These payments will reduce the outstanding principal of the 2004 Note by $83,333 per month. Payments on the 2005 Note of $51,000 per month were scheduled to begin in August 2006. These payments will reduce the outstanding principal of the 2005 Note by $50,000 per month. Any future additional conversions of principal by Laurus on either Note will further reduce our repayment obligations. In fiscal years 2004 and 2005, the Company estimated the valuation of the conversion feature and the warrants for the May 2004 and January 2005 Notes in accordance with EITF 00-27 and EITF 98-5, using the Black-Scholes pricing model and other assumptions deemed reasonable by management. At June 30, 2006 the Company corrected its accounting for derivative financial instruments, for the May 2004 and January 2005 Notes, to conform to the requirements of Statements of Accounting Standards No. 133, as amended, and Financial Accounting Standards Board Emerging Issues Task Force (EITF) No. 00-19. Embedded conversion features that meet the definition of derivative financial instruments have, where applicable, been bifurcated from host instruments, the May 2004 and January 2005 Notes, and, in all instances derivative financial instruments have been recorded as assets or liabilities and are carried at fair value. The Company restated prior fiscal years results to conform to the requirements of the Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections. Net fair value adjustments included in earnings (loss) related to these instruments amounted to $298,616 and ($265,928) for the fiscal year ending June 30, 2006 and 2005, respectively. Accordingly, the balances for fiscal years 2004 and 2005 have been restated and balances for fiscal 2006 and fiscal 2007 correctly accounted for. LOAN AND SECURITY AGREEMENT WITH FRANKLIN FUNDING On November 3, 2005, the Company entered into a loan and security agreement with Franklin Funding, Inc., providing for a non-revolving line of credit of up to $500,000 for equipment financing collateralized by the equipment. In connection with the loan and security agreement, the Company agreed to grant to Franklin Funding stock purchase warrants to purchase up to 50,000 shares of the Company's common stock, in increments of 5,000 shares, for each $50,000 borrowed, each with an exercise price determined as of the respective date of borrowing and expiration date of 10 years. Through June 30, 2006, the Company has borrowed a total of $350,000 under this equipment line of credit and issued to Franklin Funding warrants to purchase 35,000 shares, at an exercise price of $1.17 per share. The loan and security agreement provided that a maximum of $500,000 was available for borrowing until May 3, 2006, consequently no further borrowings may be made under the loan and security agreement. The Company recognized expenses related to the grant of the warrants in the fiscal years ended June 30, 2007 and June 30, 2006 of approximately $11,820 and $7,142, respectively. F-17 SUMMARY OF LAURUS AND FRANKLIN FUNDING NOTES PAYABLE
The Company had the following other notes payable as of June 30: 2007 2006 ------------ ------------ May 2004 Secured Convertible Note Payable: ------------------------------------------ Secured convertible note to Laurus, secured by all assets, interest at prime plus 2% (subject to reduction upon specified conditions), monthly payments of $83,333 plus interest beginning May 1, 2006, due May 1, 2008 $ 2,500,000 $ 2,500,000 Less: Principal amount converted into common stock (710,200) (710,200) Less: Principal payments (373,133) -- Less: Fair value of conversion feature and warrants (514,641) (896,701) ------------ ------------ 902,026 893,099 Less: Current Portion (902,026) (893,099) ------------ ------------ Long-Term Portion $ -- $ -- ============ ============ January 2005 Secured Convertible Note Payable: ---------------------------------------------- Secured convertible note to Laurus, secured by all assets, interest at prime plus 2% (subject to reduction upon specified conditions), monthly payments of $51,000 plus interest beginning August 1, 2006, due February 1, 2009 $ 1,500,000 $ 1,500,000 Less: Principal payments (550,000) -- Less: Fair value of conversion feature and warrants (247,265) (751,509) ------------ ------------ 702,735 748,491 Less: Current Portion (702,735) (748,491) ------------ ------------ Long-Term Portion $ -- $ -- ============ ============ Other Notes Payable: -------------------- Loan and security agreement, secured by specific equipment, 17.64% interest, monthly payments of $8,709, balloon payment of $30,000 due August 2006 $ -- $ 38,148 Loan and security agreement, secured by specific equipment, 17.64% interest, monthly payments of $11,878, balloon payment of $60,000 due November 2008, principal balance only 210,953 310,938 ============ ============ Principal balance plus interest 244,765 349,086 Less: Current Portion (141,533) (38,148) ------------ ------------ Long-Term Portion $ 102,232 $ 310,938 ============ ============
Aggregate maturities of notes payable (at face value, gross of the unaccreted fair value assigned to conversion, other features and warrants related to the secured convertible note financing with Laurus) are approximately as follows for the years ending June 30: 2008 $1,706,986 2009 870,634 ---------- $2,577,620 ========== F-18 9. PREFERRED AND COMMON STOCK The Company's common stock currently is quoted on the OTC Bulletin Board under the symbol "PBME". SERIES A PREFERRED STOCK Effective March 31, 2006, the holders of the outstanding shares of Series A preferred stock entered into an agreement with the Company agreeing to voluntarily exchange their shares of Series A preferred stock into common stock. The exchange rate for the Series A preferred stock was based on a price of $1.73 per share, which represents the highest ten-trading day average during the first 30 days after the quarterly results for the second quarter of fiscal 2006 (provided that at least 12,000 shares must have traded during the day in order for any day to qualify in the average), beginning February 16, 2006. The number of shares of common stock issuable on exchange equal the total cash consideration originally paid by the Series A preferred holders, aggregate amount of $3,100,000, (1,550,000 shares issued, liquidation preference $2.00 per share) divided by the exchange rate. Accordingly, at a rate of $1.73, upon delivery to the Company of the Series A preferred stock certificates for cancellation, the Company issued 1,791,907 shares of common stock and the outstanding 1,550,000 Series A preferred stock shares were cancelled. After giving effect to the exchange, the Company no longer has any preferred stock shares outstanding. COMMON STOCK Laurus has the option at any time to convert any or all of the outstanding principal and accrued and unpaid interest on the May 2004 and January 2005 Notes into shares of common stock at an initial conversion price of $1.06 or $1.17 per share, respectively. On various dates throughout fiscal 2006 and fiscal 2005, Laurus converted at a price of $1.06 a total of $646,600 and $63,600 of the principal amount, respectively, due under the May 2004 Note into 634,400 and 62,400 shares, respectively, of the Company's common stock. No conversions were executed for the fiscal year ended June 30, 2007. Laurus has converted a total of $710,200 in principal on the 2004 Note, leaving a remaining principal balance on the 2004 Note of $1,416,667, net of principal payments. As of June 30, 2007, the Company held treasury common stock in the amount of 269,272 ($3,295 par value). For the fiscal year ended June 30, 2007, we added 187,200 shares ($1,872 par value) to treasury common stock that we purchased during the fiscal year. For the fiscal year ended June 30, 2006, there were no shares of common stock added to the treasury common stock in the amount of 82,072 ($1,423 par value). F-19 10. INCOME TAXES The Company follows SFAS 109, as amended to prepare its income taxes. The income tax expense reconciled to the tax expense computed at the statutory rate was approximately as follows during the years ended June 30: 2007 2006 ---------- ---------- Tax benefit computed at federal statutory rate $ (372,000) $ 61,000 Permanent differences 74,000 550,000 Valuation allowance (tax benefit of recognizing prior year net operating loss carryforward) $ 298,000 $ (611,000) ---------- ---------- $ -- $ -- ========== ========== Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's net deferred tax assets are approximately as follows at June 30: 2007 2006 ---------- ---------- Net deferred tax asset: Net operating loss carryforward $5,154,000 $4,902,000 Research and experimentation credit 326,000 326,000 Effect of stock option variable pricing 239,000 50,000 Accrued liabilities 14,000 22,000 Allowance for bad debts 10,000 11,000 Depreciation and amortization 61,000 50,000 ---------- ---------- 5,804,000 5,361,000 Less valuation allowance (5,804,000) (5,361,000) ---------- ---------- $ -- $ -- ========== ========== At June 30, 2007, operating loss carryforwards of approximately $15 million expiring through 2027 are available to offset future taxable income. For financial reporting purposes, a valuation allowance of approximately $5,804,000 has been recognized to offset the deferred tax asset due to the uncertainty of future utilization of net operating loss carryforwards and realization of other deferred tax assets. For the fiscal year ended June 30, 2007, the valuation allowance was increased by approximately $298,000, year. For the fiscal year ended June 30, 2006, the valuation allowance was decreased by approximately $611,000, respectively. 11. STOCK OPTION PLAN 1996 STOCK INCENTIVE PLAN The Company's 1996 Stock Incentive Plan (the "1996 Plan") provided for the issuance of up to 1,800,000 shares of common stock under this Plan. Options granted under the 1996 Plan may be either incentive stock options within the meaning of Section 422(b) of the Internal Revenue Code, or nonqualified options. The Company may also award stock appreciation rights, restricted stock, performance shares, loans or tax offset payments. The option price of each incentive stock option granted shall not be less than the fair value of the underlying common stock, and will expire no later than ten years following the date of grant. With respect to nonqualified options, the exercise price and term will be determined at the discretion of the Board. However, the exercise price will not be less than 85% of the fair value of the underlying stock, and the term will not exceed a period of ten years. The options generally vest over a range of immediately to five years. As of June 30, 2007, The Company's 1996 Stock Incentive Plan had expired. On May 3, 2002, the Company's board of directors voted to reduce the exercise price of all then outstanding options to $0.06 per share. No initial expense was recognized on this repricing, as the new exercise price equaled the market value of the Company's stock on that date. For the fiscal years ended June 30, 2007 and 2006, in accordance with F-20 accounting for options under variable pricing rules, the Company recognized approximately $22,614 and $943, respectively, in compensation income representing the decrease in the market price of the Company's common shares to $1.23 and $0.94 per share, as well as the reduction of 7,374 in the number of outstanding options due to either expiration or exercise. As long as any of the repriced options remains outstanding, the Company will recognize compensation expense in the future for all outstanding repriced stock options if the market value of the common stock increases, and will recognize income if the market value decreases. 2005 STOCK INCENTIVE PLAN The Company has a Stock Incentive Plan (the "2005 Plan") with 3,000,000 shares of common stock reserved for issuance under this Plan. Options granted under the Plan may be either incentive stock options within the meaning of Section 422(b) of the Internal Revenue Code, or nonqualified options. The Company may also award stock appreciation rights, restricted stock, performance shares, loans or tax offset payments. The option price of each incentive stock option granted shall not be less than the fair market value of the underlying common stock on the grant date, and will expire no later than ten years following the date of grant. With respect to nonqualified options, the exercise price and term shall be determined at the discretion of the Board. However, the exercise price shall not be less than the fair market value of the underlying common stock on the grant date, and the term will not exceed a period of ten years. The options generally vest over a range of immediately to three years. As of June 30, 2007, 2,326,521 shares of common stock remained available for future grant under the 2005 Plan. The following is a summary of the activity in the 1996 and 2005 Plans for the years ended June 30, 2007 and 2006:
Shares Under Option ----------------------------------------------- Number Weighted Weighted Average Average Of Exercise Fair Value Price per of Shares share Options Granted ----------------------------------------------- 1996 Plan - ------------------------------------ Options outstanding at June 30, 2005 1,376,109 $ 0.81 $ -- Granted 125,000 0.86 0.86 Exercised (7,902) 0.60 Terminated 0.00 0.00 ----------- ----------- Options outstanding at June 30, 2006 1,493,207 $ 0.82 =========== =========== 1996 and 2005 Plans - ------------------------------------ Granted (1996 Plan) 25,000 1.15 1.15 Granted (2005 Plan) 130,245 0.99 .99 Exercised (0) 0.00 Terminated (1996 Plan) (164,300) 1.03 ----------- ----------- Options outstanding at June 30, 2007 1,484,152 $ 0.81 =========== =========== 2005 Plan Restricted Shares - --------------------------------------------------------------------------------------- Granted 543,234 0.99 0.99 Options and Restricted Shares 2,027,386 $ 0.86 outstanding at June 30, 2007 =========== ===========
The weighted average contractual life remaining of options outstanding at June 30, 2007 is approximately 6.9 years. As of June 30, 2007, outstanding options had exercise periods which expired over the following time periods: F-21 Weighted Average Exercise Number Remaining Life Number Price Outstanding (in years) Exercisable ----- ----------- ---------- ----------- $0.51 183,917 5.2 183,917 $0.70 3,000 7.2 3,000 $0.81 911,990 6.6 750,256 $0.86 125,000 8.2 65,694 $0.90 6,000 6.7 6,000 $0.96 90,000 7.5 90,000 $0.99 130,245 9.2 42,981 $1.01 3,000 7.0 3,000 $1.15 25,000 8.5 14,375 $1.75 6,000 6.4 6,000 --------- ------- --------- 1,484,152 8.5 1,165,223 ========= ======= ========= As of June 30, 2007, the fair value of options to be vested is $149,944. The 1996 Plan expired by its terms on July 9, 2006, but outstanding options and awards previously granted under the 1996 Plan continue in accordance with their terms. 12. STOCK PURCHASE WARRANTS The following is a summary of outstanding warrants as of June 30, 2007 and 2006: Weighted Average Exercise Price Exercise Price per Share per Share Number --------- --------- ------ Warrants outstanding at June 30, 2006 $0.1875 - $1.48 $1.08 3,085,713 --------------- ----- --------- Warrants outstanding at June 30, 2007 $0.1875 - $1.60 $1.23 4,390,372 --------------- ----- --------- In May 2005, in connection with the extension and deferral of principal payments on the $2.5 million secured convertible note and the $1.5 million secured convertible note and, the Company granted the lender a warrant to purchase up to 1,000,000 shares of common stock at an exercise price of $1.05 per share, exercisable at any time prior to May 28, 2010. In January 2005, in connection with a $1.5 million secured convertible note, the Company granted the lender a warrant to purchase up to 326,087 shares of common stock at an exercise price of $1.25 per share, exercisable at any time prior to May 28, 2011. In addition, the Company issued to our broker a five-year warrant, exercisable as and to the extent that any amounts owing under the convertible note are converted into common stock, for up to 181,818 shares of common stock at an exercise price of $1.25 per share. Also in January 2005, in connection with a the deferral of principal on the $2.5 million secured convertible note, the Company granted the lender a warrant to purchase up to 200,000 shares of common stock at an exercise price of $1.48 per share, exercisable at any time prior to January 31, 2010. In June 2004, in connection with a $2.5 million secured convertible note, the Company granted the lender a warrant to purchase up to 681,818 shares of common stock at an exercise price of $1.25 per share, exercisable at any time prior to May 28, 2009. In addition, the Company issued to our broker a five-year warrant, exercisable as and to the extent that any amounts owing under the convertible note are converted into common stock, for up to 181,818 shares of common stock at an exercise price of $1.25 per share. In March and April 2006, in connection with a private placement of common stock, the Company granted warrants to investors covering 955,600 shares of unregistered common stock at $1.60 per share and the placement agents covering 225,200 shares of unregistered common stock at $1.60 per share. F-22 Through June 30, 2006, the Company has borrowed a total of $350,000 under this equipment line of credit and issued to Franklin Funding warrants to purchase 35,000 shares, at an exercise price of $1.17 per share. 13. COMMITMENTS AND CONTINGENCIES OPERATING LEASES The Company has entered into a non-cancelable operating lease for office facilities. Under the current lease which expires October 31, 2007, the Company is responsible for its proportionate share of real estate taxes, insurance and common area maintenance costs. Rent expense was $231,192 and $225,264 for the years ended June 30, 2007 and 2006, respectively. The office lease has been renewed per agreement with the lessor on April 1, 2007, effective November 1, 2007. Future minimum lease payments are as follows: Year Ended June 30, ------------------- 2008 through October 31, 2007 $ 78,052 2008 new lease through June 30, 2008 157,778 2009 241,779 2010 249,447 2011 257,115 2012 264,783 2013 89,113 ---------- $1,338,067 ========== SECURITY INTEREST In connection with its secured convertible note agreements, the Company and each of its subsidiaries have granted to Laurus Master Fund, Ltd. a secured interest in all of their assets. GUARANTOR OBLIGATION In connection with its purchase of certain assets from Saigene Corporation (Saigene), in December 2002, the Company guaranteed a note payable held by Saigene. In October 2006, the note holder contacted both Saigene and the Company for payment of principal. The Company initially paid $25,000, half as its share of the debt. Subsequent to that payment, the Company was informed that Saigene was unable to pay its half to satisfy the debt holder. The Company paid the second half of $25,000 to the debt holder to pay the note payable in full and discharge any rights to either company. 14. RETIREMENT PLAN The Company has a 401(k) Plan that was reopened to employees in May 2005. The 401(k) Plan covers all employees over the age of 21 with 1,000 hours of service in a 12-month eligibility computation. The Company makes a contribution equal to one-half of the employee's contribution up to the maximum of 6%. The Company can make discretionary contributions as determined by its board of directors, not to exceed the amount permissible under the Internal Revenue Code. The Company has not made any discretionary contributions since the plan was reopened. For the fiscal year ended June 30, 2007, the Company's matching expense was $62,175 and 401(k) payable balance was $2,550. F-23 EX-10.5B 2 exh10-5b_15449.txt FIRST AMENDMENT TO OFFICE LEASE EXHIBIT 10.5B ------------- FIRST AMENDMENT TO LEASE AGREEMENT BETWEEN THOMAS AND ELSIE KANE AND PACIFIC BIOMETRICS, INC. THE FIRST AMENDMENT TO THIS LEASE, made this 20th day of January, 1998 by and between Thomas and Elsie Kane ("Landlord") and Pacific Biometrics Inc. ("Tenant") do hereby amend the LEASE AGREEMENT for the Premises (more particularly described in Exhibit A of the Lease Agreement) dated 23rd day of April, 1997. 1. Section 1(b) entitled: Lease Commencement Date. Revise Lease as follows: The Lease shall commence on November 1, 1997. 2. Section 1(c) entitled: Lease Termination Date. Revise Lease as follows: The Lease shall terminate on October 31, 2007. 3. Section 1(d) entitled: Base Rent. The base monthly rent shall be in accordance with the revised Rent Rider attached to this FIRST AMENDMENT to Lease Agreement. 4. RENT RIDER (Attachment to Lease): Revise BASE MONTHLY RENT SCHEDULE in the RENT RIDER attachment to the Lease to conform to the provisions of the amended schedule in this FIRST AMENDMENT to Lease Agreement. THE LEASE AGREEMENT, dated April 23, 1997, shall remain in full force and effect in accordance with and subject to all terms and conditions as set forth therein except as revised and modified by this FIRST AMENDMENT to Lease, dated January 20, 1998 shall be binding upon and inure to the benefit of the respective heirs, and assigns of the parties hereto. THE PARTIES HERETO have executed this FIRST AMENDMENT to Lease Agreement in multiple copies, each copy for the purposes being deemed an original the day and year of execution. LANDLORD: TENANT: --------- ------- by: /s/ Thomas Kane --------------------- Pacific Biometrics Inc. Thomas Kane by: /s/ Elsie Kane by: /s/ Paul Kanan --------------------- --------------------- Elsie Kane Paul Kanan Its: President/CEO AMENDED RENT RIDER Landlord and Tenant should complete only those provisions below which apply. Any provision which is not completed shall not apply to the Lease. 1. Base Monthly Rent Schedule. Tenant shall pay landlord base monthly rent during the Lease Term according to the following schedule. Lease Year (Stated in Years or Months) Base Monthly Rent Amount Year 1 $20,027.05 Year 2 $20,027.05 Year 3 $20,335.80 Year 4 $20,644.55 Year 5 $20,953.30 Year 6 $21,262.05 Year 7 $21,570.80 Year 8 $18,525.00 Year 9 $19,019.00 Year 10 $19,513.00 EX-10.5C 3 exh10-5c_15449.txt SECOND AMENDMENT TO OFFICE LEASE EXHIBIT 10.5C ------------- SECOND AMENDMENT TO LEASE AGREEMENT BETWEEN THOMAS AND ELSA KANE AND PACIFIC BIOMETRICS, INC. THIS SECOND AMENDMENT to this Lease, made this 20th day of April, 2007, by and between Thomas and Elsa Kane ("Landlord") and Pacific Biometrics, Inc. ("Tenant"). R E C I T A L S: A. In accord with the terms of "Lease Agreement" of April 23, 1997 (as amended by First Amendment to Lease Agreement of January 20, 1998) Landlord has leased to Tenant the premises described in Exhibit A of the Lease Agreement. The Lease presently expires October 31, 2007. B. Landlord and Tenant wish to extend the Lease until October 31, 2012 and also wish to grant to Tenant an option to extend for an additional five (5) years thereafter. C. Landlord and Tenant wish to retain and reaffirm most of the paragraphs of the Lease Agreement of April 23, 1997 with those retained provisions controlling the Landlord Tenant relationship during the extended period(s). The retained provisions are attached as Exhibit A to this Second Amendment. NOW, THEREFORE, IT IS HEREBY AGREED as follows: 1. The Lease of April 23, 1997 be and hereby is extended for a five (5) year period and it will accordingly terminate at midnight on October 31, 2012. It is agreed that during the extended period the provisions of the Lease contained in Exhibit A attached will control. 2. During the five (5) year extended term, the monthly rent will be: Year 1 $20,361.00 Year 2 $21,000.00 Year 3 $21,639.00 Year 4 $22,278.00 Year 5 $22,917.00 The above rental reflects an agreed reduction in rent by Landlord of $38,325.00 as a rent allowance to Tenant for Landlord's contribution to cost of improvements performed and to be performed by Tenant. In addition, Landlord shall pay to Tenant an additional $38,325.00 in cash upon mutual execution of this Second Amendment as 1 a cash allowance to Tenant for Landlord's contribution to cost of improvements performed, and to be performed, by Tenant. These approved improvements are scheduled on Exhibit B attached. 3. Landlord grants to Tenant the exclusive option and privilege of extending the term of this Lease for an additional five (5) year period following October 31, 2012 upon the same terms and conditions in Exhibit A attached hereto and incorporated herein. If Tenant decides to exercise this option, Tenant shall give written notice to Landlord of its election not less than sixty (60) days prior to October 31, 2012. Upon the giving of such notice, the Lease shall be extended and shall continue for the additional five (5) year period and the execution of a new lease or instrument of any kind shall not be required, PROVIDED THAT the amount of rent for the period following October 31, 2012 shall be agreed by Landlord and Tenant or if unable to agree, in accord with the following procedure: Within ten (10) days after the Notice of Election to Exercise, Landlord and Tenant shall each appoint a commercial real estate broker or appraiser with at least ten (10) years of experience with properties similar to the Premises in the general geographical area in which the Premises are located. The appraiser must be a licensed appraiser or a licensed real estate broker who has not been regularly employed or retained as a consultant, appraiser or agent for the appointing party. Within ten (10) days after both appraisers have been appointed, the appraisers shall decide what the fair market rent for the extended term would be and shall promptly notify Landlord and Tenant of their decision which shall be final and binding. In the event the appraisers do not agree, they shall each propose one (1) fair market value rent number in writing and shall then jointly appoint a third appraiser, who, after consultation, shall select one (1) rent number or the other as the fair market rent. 4. Notwithstanding anything to the contrary in the Lease Agreement, Tenant may, upon delivery of notice to Landlord, sublease all or part of the Premises. Tenant's notice of intent to sublease must be delivered to Landlord at least fourteen (14) days prior to the proposed date of sublease. Tenant's notice must contain (1) the form of Sublease Agreement to be used; (2) the legal name of the subtenant; (3) a description of the nature of subtenant's business; (4) a summary of its business history; and (5) a brief financial summary of subtenant (which Landlord shall treat as confidential) sufficient to inform Landlord with regard to the subtenant's financial viability. As noted in the Lease Agreement, any such assignment or sublease shall not release Tenant from Tenant's Lease Agreement obligations. Landlord, after making a reasonable evaluation of items (1) through (5) may refuse to consent to the sublease, if the proposed subtenant would be unsatisfactory. 2 5. NOTICE OF LANDLORD'S INTENTION TO LIST AND/OR SELL THE PROPERTY AND TO PERMIT TENANT TO MAKE THE FIRST OFFER. Landlord agrees that if, at any time during the term of this Lease, a decision is made to enter a listing agreement and/or sell the property, Landlord will give written notice to Tenant that such decision has been made thirty (30) days prior to signing a Listing Agreement and/or contract to sell the property. Landlord agrees that, during the thirty (30) day period, Landlord will neither accept nor consider any purchase offers from any other party. Tenant shall thereby be entitled to make the first offer. 6. Except as modified herein, the Lease Agreement shall remain in full force and effect. IN WITNESS WHEREOF the parties have executed this Second Amendment to Lease Agreement on the day and year first above written. LANDLORD: TENANT: /s/ Thomas Kane PACIFIC BIOMETRICS, INC. - ------------------------ Thomas Kane /s/ Elsa Kane /s/ Ronald Helm - ------------------------ ------------------------------- Elsa Kane By: Ronald Helm, President/CEO 3 STATE OF WASHINGTON ) ) ss. COUNTY OF KING ) On this day personally appeared before me Thomas Kane and Elsa Kane, to me known to be the individuals described in and who executed the within and foregoing instrument, and acknowledged that they signed the same as their free and voluntary act and deed, for the uses and purposes therein mentioned. GIVEN under my hand and official seal this 20th day of April, 2007. /s/ Cristyann Laxamana (Printed Name: Cristyann Laxamana ) -------------------------- Notary Public for the State of Washington residing at: 23302 59th Pl. S ---------------------------- My commission expires: June 20, 2010 ------------------ STATE OF WASHINGTON ) ) ss. COUNTY OF KING ) On this 20th day of April, 2007, before me, the undersigned, a Notary Public in and for the State of Washington, duly commissioned and sworn, personally appeared Ronald Helm, to me known to be the President and CEO of Pacific Biometrics, Inc., the corporation that executed the foregoing instrument, and acknowledged the said instrument to be the free and voluntary act and deed of said corporation, for the uses and purposes therein mentioned, and on oath stated that he is authorized to execute the said instrument and that the seal affixed is the corporate seal of said corporation. Witness my hand and official seal hereto affixed the day and year first above written. /s/ Cristyann Laxamana (Printed Name: Cristyann Laxamana ) -------------------------- Notary Public for the State of Washington residing at: 23302 59th Pl. S ---------------------------- My commission expires: June 20, 2010 ------------------ 4 EXHIBIT A LEASE AGREEMENT (Single Tenant for Entire Parcel - Triple Net) This Has Been Prepared For Submission To Your Attorney For Review And Approval Prior To Signing No Representation is Made By Licensee As To Its Legal Sufficiency Or Tax Consequences CBA Text Disclaimer. Text deleted try licensee indicated by strike. New text inserted try licensee Indicated by small capital letters. THIS LEASE AGREEMENT (the "Lease") is entered into this _____ day of ________________ between TOM KANE AND ELSA KANE ("Landlord"), and PACIFIC BIOMETRICS, INC. ("Tenant"). Landlord and Tenant agree as follows: 1. LEASE SUMMARY. a. Leased Premises. The leased premises (the "Premises") consist of the real property legally described on attached Exhibit A, and all improvements thereon. b. Lease Commencement Date. The Lease shall commence on November 1, 2007, or such earlier or later date as provided in Section 3 (the "Commencement Date"). c. Lease Termination Date. The Lease shall terminate at midnight on October 31, 2012, or such earlier or later date as provided in Section 3 (the "Termination Date"). d. Base Rent. The base monthly rent shall be (check one): [__] $_______, or [XX] according to the Rent Rider attached hereto. Rent shall be payable at Landlord's address shown in Section 1(h) below, or such other place designated in writing by Landlord. g. Permitted Use. The Premises shall be used only for GENERAL OFFICE AND TESTING LABORATORY and for no other purpose without the prior written consent of Landlord. h. Notice and Payment Addresses: Landlord: 810 WEST HIGHLAND DRIVE, SEATTLE, WA 98119 Fax No.: 206-298-2936 ------------------------------------------- Tenant: 220 WEST HARRISON, SEATTLE, WA 98119 Fax No.: 206-298-9838 ------------------------------------- 2. PREMISES. Landlord leases to Tenant, and Tenant leases from Landlord the Premises upon the terms specified in this Lease. 3. TERM. a. Commencement Date. The Lease shall commence on the date specified in Section 1(b). 4. RENT. Tenant shall pay Landlord without demand, deduction or offset, in lawful money of the United States, the monthly rental stated in Section 1(d) in advance on or before the first day of each month during the Lease Term, and any other additional payments due to Landlord (collectively the "Rent") when required under this Lease. Payments for any partial month at the beginning or end of the Lease term shall be prorated. If any sums payable by Tenant to Landlord under this Lease are not received by the TENTH (10TH) day of each month, Tenant shall pay Landlord in addition to the amount due, for the cost of collecting and handling such late payment, an amount equal to the greater of $100 or five percent (5%) of the delinquent amount. In addition, all delinquent sums payable by Tenant to Landlord and not paid within TEN (10) days of the due date shall, at Landlord's option, bear interest at the rate of twelve percent (12%) per annum, or the highest rate of interest allowable by law, whichever is less. Interest on all delinquent amounts shall be calculated from the original due date to the date of payment. Landlord's acceptance of less than the full amount of any payment due from Tenant shall not be deemed an accord and satisfaction or compromise of such payment unless Landlord specifically consents in writing to payment of such lesser sum as an accord and satisfaction or compromise of the amount which Landlord claims. 1 6. USES. The Premises shall be used only for the use(s) specified in Section 1(g) above (the "Permitted Use"), and for no other business or purpose without the prior written consent of Landlord. No act shall be done on or around the Premises that is unlawful or that will increase the existing rate of insurance on the Premises. Tenant shall not commit or allow to be committed any waste upon the Premises, or any public or private nuisance. 7. COMPLIANCE WITH LAWS. Tenant shall not cause or permit the Premises to be used in any way which violates any law, ordinance, or governmental regulation or order. Landlord represents to Tenant that, to the best of Landlord's knowledge, with the exception of any Tenant's Work, as of the Commencement Date, the Premises comply with all applicable laws, rules, regulations, or orders, including without limitation, the Americans With Disabilities Act, if applicable, and Landlord shall be responsible to promptly cure any noncompliance which existed on the Commencement Date. Tenant shall be responsible for complying with all laws applicable to the Premises as a result of Tenant's particular use, such as modifications required by the Americans With Disabilities Act as a result of Tenant opening the Premises to the public as a place of public accommodation. If the enactment or enforcement of any law, ordinance, regulation or code during the Lease term requires any changes to the Premises during the Lease term, the Tenant shall perform all such changes at its expense, if the changes are required due to the nature of Tenant's activities at the Premises, or to alterations that Tenant seeks to make to the Premises; otherwise, Landlord shall perform all such changes at its expense. 8. UTILITIES. Landlord shall not be responsible for providing any utilities to the Premises, but represents and warrants to Tenant that as of the Commencement Date electricity, water, sewer, and telephone utilities are available to the Premises. Tenant shall determine whether the available capacity of such utilities will meet Tenant's needs. Tenant shall install and connect, if necessary, and directly pay for all water, sewer, gas, janitorial, electricity, garbage removal, heat, telephone, and other utilities and services used by Tenant on the Premises during the Term, SO LONG AS such services are billed directly to Tenant. 9. TAXES. Tenant shall pay all Taxes (defined below) applicable to the Premises during the Lease term. All payments for Taxes shall be made at least ten (10) days prior to their due date. Tenant shall promptly furnish Landlord with satisfactory evidence that Taxes have been paid. If any Taxes paid by Tenant cover any period of time before or after the expiration of the Term, Tenant's share of those Taxes paid will be prorated to cover only the period of time within the tax fiscal year during which this Lease was in effect, and Landlord shall promptly reimburse Tenant to the extent required. If Tenant fails to timely pay any Taxes, Landlord may pay them, and Tenant shall repay such amount to Landlord with Tenant's next rent installment. The term "Taxes" shall mean: (i) any form of real estate tax or assessment imposed on the Premises by any authority, including any city, state or federal government, or any improvement district, as against any legal or equitable interest of Landlord or Tenant in the Premises or in the real property of which the Premises are a part, or against rent paid for leasing the Premises; and (ii) any form of personal property tax or assessment imposed on any personal property, fixtures, furniture, tenant improvements, equipment, inventory, or other items, and all replacements, improvements, and additions to them, located on the Premises, whether owned by Landlord or Tenant. "Taxes" shall exclude any net income tax imposed on Landlord for income that Landlord receives under this Lease. Tenant may contest the amount or validity, in whole or in part, of any Taxes at its sole expense, only after paying such Taxes or posting such security as Landlord may reasonably require in order to protect the Premises against loss or forfeiture. Upon the termination of any such proceedings, Tenant shall pay the amount of such Taxes or part of such Taxes as finally determined, together with any costs, fees, interest penalties, or other related liabilities. Landlord shall cooperate with Tenant in contesting any Taxes, provided Landlord incurs no expense or liability in doing so. 10. ALTERATIONS. Tenant may make alterations, additions or improvements to the Premises, including any Tenant's Work identified on attached Exhibit B ("Alterations"), with the prior written consent of Landlord WHICH CONSENT WILL NOT BE UNREASONABLY WITHHELD OR DELAYED. The term "Alterations" shall not include the installation of shelves, movable partitions, Tenant's equipment, and trade fixtures which may be performed without damaging existing improvements or the structural integrity of the Premises, and Landlord's consent shall not be required for Tenant's installation of those items. Tenant shall complete Alterations in compliance with all applicable laws and in accordance with plans and specifications approved by Landlord, and using contractors approved by Landlord. Landlord shall be deemed the owner of all Alterations except for those which Landlord requires to be removed at the end of the Lease term. Tenant shall remove all Alterations at the end of the Lease term unless Landlord conditioned its consent upon Tenant leaving a specified Alteration at the Premises, in which case Tenant shall not remove such Alteration. Tenant shall immediately repair any damage to the Premises caused by removal of Alterations. 2 11. REPAIRS AND MAINTENANCE. Tenant shall, at its sole expense, maintain the Premises in good condition and promptly make all NON-STRUCTURAL repairs and replacements necessary to keep the Premises in safe operating condition, but excluding the roof, foundation and exterior walls, which Landlord shall maintain in good condition and repair at Landlord's expense. Tenant shall not damage any demising wall or disturb the structural integrity of the Premises and shall promptly repair any damage or injury done to any such demising walls or structural elements caused by Tenant or its employees, agents, contractors, or invitees. Notwithstanding anything in this Section to the contrary, Tenant shall not be responsible for any repairs to the Premises made necessary by the acts of Landlord or its agents, employees, contractors or invitees therein. Upon expiration of the Lease term, whether by lapse of time or otherwise, Tenant shall promptly and peacefully surrender the Premises, together with all keys, to Landlord in as good condition as when received by Tenant from Landlord or as thereafter improved, reasonable wear and tear and insured casualty excepted. 12. ACCESS. After reasonable notice from Landlord (except in cases of emergency, where no notice is required), Tenant shall permit Landlord and its agents and employees to enter the Premises at all reasonable times for the purposes of repair or inspection. This Section shall not impose any repair or other obligation upon Landlord not expressly stated elsewhere in this Lease. After reasonable notice to Tenant, Landlord shall have the right to enter the Premises for the purpose of showing the Premises to prospective purchasers or lenders at any time, and to prospective tenants within 180 days prior to the expiration or sooner termination of the Lease term. NOTWITHSTANDING ANYTHING TO THE CONTRARY IN THIS LEASE, LANDLORD RECOGNIZES THE WORK TO BE PERFORMED BY TENANT IS CONFIDENTIAL AND PROPRIETARY, AND LANDLORD WILL USE ITS BEST EFFORTS TO ENTER THE PREMISES, OR ALLOW ITS AGENTS AND EMPLOYEES TO ENTER THE PREMISES, ONLY WHEN ACCOMPANIED BY AN ESCORT PROVIDED BY TENANT. LANDLORD WILL BE LIABLE TO TENANT FOR ANY DAMAGE RESULTING FROM LANDLORD'S VIOLATION OF THIS SECTION 12. 13. SIGNAGE. Tenant shall obtain Landlord's written consent before installing any signs upon the Premises WHICH CONSENT MAY NOT BE UNREASONABLY WITHHELD OR DELAYED. Tenant shall install any approved signage at Tenant's sole expense and in compliance with all applicable laws. Tenant shall not damage or deface the Premises in installing or removing signage and shall repair any injury or damage to the Premises caused by such installation or removal. 14. DESTRUCTION OR CONDEMNATION. a. Damage and Repair. If the Premises are partially damaged but not rendered untenantable, by fire or other insured casualty, then Landlord shall diligently restore the Premises and this Lease shall not terminate. The Premises shall not be deemed untenantable if less than twenty-five percent (25%) of the Premises are damaged. If insurance proceeds are available to Landlord but are not sufficient to pay the entire cost of restoring the Premises, then Landlord may elect to terminate this Lease and keep the insurance proceeds, by notifying Tenant within sixty (60) days of the date of such casualty. LANDLORD MAY, HOWEVER, CARRY "FULL REPLACEMENT COST" INSURANCE. If the Premises are entirely destroyed, or partially damaged and rendered TOTALLY untenantable, by fire or other casualty, Landlord may, at its option: (a) terminate this Lease as provided herein, or (b) restore the Premises to their previous condition. If, within 60 days after receipt by Landlord from Tenant of written notice that Tenant REASONABLY deems the Premises untenantable, Landlord fails to notify Tenant of its election to restore the Premises, or if Landlord is unable to restore the Premises within six (6) months of the date of the casualty event, then Tenant may elect to terminate the Lease. If Landlord restores the Premises under this Section 14(a), Landlord shall proceed with reasonable diligence to complete the work, and the base monthly rent shall be abated in the same proportion as the untenantable portion of the Premises bears to the whole Premises, provided that there shall be a rent abatement only if the damage or destruction of the Premises did not result from, THE neglect of Tenant, or Tenant's officers, contractors, licensees, agents, servants, employees, guests, OR invitees. Provided, Landlord complies with its obligations under this Section, no damages, compensation or claim shall be payable by Landlord for inconvenience, loss of business or annoyance directly, incidentally or consequentially arising from any repair or restoration of any portion of the Premises. Landlord will not carry insurance of any kind for the protection of Tenant or any improvements paid for by Tenant or as provided in Exhibit B or on Tenant's furniture or on any fixtures, equipment, improvements or appurtenances of Tenant under this Lease, and Landlord shall not be obligated to repair any damage thereto or replace the same unless the damage is caused by Landlord's negligence. b. If the Premises are made untenantable by eminent domain, or conveyed under a threat of condemnation, this Lease shall automatically terminate as of the earlier of the date title vests in the condemning authority or the condemning authority first has possession of the Premises and all Rents and other payments shall be paid to that date. In case of taking of a part of the Premises that does not render the Premises untenantable, then this Lease shall continue in full force and effect and the base monthly rental shall be equitably reduced based on the proportion by which the floor area of any structures is reduced, such 3 reduction in Rent to be effective as of the earlier of the date the condemning authority first has possession of such portion or title vests in the condemning authority. Landlord shall be entitled to the entire award from the condemning authority attributable to the value of the Premises and Tenant shall make no claim for the value of its leasehold. Tenant shall be permitted to make a separate claim against the condemning authority for moving expenses or damages resulting from interruption in its business, provided that in no event shall Tenant's claim reduce Landlord's award. 15. INSURANCE. a. Liability Insurance. During the Lease term, Tenant shall pay for and maintain commercial general liability insurance with broad form property damage and contractual liability endorsements. This policy shall name Landlord as an additional insured, and shall insure Tenant's activities and those of Tenant's employees, officers, contactors, licensees, agents, servants, employees, guests, invitees or visitors with respect to the Premises against loss, damage or liability for personal injury or death or loss or damage to property with a combined single limit of not less than $1,000,000, and a deductible of not more than $5,000. The insurance will be noncontributory with any liability insurance carried by Landlord. b. Casualty Insurance. During the Lease term, Tenant shall pay for and maintain all-risk coverage casualty insurance for the Premises, in an amount sufficient to prevent Landlord or Tenant from becoming a co-insurer under the terms of the policy, and in an amount not less than the replacement cost of the Premises, with a deductible of not more than $5,000. The casualty insurance policy shall name Tenant as the insured and Landlord and Landlord's lender(s) as additional insureds, with loss payable to Landlord, Landlord's lender(s), and Tenant as their interests may appear. In the event of a casually loss on the Premises, Landlord may apply insurance proceeds under the casualty insurance policy in the manner described in Section 14(a). c. Miscellaneous. Insurance required under this Section shall be with companies rated A-XV or better in Best's Insurance Guide, and which are authorized to transact business in the State of Washington. No Insurance policy shall be canceled or reduced in coverage and each such policy shall provide that it is not subject to cancellation or a reduction in coverage except after thirty (30) days prior written notice to Landlord. Tenant shall deliver to Landlord upon commencement of the Lease and from time to time thereafter, copies or certificates of the insurance policies required by this Section. In no event shall the limit of such policies be considered as limiting the liability of Tenant under this Lease. d. Waiver of Subrogation. Landlord and Tenant hereby release each other and any other tenant, their agents or employees, from responsibility for, and waive their entire claim of recovery for any loss or damage arising from any cause covered by insurance required to be carried by each of them. Each party shall provide notice to the insurance carrier or carriers of this mutual waiver of subrogation, and shall cause its respective insurance carriers to waive all rights of subrogation against the other. This waiver shall not apply to the extent of the deductible amounts to any such policies or to the extent of liabilities exceeding the limits of such policies. 16. INDEMNIFICATION. Tenant shall defend, indemnify, and hold Landlord harmless against all liabilities, damages, costs, and expenses, including attorneys' fees, arising from any negligent or wrongful act or omission of Tenant or Tenant's officers, contractors, licensees, agents, servants, employees, guests, OR invitees on or around the Premises as a result of any act, omission or negligence of Tenant, or Tenant's officers, contractors, licensees, agents, servants, employees, guests, invitees, or visitors, or arising from any breach of this Lease by Tenant. Tenant shall use legal counsel acceptable to Landlord in defense of any action within Tenant's defense obligation. Landlord shall defend, indemnify and hold Tenant harmless against all liabilities, damages, costs, and expenses, including attorneys' fees, arising from any negligent or wrongful act or omission of Landlord or Landlord's officers, contractors, licensees, agents, servants, employees, guests, invitees, or visitors on or around the Premises or arising from any breach of this Lease by Landlord. Landlord shall use legal counsel acceptable to Tenant in defense of any action within Landlord's defense obligation. 17. ASSIGNMENT AND SUBLETTING. Tenant shall not assign, sublet, mortgage, encumber or otherwise transfer any interest in this Lease (collectively referred to as a "Transfer") or any part of the Premises, without first obtaining Landlord's written consent, which shall not be unreasonably withheld or delayed. No Transfer shall relieve Tenant of any liability under this Lease notwithstanding Landlord's consent to such transfer. Consent to any Transfer shall not operate as a waiver of the necessity for Landlord's consent to any subsequent Transfer. If Tenant is a partnership, limited liability company, corporation, or other entity, any transfer of this Lease by merger, consolidation, redemption or liquidation, or any change(s) in the ownership of, or power to vote, which singularly or collectively represents a majority of the beneficial interest in Tenant, shall constitute a Transfer under this Section. As a condition to Landlord's approval, if given, any potential assignee or sublessee otherwise approved by Landlord shall assume all obligations of Tenant under this Lease and shall be jointly and severally liable with Tenant and any guarantor, if 4 required, for the payment of Rent and performance of all terms of this Lease. In connection with any Transfer, Tenant shall provide Landlord with copies of all assignments, subleases and assumption Instruments. NOTWITHSTANDING ANYTHING TO THE CONTRARY IN THIS LEASE, IF TENANT IS A PUBLICLY OWNED COMPANY, TRANSFERS OF STOCK IN TENANT IN ANY AMOUNT WILL BE PERMITTED WITHOUT LANDLORD'S CONSENT. 18. LIENS. Tenant shall keep the Premises free from any liens created by or through Tenant. Tenant shall indemnify and hold Landlord harmless from liability from any such liens including, without limitation, liens arising from any Alterations. If a lien is filed against the Premises by any person claiming by, through or under Tenant, Tenant shall, upon request of Landlord, at Tenant's expense, immediately furnish to Landlord a bond in form and amount and issued by a surety satisfactory to Landlord, indemnifying Landlord and the Premises against all liabilities, costs and expenses, including attorneys' fees, which Landlord could reasonably incur as a result of such lien(s). 19. DEFAULT. The following occurrences shall each be deemed an Event of Default by Tenant: a. Failure To Pay. Tenant fails to pay any sum, including Rent, due under this Lease following THREE (3) days written notice from Landlord of the failure to pay. c. Insolvency. Tenant becomes insolvent, voluntarily or involuntarily bankrupt, or a receiver, assignee, or other liquidating officer is appointed for Tenant's business, provided that in the event of any Involuntary bankruptcy or other insolvency proceeding, the existence of such proceeding shall constitute an Event of Default only if such proceeding is not dismissed or vacated within 60 days after its institution or commencement. d. Levy or Execution. Tenant's interest in this Lease or the Premises, or any part thereof, is taken by execution or other process of law directed against Tenant, or is taken upon or subjected to any attachment by any creditor of Tenant, if such attachment is not discharged within 15 days after being levied. e. Other Non-Monetary Defaults. Tenant breaches any agreement, term or covenant of this Lease other than one requiting the payment of money and not otherwise enumerated in this Section, and the breach continues for a period of 10 days after notice by Landlord to Tenant of the breach. G. NOTWITHSTANDING ANYTHING IN THE LEASE TO CONTRARY, IF ANY BREACH OF THIS LEASE BY TENANT CANNOT REASONABLY BE CURED WITHIN THIRTY (30) DAYS, SUCH BREACH WILL NOT BE AN EVENT OF DEFAULT UNDER THIS LEASE SO LONG AS TENANT COMMENCES TO CURE THE BREACH WITHIN THE THIRTY (30) DAY PERIOD AND DILIGENTLY PURSUES TO CURE THE BREACH WITHIN A REASONABLE PERIOD OF TIME. 20. REMEDIES. Landlord shall have the following remedies upon an Event of Default. Landlord's rights and remedies under this Lease shall be cumulative, and none shall exclude any other right or remedy allowed by law. a. Termination of Lease. Landlord may terminate Tenant's interest under the Lease, but no act by Landlord other than written notice from Landlord to Tenant of termination shall terminate this Lease. The Lease shall terminate on the date specified in the notice of termination. Upon termination of this Lease, Tenant will remain liable to Landlord for damages in an amount equal to the rent and other sums that would have been owing by Tenant under this Lease for the balance of the Lease term, less the net proceeds, if any, of any reletting of the Premises by Landlord subsequent to the termination, after deducting all Landlord's Reletting Expenses (as defined below). Landlord shall be entitled to either collect damages from Tenant monthly on the days on which rent or other amounts would have been payable under the Lease, or alternatively, Landlord may accelerate Tenant's obligations under the Lease and recover from Tenant: (i) unpaid rent which had been earned at the time of termination; (ii) the amount by which the unpaid rent which would have been earned after termination until the time of award exceeds the amount of rent loss that Tenant proves could reasonably have been avoided; (iii) the amount by which the unpaid rent for the balance of the term of the Lease after the time of award exceeds the amount of rent loss that Tenant proves could reasonably be avoided (discounting such amount by the discount rate of the Federal Reserve Bank of San Francisco at the time of the award, plus 1%); and (iv) any other amount necessary to compensate Landlord for all the detriment proximately caused by Tenant's failure to perform its obligations under the Lease, or which in the ordinary course would be likely to result from the Event of Default, including without limitation Reletting Expenses described in Section 20(b). b. Re-Entry and Reletting. Landlord may continue this Lease in full force and effect, and without demand or notice, re-enter and take possession of the Premises or any part thereof, expel the Tenant from the Premises and anyone claiming through or under the Tenant, and remove the personal property of either. Landlord may relet the Premises, or any part of them, in Landlord's or Tenant's name for the account of Tenant, for such period of time and at such other terms and conditions, as 5 Landlord, in its discretion, may determine. Landlord may collect and receive the rents for the Premises. Re-entry or taking possession of the Premises by Landlord under this Section shall not be construed as an election on Landlord's part to terminate this Lease, unless a written notice of termination is given to Tenant. Landlord reserves the right following any re-entry or reletting, or both, under this Section to exercise its right to terminate the Lease. During the Event of Default, Tenant will pay Landlord the rent and other sums which would be payable under this Lease if repossession had not occurred, LESS PLUS the net proceeds, if any, after reletting the Premises, after deducting Landlord's Reletting Expenses. "Reletting Expenses" is defined to include all expenses incurred by Landlord in connection with reletting the Premises, including without limitation, all repossession costs, brokerage commissions, attorneys' fees, remodeling and repair costs, costs for removing and storing Tenant's property and equipment, and rent concessions granted by Landlord to any new Tenant, prorated over the life of the new lease. c. Waiver of Redemption Rights. Tenant, for itself, and on behalf of any and all persons claiming through or under Tenant, including creditors of all kinds, hereby waives and surrenders all rights and privileges which they may have under any present or future law, to redeem the Premises or to have a continuance of this Lease for the Lease term, as it may have been extended. d. Nonpayment of Additional Rent. All costs which Tenant agrees to pay to Landlord pursuant to this Lease shall in the event of nonpayment be treated as if they were payments of Rent and Landlord shall have all the rights herein provided for in case of nonpayment of Rent. e. Failure to Remove Property. If Tenant fails to remove any of its property from the Premises at Landlord's request following an uncured Event of Default, Landlord may, at its option, remove and store the property at Tenant's expense and risk. If Tenant does not pay the storage cost within five (5) days of Landlord's request, Landlord may, at its option, have any or all of such property sold at public or private sale (and Landlord may become a purchaser at such sale), in such manner as Landlord deems proper, without notice to Tenant. Landlord shall apply the proceeds of such sale: (i) to the expense of such sale, including reasonable attorneys' fees actually incurred; (ii) to the payment of the costs or charges for storing such property; (iii) to the sums of any other sums of money which may then be or thereafter become due Landlord from Tenant under any of the terms hereof; and (iv) the balance, if any, to Tenant. Nothing in this Section shall limit Landlord's right to sell Tenant's personal Property as permitted by law to foreclose Landlord's lien for unpaid rent. F. LANDLORD DEFAULT. LANDLORD WILL BE IN DEFAULT UNDER THIS LEASE IF LANDLORD FAILS TO PERFORM OR OBSERVE ANY OBLIGATION OF LANDLORD UNDER THIS LEASE IF THE FAILURE IS NOT CURED WITHIN THIRTY (30) DAYS AFTER WRITTEN NOTICE HAS BEEN GIVEN BY TENANT TO LANDLORD. IF THE DEFAULT CANNOT REASONABLY BE CURED WITHIN THIRTY (30) DAYS, LANDLORD WILL NOT BE IN DEFAULT IF LANDLORD COMMENCES TO CURE THE DEFAULT WITHIN THE THIRTY (30) DAY PERIOD AND DILIGENTLY PURSUES TO CURE THE DEFAULT WITHIN A REASONABLE PERIOD OF TIME. IF, HOWEVER, THE NATURE OF THE DEFAULT ADVERSELY IMPACTS TENANT'S ABILITY TO CONDUCT THEIR BUSINESS, THEN CURE PERIOD SHOULD BE NO MORE THAN FIVE (5) WORKING DAYS AFTER TENANT'S NOTICE. IF LANDLORD IS IN DEFAULT UNDER THIS LEASE, TENANT MAY (A) CURE LANDLORD'S DEFAULT AND OFFSET RENT PAYMENTS UNTIL TENANT HAS RECOVERED THE COST OF SUCH CURE OR (B) TERMINATE THIS LEASE, IN WHICH CASE THIS LEASE SHALL BE OF NO FURTHER FORCE OR EFFECT AND NEITHER PARTY SHALL HAVE ANY FURTHER OBLIGATION TO THE OTHER. 21. MORTGAGE SUBORDINATION AND ATTORNMENT. This Lease shall automatically be subordinate to any mortgage or deed of trust created by Landlord which is now existing or hereafter placed upon the Premises including any advances, interest, modifications, renewals, replacements or extensions ("Landlord's Mortgage"), provided the holder of any Landlord's Mortgage or any person(s) acquiring the Premises at any sale or other proceeding under any such Landlord's Mortgage shall elect to continue this Lease in full force and effect. Tenant shall attorn to the holder of any Landlord's Mortgage or any person(s) acquiring the Premises at any sale or other proceeding under any Landlord's Mortgage provided such person(s) assume the obligations of Landlord under this Lease. Tenant shall promptly and in no event later than fifteen (15) days execute, acknowledge and deliver documents which the holder of any Landlord's Mortgage may reasonably require as further evidence of this subordination and attornment. Notwithstanding the foregoing, Tenant's obligations under this Section are conditioned on the holder of each of Landlord's Mortgage and each person acquiring the Premises at any sale or other proceeding under any such Landlord's Mortgage not disturbing Tenant's occupancy and other rights under this Lease, so long as no uncured Event of Default exists. 22. NON-WAIVER. Landlord's waiver of any breach of any term contained in this Lease shall not be deemed to be a waiver of the same term for subsequent acts of Tenant. The acceptance by Landlord or Rent or other amounts due by Tenant hereunder shall not be deemed to be a waiver of any breach by Tenant preceding such acceptance. 23. HOLDOVER. If Tenant shall, without the written consent of Landlord, hold over after the expiration or termination of the Term, such tenancy shall be deemed to be on a month-to-month basis and may be terminated according to Washington law. 6 During such tenancy, Tenant agrees to pay to Landlord 125% of the rate of rental last payable under this Lease, unless a different rate is agreed upon by Landlord. All other terms of the Lease shall remain in effect. 24. NOTICES. All notices under this Lease shall be in writing and effective (i) when delivered in person; (ii) three (3) days after being sent by registered or certified mail to Landlord or Tenant, as the case may be, at the Notice Addresses set forth in Section 1(h); or (iii) upon confirmed transmission by facsimile to such persons at the facsimile numbers set forth in Section 1(h) or such other addresses/facsimile numbers as may from time to time be designated by such parties in writing. 25. COSTS AND ATTORNEYS' FEES. If Tenant or Landlord engage the services of an attorney to collect monies due or to bring any action for any relief against the other, declaratory or otherwise, arising out of this Lease, including any suit by Landlord for the recovery of Rent or other payments, or possession of the Premises, the losing party shall pay the prevailing party a reasonable sum for attorneys' fees in such suit, at trial and on appeal. 26. ESTOPPEL CERTIFICATES. Tenant shall, from time to time, upon written request of Landlord, execute, acknowledge and deliver to Landlord or its designee a written statement specifying the following, subject to any modifications OR ADDITIONS necessary to make such statements true and complete: (i) the date the Lease term commenced and the date it expires; (ii) the amount of minimum monthly Rent and the date to which such Rent has been paid; (iii) that this Lease is in full force and effect and has not been assigned, modified, supplemented or amended in any way; (iv) that this Lease represents the entire agreement between the parties; (v) that all conditions under this Lease to be performed by Landlord have been satisfied; (vi) that there are no existing claims, defenses or offsets which the Tenant has against the enforcement of this Lease by Landlord; (vii) that no Rent has been paid more than one month in advance; and (viii) that no security has been deposited with Landlord (or, if so, the amount thereof). Any such statement delivered pursuant to this Section may be relied upon by a prospective purchaser of Landlord's interest or assignee of any mortgage or new mortgagee of Landlord's interest in the Premises. If Tenant shall fail to respond within ten (10) days of receipt by Tenant of a written request by Landlord as herein provided, Tenant shall be deemed to have given such certificate as above provided without modification and shall be deemed to have admitted the accuracy of any information supplied by Landlord to a prospective purchaser or mortgagee. 27. TRANSFER OF LANDLORD'S INTEREST. This Lease shall be assignable by Landlord without the consent of Tenant. In the event of any transfer or transfers of Landlord's interest in the Premises, other than a transfer for security purposes only, upon the assumption of this Lease by the transferee, Landlord shall be automatically relieved of obligations and liabilities accruing from and after the date of such transfer, except for any retained security deposit or prepaid rent, and Tenant shall attorn to the transferee. 28. RIGHT TO PERFORM. If Tenant shall fail to timely pay any sum or perform any other act on its part to be performed hereunder, Landlord may make any such payment or perform any such other act on Tenant's part to be made or performed as provided in this Lease. Tenant shall, on demand, reimburse Landlord for its expenses incurred in making such payment or performance. Landlord shall (in addition to any other right or remedy of Landlord provided by law) have the same rights and remedies in the event of the nonpayment of sums due under this Section as in the case of default by Tenant in the payment of Rent. 29. HAZARDOUS MATERIAL. Landlord represents and warrants to Tenant that to the best of Landlord's knowledge, there is no "Hazardous Material" (as defined below) on, in, or under the Premises as of the Commencement Date except as otherwise disclosed to Tenant in writing before the execution of this Lease. LANDLORD DISCLOSES THAT THERE ARE CERTAIN AREAS OF THE BUILDING WHICH CONTAIN ASBESTOS. If there is any Hazardous Material on, in, or under the Premises as of the Commencement Date which has been or thereafter becomes unlawfully released through no fault of Tenant, then Landlord shall indemnify, defend and hold Tenant harmless from any and all claims, judgments, damages, penalties, fines, costs, liabilities or losses including without limitation sums paid in settlement of claims, attorneys' fees, consultant fees and expert fees, incurred or suffered by Tenant either during or after the Lease term as the result of such contamination. Tenant shall not cause or permit any Hazardous Material to be brought upon, kept, or used in or about, or disposed of on the Premises by Tenant, its agents, employees, contractors or invitees, except in strict compliance with all applicable federal, state and local laws, regulations, codes and ordinances. If Tenant breaches the obligations stated In the preceding sentence, then Tenant shall indemnify, defend and hold Landlord harmless from any and all claims, judgments, damages, penalties, fines, costs, liabilities or losses including, without limitation, diminution in the value of the Premises, damages for the loss or restriction on use of rentable or usable space or of any amenity of the Premises, or elsewhere, damages arising from any adverse impact on marketing of space at the Premises, and sums paid in settlement of claims, attorneys' fees, consultant fees and expert fees incurred or suffered by Landlord either during or after the Lease term. These indemnifications by Landlord and Tenant include, without limitation, costs incurred in connection with any investigation of site conditions or any clean-up, remedial, removal or restoration work, whether or not required by any federal, state or local governmental agency or political 7 subdivision, because of Hazardous Material present in the Premises, or in soil or ground water on or under the Premises. Tenant shall immediately notify Landlord of any inquiry, investigation or notice that Tenant may receive from any third party regarding the actual or suspected presence of Hazardous Material on the Premises. Without limiting the foregoing, if the presence of any Hazardous Material brought upon, kept or used in or about the Premises by Tenant, its agents, employees, contractors or invitees, results in any unlawful release of Hazardous Material on the Premises or any other property, Tenant shall promptly take all actions, at its sole expense, as are necessary to return the Premises or any other property, to the condition existing prior to the release of any such Hazardous Material; provided that Landlord's approval of such actions shall first be obtained, which approval may be withheld at Landlord's sole discretion. As used herein, the term "Hazardous Material" means any hazardous, dangerous, toxic or harmful substance, material or waste including biomedical waste which is or becomes regulated by any local governmental authority, the State of Washington or the United States Government due to its potential harm to the health, safety or welfare of humans or the environment. 30. RIGHT OF ENTRY. Landlord and its agents, employees and contractors shall have the right to enter the Premises at reasonable times for inspection, to make repairs, alterations, and improvements, to show the Premises to prospective purchasers and, within six (6) months prior to the expiration of the Lease term, to show the Premises to prospective tenants. NOTWITHSTANDING ANYTHING TO THE CONTRARY IN THIS LEASE, LANDLORD RECOGNIZES THE WORK TO BE PERFORMED ON THE PREMISES BY TENANT IS CONFIDENTIAL AND PROPRIETARY, AND LANDLORD WILL USE ITS BEST EFFORTS TO ENTER THE PREMISES, OR ALLOW ITS AGENTS AND EMPLOYEES TO ENTER THE PREMISES, ONLY WHEN ACCOMPANIED BY AN ESCORT PROVIDED BY TENANT. LANDLORD WILL BE LIABLE TO TENANT FOR ANY DAMAGE RESULTING FROM LANDLORD'S VIOLATION OF THIS SECTION 30. 31. QUIET ENJOYMENT. So long as Tenant pays the Rent and performs all of its obligations in this Lease, Tenant's possession of the Premises will not be disturbed by Landlord or anyone claiming by, through or under Landlord, or by the holders of any Landlord's Mortgage or any successor thereto. 32. GENERAL. a. Heirs and Assigns. This Lease shall apply to and be binding upon Landlord and Tenant and their respective heirs, executors, administrators, successors and assigns. b. Brokers' Fees. Tenant represents and warrants to Landlord that it has not engaged any broker, finder or other person who would be entitled to any commission or fees for the negotiation, execution, or delivery of this Lease. Tenant shall indemnify and hold Landlord harmless against any loss, cost, liability or expense incurred by Landlord as a result of any claim asserted by any such broker, finder or other person on the basis of any arrangements or agreements made or alleged to have been made by or on behalf of Tenant. This subparagraph shall not apply to brokers with whom Landlord has an express written brokerage agreement. c. Entire Agreement. This Lease contains all of the covenants and agreements between Landlord and Tenant relating to the Premises. No prior agreements or understanding pertaining to the Lease shall be valid or of any force or effect and the covenants and agreements of this Lease shall not be altered, modified or added to except in writing signed by Landlord and Tenant d. Severability. Any provision of this Lease which shall prove to be invalid, void or illegal shall in no way affect, impair or invalidate any other provision of this Lease. e. Force Majeure. Time periods for either party's performance under any provisions of this Lease (excluding payment of Rent) shall be extended for periods of time during which the party's performance is prevented due to circumstances beyond such party's control, including without limitation, fires, floods, earthquakes, lockouts, strikes, embargoes, governmental regulations, acts of God, public enemy, war or other strife. f. Governing Law. This Lease shall be governed by and construed in accordance with the laws of the State of Washington. g. Memorandum of Lease. This Lease shall not be recorded. However, Landlord and Tenant shall, at the other's request, execute and record a memorandum of Lease in recordable form that identifies Landlord and Tenant, the commencement and expiration dates of the Lease, and the legal description of the Premises as set forth on attached Exhibit A. h. Submission of Lease Form Not an Offer. One party's submission of this Lease to the other for review shall not constitute an offer to lease the Premises. This Lease shall not become effective and binding upon Landlord and Tenant until it has been fully signed by both Landlord and Tenant. 8 i. Authority of Parties. Any individual signing this Lease on behalf of an entity represents and warrants to the other that such individual has authority to do so and, upon such individual's execution, that this Lease shall be binding upon and enforceable against the party on behalf of whom such individual is signing. 33. EXHIBITS AND RIDERS. The following exhibits and riders are made a part of this Lease: Exhibit A - Legal Description Exhibit B - Tenant Improvement Schedule (Check the box for any of the, following that will apply. Any riders checked shall be effective only upon being initialed by the parties and attached to the Lease. Capitalized terms used in the Riders have the meanings given to them in the Lease.) [ ] Retail Use Rider [ ] Arbitration Rider [ ] Guaranty of Tenant's Lease Obligations Rider [ ] Option to Extend Rider 9 LIMITATION ON LANDLORD'S LIABILITY RIDER Landlord and Tenant agree that Tenant's recourse against Landlord for any obligations of Landlord under this Lease shall be limited to Tenant's execution against Landlord's right, title and interest from time to time in the Premises. Neither Landlord nor any of its partners, shareholders, members, officers, directors, or other principals shall have any personal liability to Tenant as the result of any breach or default by Landlord under this Lease. /s/ JAK /s/ PJK - -------------------- ------------------ Landlord's Initials: Tenant's Initials: /s/ EK - -------------------- ------------------ Landlord's Initials: Tenant's Initials: 10 STATE OF WASHINGTON ) ) ss. COUNTY OF KING ) I certify that I know or have satisfactory evidence that Elsie Kane is the person who appeared before me and said person acknowledged that Elsie Kane signed this instrument, on oath stated that Elsie Kane was authorized to execute the instrument and acknowledged it as the landlord of said to be the free and voluntary act of such party for the uses and purposes mentioned in the instrument. DATED: 5-12, 1997 (Seal or stamp) /s/ Holly Fergusa ----------------------------------------- (Printed Name: Holly Fergusa ) -------------------------- Notary Public for the State of Washington residing at: Seattle ---------------------------- My commission expires: 2-27-98 ------------------ STATE OF WASHINGTON ) ) ss. COUNTY OF KING ) I certify that I know or have satisfactory evidence that Thomas Kane is the person who appeared before me and said person acknowledged that Thomas Kane signed this instrument, on oath stated that Thomas Kane was authorized to execute the instrument and acknowledged it as the landlord of said to be the free and voluntary act of such party for the uses and purposes mentioned in the instrument. DATED: 5-12, 1997 (Seal or stamp) /s/ Holly Fergusa ----------------------------------------- (Printed Name: Holly Fergusa ) -------------------------- Notary Public for the State of Washington residing at: Seattle ---------------------------- My commission expires: 2-27-98 ------------------ 11 Exhibit A [Legal Description] Lot 7, 8 and South Half of Lot 9, Block 12, of D.T. Denny's North Seattle Addition to the City of Seattle as recorded In Volume 1 of Plats, Page 41, King County, Washington. 12 STATE OF WASHINGTON ) ) ss. COUNTY OF KING ) I certify that I know or have satisfactory evidence that Paul Kanan is the person who appeared before me and said person acknowledged that Paul Kanan signed this instrument, on oath stated that Paul Kanan was authorized to execute the instrument and acknowledged it as the President & CEO of Pacific Biometrics, Inc. to be the free and voluntary act of such party for the uses and purposes mentioned in the instrument. DATED: May 14, 1997 (Seal or stamp) /s/ Max Mayer ----------------------------------------- (Printed Name: Max Mayer ) -------------------------- Notary Public for the State of Washington residing at: Seattle ---------------------------- My commission expires: Sept. 27, 2000 ------------------ STATE OF WASHINGTON ) ) ss. COUNTY OF __________ ) I certify that I know or have satisfactory evidence that ____________________ is the person who appeared before me and said person acknowledged that ____________________ signed this instrument, on oath stated that ____________________ was authorized to execute the instrument and acknowledged it as the ____________________ of ____________________ to be the free and voluntary act of such party for the uses and purposes mentioned in the instrument. DATED:______________________________. (Seal or stamp) (Printed Name: ) -------------------------- Notary Public for the State of Washington residing at: ---------------------------- My commission expires: ------------------ 13 IN WITNESS WHEREOF this Lease has been executed the date and year first above written. TOM KANE /S/ THOMAS KANE PACIFIC BIOMETRICS, INC. ----------------------- ------------------ LANDLORD: TENANT: ELSA KANE /S/ ELSA KANE /s/ Paul G. Kanan ---------------------- ------------------------------ LANDLORD: TENANT: Paul G. Kanan - -------------------------------- ------------------------------ By: By: President & CEO - -------------------------------- ------------------------------ Its: Its: 14 EXHIBIT B 6/23/2006 Pacific Biometrics, Inc. Building Improvement Needs
- --------------------------------------- ----------- ---------- ----------- ------------ ------------ Building Improvements Listing J / L / P Estimate Blend - --------------------------------------- ----------- ---------- ----------- ------------ ------------ A B C D - --------------------------------------- ----------- ---------- ----------- ------------ ------------ Window Replacement J / L / P $130,000 - --------------------------------------- ----------- ---------- ----------- ------------ ------------ Painting Interior and Exterior J / L / P $39,230 $39,250 - --------------------------------------- ----------- ---------- ----------- ------------ ------------ Canopy Replacement J / L / P $15,000 $15,000 - --------------------------------------- ----------- ---------- ----------- ------------ ------------ Rest rooms Renovation/Update J / L / P $ 9,800 $ 9,800 - --------------------------------------- ----------- ---------- ----------- ------------ ------------ Chemical Hood Move J / L / P $11,750 $11,750 - --------------------------------------- ----------- ---------- ----------- ------------ ------------ Power Upgrade - Facility J / L / P $189,000 - --------------------------------------- ----------- ---------- ----------- ------------ ------------ Short Term 200A Breaker & Circuit box J / L / P $30,000 $30,000 - --------------------------------------- ----------- ---------- ----------- ------------ ------------ Clear Boiler room J / L / P $ 4,500 $ 4,500 - --------------------------------------- ----------- ---------- ----------- ------------ ------------ Locker Room Renovation J / L / P $ 3,000 $ 3,000 - --------------------------------------- ----------- ---------- ----------- ------------ ------------ Project Management Area Renovation J / L / P $20,000 $20,000 - --------------------------------------- ----------- ---------- ----------- ------------ ------------ Resurface the parking lot surface??? J / L / P $20,000 $20,000 - --------------------------------------- ----------- ---------- ----------- ------------ ------------ Alley way repair??? J / L / P ??? - --------------------------------------- ----------- ---------- ----------- ------------ ------------ Total $123,300 $30,000 $319,000 $153,300 - --------------------------------------- ----------- ---------- ----------- ------------ ------------ Off Site Space Rental for Freezers - --------------------------------------- ----------- ---------- ----------- ------------ ------------ Freezer Storage Offsite (For 3 Yrs.) J / L / P $30,240 - --------------------------------------- ----------- ---------- ----------- ------------ ------------ 8 units per year cost J / L / P - --------------------------------------- ----------- ---------- ----------- ------------ ------------ Moving and setup J / L / P $ 1,500 - --------------------------------------- ----------- ---------- ----------- ------------ ------------
EX-23.1 4 exh23-1_15449.txt CONSENT OF WILLIAM AND WEBSTER EXHIBIT 23.1 ------------ Board of Directors Pacific Biometrics, Inc. Seattle, Washington CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We consent to the use of our audit report dated October 3, 2006, on the financial statements of Pacific Biometrics, Inc., for the filing with and attachment to the Form 10-KSB for the year ended June 30, 2007, and for incorporation by reference in the Registration Statements of Pacific Biometrics, Inc. on Form S-8 (File Nos. 333-23497 and 333-109795). /s/ Williams & Webster, P.S. - ------------------------------- Williams & Webster, P.S. CERTIFIED PUBLIC ACCOUNTANTS Spokane, Washington October 5, 2007 EX-23.2 5 exh23-2_15449.txt CONSENT OF PMB HELIN DONOVAN, LLP EXHIBIT 23.2 ------------ Board of Directors Pacific Biometrics, Inc. Seattle, Washington CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We consent to the use of our audit report dated September 20, 2007, on the financial statements of Pacific Biometrics, Inc., for the filing with and attachment to the Form 10-KSB for the year ended June 30, 2007, and for incorporation by reference in the Registration Statements of Pacific Biometrics, Inc. on Form S-8 (File Nos. 333-23497 and 333-109795). /s/ PMB Helin Donovan, LLP - ------------------------------ PMB Helin Donovan, LLP CERTIFIED PUBLIC ACCOUNTANTS San Francisco, California October 5, 2007 EX-31.1 6 exh31-1_15449.txt 302 CERTIFICATION OF THE C.E.O. EXHIBIT 31.1 ------------ CERTIFICATION I, Ronald R. Helm, certify that: 1. I have reviewed this annual report on Form 10-KSB of Pacific Biometrics, Inc. 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report. 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report. 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and we have: a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b. Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation. c. Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function): a. All significant deficiencies in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information ; and b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: October 5, 2007 /s/ Ronald R. Helm --------------------------- Ronald R. Helm President and Chief Executive Officer EX-31.2 7 exh31-2_15449.txt 302 CERTIFICATION OF THE V.P. OF FINANCE EXHIBIT 31.2 ------------ CERTIFICATION I, John P. Jensen, certify that: 1. I have reviewed this annual report on Form 10-KSB of Pacific Biometrics, Inc. 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report. 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report. 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and we have: a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b. Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation. c. Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function): a. All significant deficiencies in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information ; and b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: October 5, 2007 /s/ John P. Jensen -------------------------------- John P. Jensen Vice President of Finance and Controller EX-32.1 8 exh32-1_15449.txt 906 CERTIFICATION OF THE CEO AND VP OF FINANCE EXHIBIT 32.1 ------------ CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Pacific Biometrics, Inc. (the "Company") on Form 10-KSB for the fiscal year ended June 30, 2007 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), we, Ronald R. Helm, President and Chief Executive Officer of the Company, and John P. Jensen, Vice President of Finance and Controller, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. Date: October 5, 2007 /s/ Ronald R. Helm -------------------------------- Ronald R. Helm President and Chief Executive Officer /s/ John P. Jensen -------------------------------- John P. Jensen Vice President of Finance and Controller -----END PRIVACY-ENHANCED MESSAGE-----