-----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, QUp6uVzRQKLeqBtKj1SYqjmkMOvkU5pShjWVnblGyLy2z+z2BO09BNcY6zf9V592 RZ8FakWgPrxVD1XFOGrD+w== 0000892569-97-003137.txt : 19971113 0000892569-97-003137.hdr.sgml : 19971113 ACCESSION NUMBER: 0000892569-97-003137 CONFORMED SUBMISSION TYPE: SB-2/A PUBLIC DOCUMENT COUNT: 8 FILED AS OF DATE: 19971113 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: MEDICAL SCIENCE SYSTEMS INC CENTRAL INDEX KEY: 0001037649 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-MEDICAL LABORATORIES [8071] IRS NUMBER: 943123681 STATE OF INCORPORATION: TX FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: SB-2/A SEC ACT: SEC FILE NUMBER: 333-37441 FILM NUMBER: 97716036 BUSINESS ADDRESS: STREET 1: 4400 MACARTHUR BLVD STREET 2: STE 980 CITY: NEWPORT BEACH STATE: CA ZIP: 92660-2031 BUSINESS PHONE: 7144409730 MAIL ADDRESS: STREET 1: 4400 MACARTHUR BLVD STREET 2: STE 980 CITY: NEWPORT BEACH STATE: CA ZIP: 92660-2031 SB-2/A 1 AMENDMENT NO. #2 TO FROM SB-2 1 AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON NOVEMBER 13, 1997 REGISTRATION NO. 333-37441 ================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ AMENDMENT NO. 2 TO FORM SB-2 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 MEDICAL SCIENCE SYSTEMS, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) TEXAS 8099 94-3123681 (STATE OR OTHER JURISDICTION OF (PRIMARY STANDARD INDUSTRIAL (I.R.S. EMPLOYER) INCORPORATION OR ORGANIZATION) CLASSIFICATION CODE NUMBER) IDENTIFICATION NO.)
4400 MACARTHUR BOULEVARD, SUITE 980 NEWPORT BEACH, CALIFORNIA 92660 (714) 440-9730 (ADDRESS AND TELEPHONE NUMBER OF PRINCIPAL EXECUTIVE OFFICES) PAUL J. WHITE PRESIDENT AND CHIEF EXECUTIVE OFFICER MEDICAL SCIENCE SYSTEMS, INC. 4400 MACARTHUR BOULEVARD, SUITE 980 NEWPORT BEACH, CALIFORNIA 92660 (714) 440-9730 (NAME, ADDRESS AND TELEPHONE NUMBER OF AGENT FOR SERVICE OF PROCESS) THE COMMISSION IS REQUESTED TO SEND COPIES OF ALL COMMUNICATION TO: CHRISTOPHER A. WILSON, ESQ. DANIEL J. TANGEMAN, ESQ. JEFFERS, WILSON, SHAFF & FALK, LLP 18881 VON KARMAN AVENUE, SUITE 1400 IRVINE, CALIFORNIA 92612 (714) 660-7700 WILLIAM M. PRIFTI, ESQ. LYNNFIELD WOODS OFFICE PARK 220 BROADWAY SUITE 204 LYNNFIELD, MASSACHUSETTS 01940 (781) 593-4525 APPROXIMATE DATE OF PROPOSED SALE TO THE PUBLIC: As soon as possible after the effective date. If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [ ] If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [ ] If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box. [ ] CALCULATION OF REGISTRATION FEE ============================================================================================================ PROPOSED MAXIMUM PROPOSED MAXIMUM TITLE OF EACH CLASS OF AMOUNT TO BE OFFERING PRICE PER AGGREGATE OFFERING AMOUNT OF SECURITIES TO BE REGISTERED REGISTERED SHARE PRICE(1) REGISTRATION FEE - ------------------------------------------------------------------------------------------------------------ Common Stock, no par value..................... 2,500,000 $ 9.00 $22,500,000 $6,818 Underwriters' Warrants(2)... 250,000 $ .001 $ 250 $ 0(3) Common Stock, no par value(4).................. 250,000 $14.85 $ 3,712,500 $1,125 Common Stock, no par value(5).................. 375,000 $ 9.00 $ 3,375,000 $1,023 Total.............. $8,966(6) ============================================================================================================
(1) Estimated solely for purposes of calculating the registration fee, pursuant to rule 457(a) and (g) under the Securities Act. (2) To be sold to the Representatives of the Underwriters. (3) None pursuant to Rule 457(g). (4) Issuable upon exercise of the Underwriters' Warrants. (5) Issuable upon exercise of the Underwriters' option to purchase to cover over-allotments, if any. (6) $5,257 has previously been paid. THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF THE SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(a), MAY DETERMINE. ================================================================================ 2 THE INFORMATION IN THIS PROSPECTUS IS NOT COMPLETE. WE MAY NOT SELL THESE SECURITIES UNTIL THE REGISTRATION STATEMENT FILED WITH THE SEC IS EFFECTIVE. THIS PROSPECTUS IS NOT AN OFFER TO SELL NOR IS IT SEEKING AN OFFER TO BUY THESE SECURITIES IN ANY STATE WHERE THE OFFER OR SALE IS NOT PERMITTED. SUBJECT TO COMPLETION, DATED NOVEMBER 13, 1997 Initial Public Offering Prospectus [MEDICAL SCIENCE SYSTEMS LOGO] 2,500,000 shares of Common Stock $8 to $9 per share Medical Science Systems, Inc. 4400 MacArthur Boulevard Suite 980 Newport Beach, California 92660 (714) 440-9730 THE OFFERING*
PER SHARE TOTAL --------- ----------- Public Price........... $9.00 $22,500,000 Underwriting discounts........... $ .72 $ 1,800,000 Proceeds to Company.... $8.28 $20,700,000
- --------------- *Assumes a $9 per share offering price. We develop genetic tests which indicate whether a person is more likely to develop or will be more severely affected by certain common diseases which are treatable and preventable. We recently began marketing our initial test related to periodontitis (gum disease). Provided that our clinical trials continue to produce favorable results, we intend to commence marketing our other genetic tests which indicate susceptibility to osteoporosis (bone disease), coronary artery disease (heart disease) and diabetic retinopathy (blindness associated with diabetes) in 1998 and 1999. Proposed Trading Symbol NASDAQ NATIONAL MARKET(R) -- MSSI This Investment Involves a High Degree of Risk. Please Refer to "Risk Factors" Beginning on Page 9. The Securities and Exchange Commission (SEC) and state securities regulators have not approved these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense and should be reported immediately to the SEC by calling 1-800-SEC-0330. Nutmeg Securities, Ltd. Millennium Financial Group, Inc. 3 [Pictorial Depiction of Biological and Behavioral Risk Factors Contributing to Disease Progression] Our website is located at http://www.medscience.com. This prospectus includes names and marks which we believe to be trademarks or servicemarks of third parties. We have no ownership interest in any of the intellectual property indicated by the trademark or servicemark symbols of third parties referenced in this prospectus. Upon the effective date of the registration statement, of which this prospectus is a part, our company will become a reporting company. Thereafter, we intend to distribute to our shareholders annual reports containing audited financial statements. We will also make available copies of quarterly reports for the first three quarters of each fiscal year containing unaudited interim financial information. Certain persons who participate in this offering may engage in transactions that stabilize, maintain or otherwise affect the price of the Shares, including purchases of the Shares to maintain their market price or purchases to cover some or all of the Underwriters' short position in the Shares. 4 MEDICAL SCIENCE SYSTEMS, INC. PROSPECTUS INTRODUCTION Please read this prospectus carefully. It describes our company, finances and products. Federal and state securities laws require that we include in this prospectus all the important information that investors will need to make an investment decision. You should rely only on the information contained in this prospectus to make your investment decision. We have not authorized anyone to provide you with information that is different from what is contained in this prospectus. TABLE OF CONTENTS Summary......................... 1 Risk Factors.................... 9 The Company..................... 17 Use of Proceeds................. 18 Dividend Policy................. 19 Capitalization.................. 19 Dilution........................ 20 Selected Financial Data......... 21 Management's Discussion and Analysis of Financial Condition and Results of Operations................... 22 Business........................ 25 Management...................... 46 Certain Relationships and Related Party Transactions... 52 Principal Shareholders.......... 53 Description of Securities....... 54 Shares Eligible for Future Sale......................... 55 Underwriting.................... 57 Legal Matters................... 58 Experts......................... 58 Additional Information.......... 58 Index to Financial Statements... F-1
5 MEDICAL SCIENCE SYSTEMS, INC. Summary ABOUT OUR COMPANY Our company has developed genetic tests which indicate whether an individual is genetically more likely to be affected or more severely affected by certain common diseases which are treatable and preventable. We have focused on four diseases initially: periodontitis (gum disease), osteoporosis (bone disease), coronary artery disease (heart disease) and diabetic retinopathy (blindness associated with diabetes). We have identified several genetic markers which, if present in a patient, increase the probability that such patient will be affected by the disease or that the disease will be more severe. Moreover, we are the only company that we know of that has brought to market a test (our periodontal susceptibility test) that identifies a genetic marker which indicates a greater susceptibility to a disease which is treatable and preventable. Our company's ability to identify genetic markers related to common diseases is enhanced by a strategic alliance with Sheffield University. Sheffield University provides us with access to critical biotechnology research in molecular genetics. This arrangement helps provide for the development of additional genetic testing products in the future and reduces our capital costs relative to biotechnology firms that support large in-house research programs. See "Competitive Advantages" at page 42. We have ten (10) patent applications pending, including applications covering each of our four genetic susceptibility tests. We have also been issued one patent related to our computer modeling technology. In June 1997, the United States Patent and Trademark Office notified us that the patents for our periodontal and osteoporosis susceptibility tests are expected to issue. While the issuance of those patents is likely, the Patent and Trademark Office could disallow the patents at any time prior to the actual issue date. See "Intellectual Property" at page 40. MISSION Our mission is to improve patient care and treatment outcomes by incorporating genetic information about a patient's susceptibility to disease into overall risk assessment and treatment planning. We believe that doctors and dentists will use our genetic susceptibility tests to assess the risk involved for any particular patient and to adopt appropriate treatments or therapy, including preventive measures. 1 6 Summary (con't) PRODUCTS AND SERVICES PERIODONTAL SUSCEPTIBILITY TEST - Description. Our periodontal susceptibility test is a genetic test capable of detecting individuals with an increased susceptibility to developing severe gum disease (periodontitis). Periodontitis is a bacterially-induced chronic inflammation that destroys the collagen fibers and bone that support the teeth -- ultimately resulting in tooth loss. - Market. According to industry data, in the United States alone, an estimated one-third of all adults, or 67 million people, suffer from some form of periodontitis. Approximately 13 million people seek professional treatment annually for periodontal disease, resulting in over 17 million periodontal procedures and annual expenditures of approximately $6 billion. Because of the great prevalence of periodontitis, we believe that a substantial portion of the United States' population receiving dental care will be our initial target market. - Launch. On October 3, 1997, we commercially launched our periodontal susceptibility test at the American Academy of Periodontology's Annual Meeting in San Diego, California. OSTEOPOROSIS SUSCEPTIBILITY TEST - Description. Our osteoporosis susceptibility test is a genetic test capable of detecting individuals with an increased susceptibility to developing osteoporosis. Osteoporosis is a disease which causes a decrease in the amount of normal bone, making the affected individual more susceptible to fractures. - Market. According to industry data, in the United States alone, an estimated 28 million people, suffer from osteoporosis. Post-menopausal osteoporosis, stemming from the loss of estrogen, affects more than one-half of all women over 65 years of age and has been detected in as many as 90% of the women over age 75. Osteoporosis is responsible for a majority of the 1.5 million bone fractures each year and leads to disabilities costing more than $10 billion in medical, social and nursing home costs. - Launch. We have confirmed the results of our initial trials which demonstrated a relationship between a certain genetic marker and an individual's likelihood to develop or be more severely affected 2 7 Summary (con't) by osteoporosis. We are currently gathering information on the clinical utility of our osteoporosis susceptibility test. Provided that our clinical trials continue to produce favorable results, we anticipate commercially launching this test in late 1998. See "Pre-Marketing Trials/Status of Susceptibility Tests" at pages 35 and 36; "Difficulty of Developing Genetic Susceptibility Tests" at page 10. CORONARY ARTERY DISEASE SUSCEPTIBILITY TEST - Description. Our coronary artery disease susceptibility test is a genetic test capable of detecting individuals with an increased susceptibility to developing coronary artery disease (or "CAD"). CAD is a condition where the arteries that supply blood to the heart have become partially obstructed by plaque accumulation. CAD results in heart attacks due to damage to the heart muscle when blood supply (and therefore oxygen) is cut off and heart muscle cells die. An individual testing positive under our CAD susceptibility test has between a 2.4 to 5.4 times greater change of developing coronary artery disease than the general population. - Market. More than one in four Americans, or about 60 million, now have some form of cardiovascular disease. Cardiovascular diseases kill nearly one million Americans every year. Every year since 1919, cardiovascular disease has been the number one cause of death in the United States. Approximately 13.5 million Americans suffer from coronary artery disease, and approximately half a million Americans die each year from this disease. - Launch. We have confirmed the results of our initial trials which demonstrated a relationship between a certain genetic marker and an individual's likelihood to develop or be more severely affected by coronary artery disease. We are currently gathering information on the clinical utility of our coronary artery disease test. Provided that our clinical trials continue to produce favorable results, we anticipate commercially launching this test sometime in 1999. See "Pre-Marketing Trials/Status of Susceptibility Tests" at pages 35 and 36; "Difficulty of Developing Genetic Susceptibility Tests" at page 10. DIABETIC RETINOPATHY SUSCEPTIBILITY TEST - Description. Our diabetic retinopathy susceptibility test is a genetic test capable of detecting diabetic individuals who have an increased susceptibility to developing sight-threatening retinopathy. Diabetic retinopathy refers to diabetic complications 3 8 Summary (con't) affecting the retina that predictably lead to severe vision loss or even blindness. - Market. In the United States there are approximately 16 million people suffering from diabetes. It is estimated that only one-half of this number have been diagnosed. Diabetic retinopathy is one of the most common complications of diabetes. It is the fourth leading cause of legal blindness in the U.S. and the leading cause of blindness in people ages 20 to 74. Each year 15,000 to 39,000 people lose their sight from diabetic retinopathy. - Launch. We are currently confirming the results of our initial trials which demonstrated a relationship between a certain genetic marker and a diabetic individual's likelihood to develop diabetic retinopathy. Upon completion of the confirmatory trials more information will be gathering regarding the clinical utility of the diabetic retinopathy test. Provided that our confirmatory and subsequent clinical trials produce favorable results, we anticipate commercially launching this test sometime in 1999. See "Pre-Marketing Trials/Status of Susceptibility Tests" at pages 35 and 36; "Difficulty of Developing Genetic Susceptibility Tests" at page 10. COST OF PRODUCTS AND SERVICES We have recently commercially launched our periodontal susceptibility test and are marketing the test at $210 per test. Although we cannot be certain, we anticipate that the remainder of our genetic susceptibility tests will be marketed at a price between $200 and $250. Final pricing of these other tests will be determined at the time of commercial launch. We anticipate our direct cost (exclusive of sales and marketing) on a per test basis to be between $45-$80 depending primarily upon volume considerations. RISKS OF INVESTING An investment in our company is subject to many risks. We summarize some of the most serious risks below. A more detailed list of the risk factors is found under "Risk Factors" at page 9. You should read and understand all risk factors before making your decision to invest. - Uncertainty of Market Acceptance for Genetic Susceptibility Tests. Consumers may not accept our current genetic susceptibility tests or others in development or may accept the tests much later than we anticipate. - New Business Venture. Our genetic susceptibility testing business is relatively new and may be affected significantly by 4 9 Summary (con't) unknown economic and market conditions over which we have no control. - History of Operating Losses; Accumulated Deficit; Uncertainty of Future Profitability. Our company incurred a net loss of $788,546 in 1996 and anticipates a net loss of approximately $4.0 million in 1997. As of September 30, 1997, our accumulated deficit was approximately $3.91 million. It is uncertain when we will become profitable. - Intense Competition. Our company faces intense competition related to the discovery and use of disease predisposing genes and genetic markers. Even after our discovery of the genetic markers, our competition may find and patent the same markers before we do or may find other markers for the same diseases. Additionally, our competitors may have greater resources enabling them to more effectively market their discoveries. - Difficulty of Developing Genetic Susceptibility Tests. It is uncertain whether we will be successful in bringing our complete portfolio of tests to market. Even after identifying a genetic marker, many additional trials must be run in order to verify and confirm the test's accuracy and utility. Any delay in clinical trials or negative clinical results could slow or prevent our ability to successfully market our tests. - Uncertainty of Insurance Reimbursement. It is uncertain whether insurers and third-party payors will elect to reimburse patients for the cost of the genetic susceptibility tests. If insurers or third-party payors elect not to reimburse patients, it is uncertain whether individuals will elect to pay directly for our tests. - Reliance on Collaborative Partners. We have a collaborative research relationship, evidenced by an exclusive worldwide agreement, with the Section of Molecular Medicine at Sheffield University. Additionally, we have entered into agreements with Sheffield University governing each of our individual tests. If these agreements were terminated, we would need to enter into additional collaborative arrangements in order to continue to build a future pipeline of new products. - Uncertain Ability to Protect Proprietary Technology. The patent position of biotechnology companies generally is highly uncertain and involves complex legal and factual questions. Although initial approvals have been granted by the Patent and Trademark Office with respect to some of our tests, certain of our patent 5 10 Summary (con't) applications may be rejected. Even when patents are issued, the claims of any issued patents may not provide meaningful protection for our technology or products. Others may develop similar products which test for susceptibility related to the same diseases yet avoid infringing upon, or conflicting with, our anticipated patents. In addition, there can be no assurance that any patents issued to us will not be challenged, and subsequently narrowed, invalidated or circumvented. - Technological Changes Resulting in Product Obsolescence. It is possible that our competitors will develop technologies more effective than those contained or used in our products. Our competitors could develop new products which make our products less competitive or obsolete. - Limited Marketing or Sales Experience. We have limited experience in developing and commercially marketing our genetic susceptibility testing services. 6 11 Summary (con't) PAST FINANCIAL HISTORY The following graph depicts our revenues and net income or loss for each of the last three fiscal years. Our financial results are described in more detail under "Management's Discussion and Analysis of Financial Condition and Results of Operations" at page 22. Audited financial statements are included beginning at page F-1. [NET INCOME AND REVENUES GRAPH] 7 12 Medical Science Systems, Inc. Summary (con't) KEY FACTS SHARES OFFERED TO THE PUBLIC: 2,500,000 Shares OVER-ALLOTMENT OPTION: Up to 375,000 Shares (not included in 2,500,000) TOTAL SHARES OUTSTANDING PRIOR TO OFFERING: 3,738,007 Shares TOTAL SHARES OUTSTANDING AFTER OFFERING: 6,238,007 Shares (assuming no exercise of the over-allotment option) TOTAL SHARES OUTSTANDING AFTER OFFERING AND EXERCISE OF ALL OPTIONS/WARRANTS: 7,645,131 Shares PRICE PER SHARE TO PUBLIC: $9.00 per share TOTAL PROCEEDS RAISED BY OFFERING: $22,500,000 UNDERWRITERS' FEES: $1,800,000/8% of the total proceeds plus a 3% non-accountable expense allowance EXPENSES OF THE OFFERING: $355,000 NET PROCEEDS: $19,670,000 USE OF PROCEEDS: Marketing, sales, customer service and commercialization expenses; research and development activities; capital investment; repayment of bridge loans; and working capital and general corporate purposes. UNDERWRITERS' WARRANTS: Underwriters will receive warrants to purchase 250,000 Shares at an exercise price of $14.40 exercisable for five (5) years. AVERAGE PRICE PER SHARE PAID BY CURRENT SHAREHOLDERS: $0.59 NET TANGIBLE BOOK VALUE: $(1,725,016) NET TANGIBLE BOOK VALUE PER SHARE BEFORE DILUTION: $(0.46) NET TANGIBLE BOOK VALUE PER SHARE AFTER DILUTION: $2.88 MARKET: Nasdaq National Market(R) -- MSSI DIVIDEND POLICY: No Dividends Expected UNDERWRITING: Firm Commitment 8 13 RISK FACTORS The shares of Common Stock offered by this Prospectus are speculative and involve a high degree of risk of loss. Prior to making an investment, you should carefully read this entire Prospectus and consider the following risk and speculative factors: UNCERTAINTY OF MARKET ACCEPTANCE FOR GENETIC SUSCEPTIBILITY TESTS The commercial success of our genetic susceptibility tests and those that we may develop will depend upon their acceptance as medically useful and cost-effective by patients, physicians, dentists, other members of the medical and dental community and insurers. Broad market acceptance can be achieved only with substantial education about the benefits and limitations of such tests. We expect to expend substantial financial resources to effectively promote the benefits of our genetic susceptibility tests and those that we may develop. We intend to expend significant resources on educating medical and dental caregivers, policymakers, patients, insurers and others. It is uncertain whether current genetic susceptibility tests or others that we may develop will gain market acceptance on a timely basis. If patients, dentists and physicians do not accept our tests, or take a longer time to accept than we anticipate, then our revenues and profit margins may be reduced and may result in losses. See "Uncertainty of Insurance Reimbursement" at page 10. NEW BUSINESS VENTURE The securities being offered by us are subject to the risks inherent in any new business venture. Although we have operated as a contract research firm since 1986, we have limited experience and a short history of operations with respect to marketing and selling susceptibility tests or therapeutics. We have had only minimal revenues related to the sale of our genetic susceptibility testing services. With the exception of our periodontal susceptibility test, the genetic susceptibility tests anticipated to be sold by us have not yet been finally designed, developed, tested or marketed. Therefore, there can be no assurance that we will be able to complete these genetic susceptibility tests, that those tests will be accepted in the marketplace, or that the tests can be sold at a profit. Our business may also be affected significantly by economic and market conditions over which we have no control. Consequently, an investment in our Common Stock is highly speculative. We do not guarantee any return on an investment in our Common Stock. HISTORY OF OPERATING LOSSES; ACCUMULATED DEFICIT; UNCERTAINTY OF FUTURE PROFITABILITY We incurred a net operating loss of $788,546 in fiscal year 1996. We anticipate a net loss of approximately $4.0 million in 1997. As of September 30, 1997, our accumulated deficit was $3,913,577. Our losses have resulted principally from expenses incurred in research and development and from selling, general and administrative expenses. These expenses have exceeded our revenues. We have yet to generate any significant revenues from the sale of our genetic susceptibility testing services and there can be no assurance that we will be able to generate significant revenues in the future. We expect our operating losses to continue for the near future as our research and development, sales and marketing activities and operations continue. Our ability to achieve profitability depends on our ability to develop our sales and marketing capacity and our ability to successfully market and sell our products and services. It is uncertain when we will become profitable. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" at page 22. INTENSE COMPETITION Research in the field of disease predisposing genes and genetic markers is intense and highly competitive. Genetic research is characterized by rapid technological change. Our competitors in the United States and abroad are numerous and include, among others, major pharmaceutical and diagnostic companies, specialized biotechnology firms, universities and other research institutions (including those receiving funding from the Human Genome Project). Many of our potential competitors have considerably greater financial, technical, marketing and other resources than us. These greater resources may allow our competitors to discover important genes or genetic markers before us. If we, in conjunction with the Department of Molecular and Genetic Medicine at the University of Sheffield, U.K., do not discover disease predisposing 9 14 genes or genetic markers associated with increased disease severity, characterize their function, develop susceptibility tests and related information services based on such discoveries, obtain regulatory and other approvals, if needed, and launch such services or products before competitors, then our revenues and earnings will be reduced or eliminated. In addition, any of the susceptibility tests that we may develop, including our periodontal susceptibility test, could be made obsolete by less expensive or more effective tests or methods which may be developed in the future. We expect competition to intensify in our industry as technical advances are made and become more widely known. See "Uncertain Ability to Protect Proprietary Technology" at page 11, "Competition" at page 41 and "Intellectual Property" at page 40. DIFFICULTY OF DEVELOPING GENETIC SUSCEPTIBILITY TESTS It is uncertain whether we will be successful in developing and bringing to market our current portfolio or future tests based on the genetic discoveries made by us and our collaborators. Even when we discover a genetic marker (i.e., a genetic variation or polymorphism associated with increased disease incidence or severity), additional clinical trials need to be conducted to confirm the initial scientific discovery and to support the scientific discovery's clinical utility in the marketplace. The results of a clinical trial could delay, reduce the test's acceptance or cause our company to cancel a program. Such delays, reduced acceptance or cancellations would reduce revenues and may result in losses. UNCERTAINTY OF INSURANCE REIMBURSEMENT Our ability to successfully commercialize existing genetic susceptibility tests and others that we may develop depends in part on obtaining adequate reimbursement for such testing services and related treatments from government and private health care insurers (including health maintenance organizations) and other third-party payors. Physicians' and dentists' decisions to recommend genetic susceptibility tests, as well as patients' elections to pursue testing, are likely to be heavily influenced by the scope and extent of reimbursement for such tests by third-party payors. Government and private third-party payors are increasingly attempting to contain health care costs by limiting both the extent of coverage and the reimbursement rate for new testing and treatment products and services. In particular, services which are determined to be investigational in nature or which are not considered "reasonable and necessary" for diagnosis or treatment may be denied reimbursement coverage. To date, few insurers or third-party payors have agreed to reimburse patients for genetic susceptibility tests. As a result, we initially expect to bill patients directly for the genetic susceptibility tests. It remains uncertain whether insurers or third-party payors will elect to provide full reimbursement coverage for the genetic susceptibility tests in the near future. If adequate reimbursement coverage is not available from insurers or third-party payors, it is uncertain whether individuals will elect to directly pay for the test. If both insurers or third-party payors and individuals are unwilling to pay for the test, then the number of tests performed will be significantly decreased. Such a scenario would result in reduced revenues and possible losses. RELIANCE ON COLLABORATIVE PARTNERS In 1994 we entered into a strategic alliance with the Section of Molecular Medicine at Sheffield University, a world leader in the genetic aspects of common diseases with an inflammatory component. In 1996 we formalized our relationship by entering into an exclusive worldwide agreement (the "Master Agreement"). Under the terms of the Master Agreement, we will undertake the development and commercialization of any discoveries resulting from the research of Section of Molecular Medicine at Sheffield University. In exchange, Sheffield University will receive a share of the resultant net profits, with the percentage of net profits for us and Sheffield University agreed upon separately under project agreements related to each test (each a "Project Agreement"). Our share of the net profits under such Project Agreements ranges from 50% to 67%. The Master Agreement may be terminated with or without cause by either party upon six-months notice. Although termination does not affect any existing Project Agreements, any termination would limit or eliminate our access to future Sheffield University genetic discoveries that fall outside of the scope of our existing Project Agreements. 10 15 The Project Agreements (excluding the agreement covering the periodontal test which has no fixed termination date) each have a ten-year term, commencing in September 1996, which is automatically renewed for one-year periods unless terminated by either party upon a six month's prior notice. The Project Agreements may be terminated: (i) by mutual agreement, (ii) by either party 30 days after an uncured breach or default by the other party; (iii) by either party upon certain events of bankruptcy; and (iv) by our company if Professor Gordon Duff ceases to be an employee of, or head of the Section of Molecular Medicine at Sheffield University. In the case of mutual agreement to terminate, or in the case of our terminating a Project Agreement prior to the end of the ten-year term, net profits would be reallocated by mutual agreement in light of the continued responsibilities between the parties. However, Sheffield University's share of the net profits would not be allowed to fall below ten percent (10%) in such an instance. If the Master Agreement or any of the Project Agreements were terminated, we would need to enter into additional collaborative arrangements in order to continue to build a future pipeline of products. In the future we may, in order to facilitate the sale of our testing services and/or products, enter into collaborative selling arrangements with one or more other persons. It is uncertain whether we will be able to negotiate acceptable collaborative arrangements in the future or that such collaborative arrangements will be successful. If we are unable to identify collaborative partners to sell certain of our services and/or products, we may be forced to develop an internal sales force to market and sell our services and/or products in markets where we are not intending on developing a direct selling presence. Such a process would take more time and potentially cost more. As a result, our revenues and earnings would be reduced. If we do enter into collaborative selling arrangements, our success will depend upon the efforts of others and may be beyond our control. Failure of any collaborative selling arrangement could result in reduced revenues and possible losses. UNCERTAIN ABILITY TO PROTECT PROPRIETARY TECHNOLOGY Our success will partly depend on our ability to obtain patent protection, both in the United States and in other countries, for our products and services. In addition, our success will also depend upon our ability to preserve our trade secrets and to operate without infringing the proprietary rights of third parties. We have ten (10) patent applications pending, including applications covering each of our four genetic susceptibility tests. In June 1997, a Notice of Allowance was issued by the United States Patent and Trademark Office with respect to the patent applications for both our periodontal and osteoporosis susceptibility tests. A Notice of Allowance is granted by the Patent and Trademark Office, if, on examination of the application, the patent application is found to be allowable. Thereafter a fee for issuing the patent is due within three months from the date of the Notice of Allowance. When the issue fee is paid, the patent issues as soon as possible after the date of payment, dependent upon the backlog of patents at the Patent and Trademark Office. The patent is then delivered or mailed on the day of its grant, or as soon thereafter as possible. We paid the issue fee related to the application for the periodontal susceptibility test on July 18, 1997 and for the osteoporosis susceptibility test on September 8, 1997. While the issuance of these patents is likely, the exact date of issuance is not known. It is rather unlikely, but possible, that the United States Patent Trademark Commissioner could disallow the granting of our patents at any time prior to the date of issuance. There can be no assurance that our patent applications will ever be issued as patents or that the claims of any issued patents will afford meaningful protection for our technology or products. Further, others may develop similar products which test for susceptibility related to some diseases yet avoid infringing upon, or conflicting with, our anticipated patents. In addition, there can be no assurance that any patents issued to us will not be challenged, and subsequently narrowed, invalidated or circumvented. Our testing services and/or products may also conflict with patents which have been or may be granted to others. As the biotechnology industry expands and more patents are filed and issued, the risk increases that our products may give rise to a declaration of interference by the Patent and Trademark Office, or to claims of patent infringement by other companies, institutions or individuals. Such entities or persons could bring legal proceedings against us seeking damages or seeking to enjoin us from testing, manufacturing or marketing our products. Patent litigation is costly, and even if we prevail, the cost of such litigation could have an adverse effect on us. If the other parties in any such actions are successful, in addition to any liability for damages, we could be required to cease the infringing activity or obtain a license. It is uncertain whether 11 16 any license required would be available to us on acceptable terms, if at all. Failure by us to obtain a license to any technology that we may require to commercialize our products could have a material adverse effect on our business, financial condition, results of operations and cash flows. In addition, there is considerable pressure on academic institutions and other entities to publish discoveries in the genetic field. Such a publication by an academic institution or other entity, prior to our filing of a patent application on such discovery, may compromise our ability to obtain U.S. and foreign patent protection for the discovery. We also rely upon unpatented proprietary technologies. We rely on confidentiality agreements with our employees, consultants and collaborative partners to protect such proprietary technology. There can be no assurance that we can adequately protect our rights in such unpatented proprietary technologies, that others will not independently develop substantially equivalent proprietary information or techniques, or otherwise gain access to our proprietary technologies or disclose such technologies. See "Intellectual Property" at page 40. The United States Patent and Trademark Office issued new Utility Guidelines in July 1995 that address the requirements for demonstrating utility, particularly in inventions relating to human therapeutics. While the guidelines do not require clinical efficacy data for issuance of patents for human therapeutics, there can be no assurance that the Patent and Trademark Office's interpretations of such guidelines, and any chances to such interpretations will not delay or adversely affect our or our collaborators' ability to obtain patent protection. The biotechnology patent situation outside the United States is even more uncertain and is currently undergoing review and revision in many countries. TECHNOLOGICAL CHANGES RESULTING IN PRODUCT OBSOLESCENCE Market acceptance and sales of our testing services could also be adversely affected by technological change. It is uncertain whether our competitors will succeed in developing genetic susceptibility tests that circumvent or are more effective than our technologies or services. Further, it is uncertain whether such developments would render our or our collaborators' technology or services less competitive or obsolete. Further, our testing services could be rendered obsolete as a result of future innovations in the treatment of gum disease, osteoporosis, coronary artery disease or diabetes retinopathy, which could have a significant negative impact on our company's ability to market our services effectively. See "Uncertain Ability to Protect Proprietary Technology" at page 11, "Competition" at page 41 and "Intellectual Property" at page 40. LIMITED MARKETING OR SALES EXPERIENCE Our business strategy is to provide genetic susceptibility testing services aimed at common diseases that are treatable and preventable. The commercial introduction of the periodontal susceptibility test at the beginning of October 1997 represents our first such effort. In preparation for the launch of the periodontal susceptibility test, we have devoted substantial human and financial resources to the establishment and staffing of a customer service support facility and the building of a sales and marketing infrastructure. However, we have limited experience in developing and commercially marketing susceptibility testing services. It is uncertain whether our customer service support facilities and sales and marketing program will achieve efficient, effective or successful operations. Failure to successfully market such tests could reduce our revenues and may result in losses. See "Competition" at page 41 and "Government Regulation" at pages 12 and 44. GOVERNMENT REGULATION The sampling of blood, saliva or cheek scrapings from patients and subsequent analysis in a clinical laboratory does not, at the present time, require FDA or regulatory authority approval outside the U.S. for either the sampling procedure or the analysis itself. The samples are taken in the healthcare provider's office, using standard materials previously approved as medical devices, such as sterile lancets and swabs. The testing procedure itself is performed in one or more registered, certified clinical laboratories under the auspices of the Clinical Laboratory Improvement Amendments of 1988, administered by the Health Care Financing Administration. In general, the federal regulations governing approval of the laboratory facilities 12 17 and applicable state and local regulations governing the operation of clinical laboratories apply to the laboratory but not to our company. However, changes in the scope of the services offered by our company (e.g., establishing an in-house clinical laboratory) would subject our company to applicable regulations. Additionally, changes in existing regulations could require advance regulatory approval of genetic susceptibility tests which may result in a substantial curtailment or even prohibition of our activities without regulatory approval. If our tests ever require regulatory approval, the costs of introduction will increase and marketing and sales may be significantly delayed. Further, eighteen months ago the FDA proposed to regulate as medical devices the "active ingredients" (known as "analyte specific reagents" or "ASRs") of certain tests developed by, or in conjunction with, clinical laboratories. Currently, a final rule has not been issued. The FDA has specifically stated that it is not proposing a comprehensive regulatory scheme over the final tests, but rather the active ingredients (ASRs) provided to the laboratories that perform them. According to the FDA, any contemplated additional controls (e.g. submission for Pre-Market Approval applications) over the tests themselves would likely involve those tests which identify genes associated with cancer or diseases associated with dementia. If the FDA requires Pre-Market Approval of our genetic susceptibility test, our company may be required to conduct pre-clinical studies, obtain an investigational device exemption to conduct clinical tests, file a Pre-Market Approval application, and obtain FDA approval. There can be no assurance such approval would be received on a timely basis, if at all. The failure to receive such approval could require us to develop alternative testing methods or utilize approved ASRs, which could result in the delay or stop the use of such tests. Such a delay or termination could result in reduced revenues or losses. Although our primary business is to develop genetic susceptibility testing services, we may also develop or assist others to develop, drugs or other treatments for the diseases related to our tests. The FDA and comparable agencies in state and local jurisdictions and in foreign countries impose substantial requirements upon the manufacturing and marketing of drug products such as those potentially to be developed by our company or any partner. The process of obtaining FDA and other required regulatory approvals is lengthy and expensive. The time required for FDA approvals is uncertain and typically takes a number of years, depending on the type, complexity and novelty of the product. We may encounter significant delays or excessive costs in our efforts to secure necessary approvals or licenses. Because certain of the products likely to result from our research and development programs involve the application of new technologies and will be based on new approaches, such products may be subject to substantial additional review by various governmental regulatory authorities and as a result, regulatory approvals may be obtained more slowly than for products using more conventional technologies. There can be no assurance that FDA approvals will be obtained in a timely manner, if at all. Any delay in obtaining, or the failure to obtain, such approvals would adversely affect our ability to generate product or product sales. Even if FDA approvals are obtained, the marketing and manufacturing of drug products are subject to continuing FDA and other regulatory review, and later discovery of previously unknown problems with a product, manufacturer or facility may result in restrictions on the product or manufacturer, including withdrawal of the product from the market. Additional governmental regulations may be promulgated which could delay regulatory approval of our potential products. We cannot predict the impact of adverse governmental regulation which might arise from future legislative or administrative action. We intend to generate product revenues from sales outside of the United States. Distribution of our testing services or products outside the United States may be subject to extensive government regulation. These regulations, including the requirements for approvals or clearance to market, the time required for regulatory review and the sanctions imposed for violations, vary by country. It is uncertain whether we will obtain regulatory approvals in such countries or that we will be required to incur significant costs in obtaining or maintaining our foreign regulatory approvals. Failure to obtain necessary regulatory approvals or any other failure to comply with regulatory requirements could result in reduced revenues and earnings. See "Products and Services" at page 27 and "Government Regulation" at page 44. 13 18 PRODUCT LIABILITY EXPOSURE Our business exposes us to potential liability risks inherent in the testing and marketing of medical and dental related services or products. It is uncertain whether liability claims will be asserted against us. We have product and professional liability insurance which we believe provides coverage for the testing and commercial introduction of our genetic susceptibility tests. It is uncertain whether we will be able to maintain such insurance on acceptable terms. Any insurance obtained may not provide adequate coverage against potential liabilities. A liability claim, even one without merit, could result in significant legal defense costs thereby increasing our expenses, lowering our earnings and even resulting in losses. DEPENDENCE ON CLINICAL LABORATORY The clinical laboratory operated by Baylor University currently performs all of our genetics tests. Our company is not licensed as a clinical laboratory and cannot perform genetic tests. Although we believe other clinical laboratories are readily available if we cannot use Baylor University, the loss of Baylor University may result in delays in the performance of genetic tests or may increase the costs of performing genetic tests. ETHICAL, LEGAL AND SOCIAL IMPLICATIONS OF GENETIC SUSCEPTIBILITY TESTING The prospect of broadly available genetic susceptibility testing has raised issues which are currently being widely discussed by the medical and scientific communities, as well as other interested groups and organizations, regarding the appropriate utilization and the confidentiality of information provided by such testing. The recent movement towards discovery and commercialization of susceptibility tests for assessing a person's likelihood of developing a chronic disease has also focused public and legislative attention on the need to protect the privacy of genetic assessment medical information. With the progression towards more comprehensive record keeping by health insurers and managed care firms, this need has led to a number of legal initiatives. The recently enacted federal health insurance reform law (Kassebaum-Kennedy of 1996) recognizes the comparability of information obtained by genetic means to other types of personal medical information. The law prohibits insurance companies from refusing health insurance coverage to individuals on the basis of their medical history, including "genetic information." This legislation also prohibits employees from discrimination in hiring practices on the same basis. This legislation indicates a trend to protect the privacy of patients while allowing them to be screened for conditions which, can be prevented, reduced in severity or cured. In the most extreme scenario, governmental authorities could, for social or other purposes, limit the use of genetic testing or prohibit testing for genetic susceptibility to certain conditions. For these reasons, we could experience a delay or reduction in test acceptance. Such a delay or reduction could reduce our revenues or result in losses. We are taking a proactive stance in the ethical arena. We have engaged Dr. Philip Reilly, who is both an M.D. (certified specialist in clinical genetics) and an attorney, to advise us in the area of genetic testing and its ethical, legal and clinical utility ramifications. Additionally, we are currently advising doctors who administer our genetic susceptibility tests to take special efforts to maintain the confidentiality of the test results. Our intent is to avoid information about test results being disclosed to insurers until issues regarding insurability have been fully analyzed and acted upon by the appropriate legislative bodies. On August 1, 1997, we formed a joint venture named Digisphere, LLC whose purpose, in part, will be to provide marketing information to those patients who test positive on one of our tests and who subsequently send in a business reply card seeking more information. See "Product Development" at page 36. The confidentiality of patient information is subject to regulation by state law. A variety of statutes and regulations exist safeguarding privacy and regulating the disclosure and use of medical information. State constitutions may provide privacy rights and states may provide private causes of action for violations of an individual's "expectation of privacy." Tort liability may result from unauthorized access and breaches of patient confidence. We intend to comply with state law and regulations governing medical information privacy. 14 19 DEPENDENCE ON KEY PERSONNEL AND CONSULTANTS Because of the specialized scientific nature of our business, we are highly dependent upon our ability to attract and retain qualified management, scientific and technical personnel. Our company will also be dependent upon the ability to hire qualified marketing and sales personnel. Competition for scientific, marketing and sales personnel is intense. Loss of the services of Mr. White, Dr. Kornman or Dr. Newman could adversely affect our research and development programs and susceptibility testing service business and could impede the achievement of our business objectives. We do not maintain key man life insurance on any of our personnel. CONTROL BY EXISTING SHAREHOLDERS Following completion of this offering, our directors, executive officers and certain of their affiliates, will beneficially own approximately 56.14% of our outstanding Common Stock. Accordingly, these shareholders, individually and as a group, may be able to influence the outcome of shareholder votes, including votes concerning the election of directors, the adoption or amendment of provisions in our Amended and Restated Articles of Incorporation or Amended and Restated By-Laws and the approval of certain mergers and other significant corporate transactions, including a sale of substantially all of our assets. Such control by existing shareholders could have the effect of delaying, deferring or preventing a change in control. See "Principal Shareholders" at page 53. DILUTION; ABSENCE OF DIVIDENDS Purchasers in the offering will experience immediate and substantial dilution in the net tangible book value of the Common Stock from the public offering price. Additional dilution is likely to occur upon the exercise of any options or warrants that we have granted. See "Dilution" at page 20. We have never paid dividends and do not intend to pay any dividends in the foreseeable future. See "Description of Securities" at page 54. SHARES ELIGIBLE FOR FUTURE SALE Sales of substantial amounts of Common Stock in the public market following this offering could lower the market price of the Common Stock. Of the 6,238,007 shares of Common Stock to be outstanding after this offering (assuming no exercise of outstanding options, warrants or the overallotment option), 2,500,000 shares will be freely tradeable without restriction. Upon expiration of the lock-up agreements entered into by the officers and directors of our company, an additional 3,258,053 shares will become eligible for sale one year from the closing of this offering, subject to the provisions of Rule 144. See "Shares Eligible for Future Sale" at page 55. Of the remaining 479,954 shares of Common Stock, 5,000 shares will be eligible for resale under Rule 144 following this offering. The remaining 474,954 shares will have been held for less than one year and will become eligible for sale at various dates as the one-year holding period under Rule 144 is satisfied. In addition, we intend to file a registration statement on Form S-8 with respect to the shares of Common Stock issuable upon exercise of options under the 1996 Equity Incentive Plan (the "Plan"). The Plan authorizes the issuance of options relating to up to 1,000,000 shares of Common Stock. Currently, there are 800,579 options that have been issued under the Plan which generally vest over three years. See "1996 Equity Incentive Plan" at page 50. Upon filing of such registration statement, the holders of such options may, subject to vesting requirements, exercise and sell their shares immediately without restriction, except affiliates who are subject to certain volume limitations and manner of sale requirements of Rule 144. See "Shares Eligible for Future Sale" at page 55. Holders of 356,545 warrants to purchase shares are entitled to certain registration rights with respect to such shares. Upon registration, such shares may be sold in the market without limitation. See "Registration Rights" at page 55. Sales of such shares may decrease the market price for our Common Stock. See "Underwriting" at page 57. 15 20 IMPACT UPON FUTURE NET INCOME OR LOSS OF THE COMPANY BY CURRENT ACCOUNTING FOR DEBT ISSUANCE COSTS From August 1, 1997 through October 6, 1997, the Company issued Bridge Loans to investors in the aggregate amount of $1,780,000. In connection with the issuance of these Bridge Loans, the Company also issued 356,545 warrants to purchase the Company's Common Stock for $5.50 per share. The Company has determined that an additional expense of $356,545 needs to be recognized in connection with the issuance of these warrants. The $356,545 of additional interest expense is currently being amortized over fourteen months, the terms of the Bridge Loans. However, upon completion of the initial public offering, the $1,780,000 Bridge Loans will be repaid and the unamortized amount will be charged to earnings and will significantly impact the net income or loss of the Company in the quarter in which the initial public offering is completed. ARBITRARY OFFERING PRICE OF THE COMMON STOCK; POSSIBLE VOLATILITY OF COMMON STOCK PRICE The initial public offering price of the Common Stock has been determined by negotiations between our company and the Underwriter. The initial public offering price bears no relationship to earnings, asset values, book value or any other recognized criteria of value. See "Underwriting" at page 57. The market prices for securities of emerging health care companies have been highly volatile. Announcements may have a significant impact on the market price of the Common Stock. Such announcements may include biological or medical discoveries, technological innovations or new commercial services by us or our competitors, developments concerning proprietary rights, including patents and litigation matters, regulatory developments in both the United States and foreign countries, public concern as to the safety of new technologies, general market conditions as well as quarterly fluctuations in our revenues and financial results and other factors. The stock market has from time to time experienced extreme price and volume fluctuations which have particularly affected the market prices for emerging and biotechnology companies and which have often been unrelated to the operating performance of such companies. These broad market fluctuations may adversely affect the market price of our Common Stock. In the past, following periods of volatility in the market price of a company's stock, securities class action litigation has occurred against the issuing company. Such litigation could result in substantial costs and a diversion of management's attention and resources, which could have a material adverse effect on our revenues and earnings. Any adverse determination in such litigation could also subject us to significant liabilities. EFFECT OF PREFERRED STOCK AND DIRECTOR REMOVAL PROVISIONS Our Board of Directors is authorized to issue up to 5,000,000 shares of Preferred Stock and to determine the price, rights, preferences and privileges of those shares without any further vote or action by our shareholders. The rights of the holders of Common Stock will be subject to, and may be adversely affected by, the rights of the holders of any shares of Preferred Stock that may be issued in the future. While we have no present intention to issue shares of Preferred Stock, such issuance, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. In addition, such Preferred Stock may have other rights, including economic rights, senior to the Common Stock. As a result, the issuance of Preferred Stock could decrease the market value of the Common Stock. Our Amended and Restated Articles of Incorporation provide that members of the Board of Directors may be removed only for cause upon the affirmative vote of holders of at least a majority of the shares of our outstanding capital stock entitled to vote. Certain other provisions of our Amended and Restated Articles of Incorporation could also have the effect of delaying or preventing changes of control or in management. Such a delay or preventive effect could adversely affect the price of our Common Stock. 16 21 THE COMPANY Drs. Kenneth S. Kornman and Michael G. Newman founded the Company in 1986 to develop and introduce new methods, tools and technology for dental practitioners that would better predict treatment outcomes in patients. We derived our initial revenue primarily from contract research to pharmaceutical companies and others. In early 1992, we expanded our contract research program to include both medical and dental research. In 1994, we implemented an internal product discovery program. We then used profits generated from our contract research programs to fund our own product research and development. We originally operated under two separate Texas corporations, known as Oral Science Systems and Oral Science Technologies. In August 1995, Oral Science Systems was merged into Oral Science Technologies which changed its corporate name to Medical Science Systems, Inc. ("MSS"). MSS continued to function as a Subchapter "S" corporation until September 30, 1996, when it became a "C" corporation. MSS' principal executive office is located at 4400 MacArthur Boulevard, Suite 980, Newport Beach, California 92660, and may be reached by telephone at (714) 440-9730. MSS maintains a website located at http://www.medscience.com. 17 22 USE OF PROCEEDS If all 2,500,000 shares of Common Stock offered by this Prospectus are sold, we will receive net proceeds of approximately $19,670,000 (assuming the public offering price is $9.00, and assuming the over-allotment option is not exercised). If the Underwriters exercise the over-allotment option, our company would receive an additional $3,003,750. Net proceeds are determined after deduction of all commissions, discounts and expenses paid to the Underwriters (estimated to be $2,475,000) and after all expenses of the offering (estimated to be $355,000). We intend, in the following order of priority, to use the net proceeds from this offering to:
PERCENTAGE AMOUNT NET PROCEEDS ------------ ------------- Marketing, sales, customer service and commercialization expenses.................................................. $ 9,200,000 46.77% -- Expenses for sales and marketing in conjunction with the market introduction of each susceptibility test. Such expenses include market research studies, marketing collateral materials, trade show participation, public relations, advertising expenses and sales and marketing personnel. Research and development activities......................... 3,450,000 17.54% -- Continuation of clinical trials for genetic susceptibility tests under development, to provide clinical utility data, amortization of capitalized patent expense beginning when each patent issued and salaries of research and development personnel. Capital Investments......................................... 300,000 1.53% -- Expenditures for computer equipment, furniture and fixtures primarily related to increases in personnel. Repayment of Bridge Loans(1)................................ 1,780,000 9.05% Working capital and general corporate purposes.............. 4,940,000 25.11% ------------ ------ TOTAL............................................. $ 19,670,000 100.00% ============ ======
- --------------- (1) The proceeds of the Bridge Loans were applied and utilized in the following manner: $7,000 (cost of bridge financing, including legal expenses); $125,000 (initial public offering expenses); $600,000 (operating expenses, August and September 1997); $300,000 (operating expenses, October 1997); and $748,000 (remaining on balance as of November 12, 1997). The amount and timing of working capital expenditures may vary significantly depending upon numerous factors, including the progress of our research, discovery and development programs, the timing and costs involved in obtaining regulatory approvals, the costs involved in filing, prosecuting and enforcing patent claims, competing technological and market developments, payments received under collaborative agreements, changes in collaborative research relationships, the costs associated with potential commercialization of our products, including the development of marketing and sales capabilities, the cost and availability of third-party financing for capital expenditures and administrative and legal expenses. We believe that our available cash and existing sources of funding, together with the proceeds of this offering and interest earned thereon, will be adequate to maintain our current and planned operations for at least the next 18 months. Until used, we intend to invest the net proceeds of this offering in interest-bearing, investment-grade securities. While the net proceeds are so invested, the interest earned by us on such proceeds will be limited by available market rates. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" at page 22. We intend to invest and use such proceeds so as not to be considered an "investment company" under the Investment Company Act of 1940, as amended. 18 23 DIVIDEND POLICY Holders of shares of Common Stock are entitled to dividends when, as and if declared by the Board of Directors, out of funds legally available therefor. We have not yet paid any dividends and do not expect to do so in the foreseeable future. We intend to use all retained earnings for working capital and to finance the anticipated growth and expansion of our business. CAPITALIZATION The following table sets forth our capitalization (i) as of September 30, 1997; (ii) on a pro forma basis after giving effect to the issuance of $230,000 in Bridge Loans subsequent to September 30, 1997 as if the issuance of Bridge Loans occurred on September 30, 1997; and (iii) on a pro forma basis as adjusted to give effect to the receipt of net proceeds from the sale of 2,500,000 shares of Common Stock offered hereby after deducting underwriting discounts and commissions and estimated offering expenses:
SEPTEMBER 30, 1997 ----------------------------------- PRO FORMA ACTUAL PRO FORMA AS ADJUSTED ------- --------- ----------- (IN THOUSANDS) Long term debt and obligations under capital leases, less current portion(1), and Bridge Loans....................... $ 2,169 $ 2,399 $ 619 ------- ------- ------- Shareholders' equity: Preferred Stock, 5,000,000 shares authorized; none issued and outstanding actual, pro forma or pro forma as adjusted................................................ -0- -0- -0- Common Stock, no par value, 10,000,000 shares authorized; 3,738,007 shares issued and outstanding; 3,738,007 shares issued and outstanding pro forma; 6,238,007 shares issued and outstanding pro forma as adjusted(2)............................................. 2,450 2,450 22,451 Accumulated deficit........................................ (3,914) (3,914) (4,245) ------- ------- ------- Total shareholders' equity.............................. (1,464) (1,464) 18,206 ------- ------- ------- Total capitalization.................................. $ 705 $ 935 $18,825 ======= ======= =======
- --------------- (1) As of September 30, 1997, the current portion of obligations under long term debt and capital leases was approximately $187,959. (2) Excludes (i) 356,545 shares of Common Stock subject to Bridge Warrants, exercisable at $5.50 per share; (ii) 800,579 shares of Common Stock subject to outstanding options under our 1996 Equity Incentive Plan, exercisable at $3.70 or $5.00 per share; (iii) 199,421 shares of Common Stock reserved for issuance pursuant to our 1996 Equity Incentive Plan; (iv) the exercise of the Underwriters' over-allotment option; and (v) 250,000 shares of Common Stock subject to Underwriters' Warrants, exercisable at 165% of the initial public offering price of the Common Stock. See "Description of Securities" at page 54. 19 24 DILUTION As of September 30, 1997, there were 3,738,007 shares of our Common Stock outstanding, having a negative net tangible book value per share of approximately $(0.46). Net tangible book value per share represents the amount of our total tangible assets less our total liabilities, divided by the number of shares of our Common Stock outstanding. After giving effect to the sale of the 2,500,000 shares of Common Stock under this offering at a price of $9.00 per share and the application of the net proceeds therefrom (but assuming none of the options or warrants are exercised), there would be a total of 6,238,007 shares of our Common Stock outstanding with a net tangible book value of approximately $2.88 per share. This would represent an immediate increase in net tangible book value of $3.34 per share to existing shareholders and an immediate dilution of $6.12 per share to new investors. Dilution is determined by subtracting net tangible book value per share after the offering from the amount paid by new investors per share of Common Stock. The following table illustrates the per share dilution: Initial public offering price per share............................. $9.00 Net tangible book value per share as of September 30, 1997........ $(0.46) Increase attributable to new investors............................ 3.34 Adjusted net tangible book value per share after this offering...... 2.88 ----- Dilution per share to new investors................................. $6.12 =====
The following table summarizes, on a pro forma basis, as of September 30, 1997, the difference between the existing shareholders and the new investors with respect to the number of shares of Common Stock purchased from our company, the total consideration paid and the average price per share:
SHARES PURCHASED TOTAL CONSIDERATION --------------------- ----------------------- AVERAGE PRICE NUMBER PERCENT AMOUNT PERCENT PER SHARE --------- ------- ----------- ------- ------------- Existing shareholders....... 3,738,007 59.92% $ 2,190,600 8.87% $0.59 New investors............... 2,500,000 40.08 22,500,000 91.13 $9.00 --------- ------ ----------- ------ Total....................... 6,238,007 100.00% $24,690,600 100.00% ========= ====== =========== ======
The foregoing table assumes (i) no exercise of the Underwriters' over-allotment option; (ii) no exercise of the 250,000 Underwriters' Warrants; (iii) no exercise of the 356,545 Bridge Warrants, exercisable at $5.50 per share; and (iv) no exercise of stock options outstanding after September 30, 1997. As of September 30, 1997, there were options outstanding to purchase a total of 800,579 shares of Common Stock under our 1996 Equity Incentive Plan, at a weighted average exercise price of $4.37 per share. To the extent that any of the shares of Common Stock are issued on exercise of any of these warrants, options or additional options granted after September 30, 1997, there will be further dilution to new investors. See "Description of Securities" at page 54. 20 25 SELECTED FINANCIAL DATA We are providing the following selected financial data to aid you in your analysis of this potential investment. This information was derived from: (1) our 1995 and 1996 historical financial statements; and (2) from our internally prepared unaudited financial statements for the nine-month periods ended September 30, 1996 and 1997. Our financial statements as of December 31, 1995 and 1996 with the notes thereto and the related reports of Singer Lewak Greenbaum & Goldstein LLP, independent public accountants, together with our internally prepared unaudited financial statements for the nine-month periods ended September 30, 1996 and 1997 are included elsewhere in this Prospectus. Our unaudited financial statements, in the opinion of management, include all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of our financial position and results of operations for the unaudited interim periods. The selected financial data set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" at page 22 and our financial statements and related notes thereto included elsewhere in this Prospectus.
NINE MONTHS ENDED NINE MONTHS ENDED YEAR ENDED YEAR ENDED SEPTEMBER 30, SEPTEMBER 30, DECEMBER 31, 1996 DECEMBER 31, 1995 1997 1996 ----------------- ----------------- ----------------- ----------------- (IN THOUSANDS, EXCEPT PER SHARE DATA) STATEMENTS OF OPERATIONS DATA: Revenues..................... $ 1,919 $ 1,873 $ 152 $ 1,905 Cost of sales................ 548 368 149 538 --------- --------- --------- --------- Gross profit (loss).......... 1,371 1,505 3 1,367 Expenses: Research and development... 958 582 785 682 Selling, general and administrative.......... 1,163 756 2,164 776 --------- --------- --------- --------- Total expenses.......... 2,121 1,338 2,949 1,458 --------- --------- --------- --------- Operating income (loss)...... (750) 167 (2,946) (91) Other income (expense), net........................ (33) (14) (96) (6) Provision for income taxes... (6) (3) -0- -0- Net income (loss)............ $ (789) $ 150 $ (3,042) $ (97) ========= ========= ========= ========= Earnings (loss) per share.... $ (.18) $ .03 $ (.71) $ .(02) ========= ========= ========= ========= Shares used in computing earnings (loss) per share(1)................... 4,288,436 4,288,436 4,288,436 4,288,436 ========= ========= ========= =========
- --------------- (1) Includes all shares issuable upon the exercise of options and warrants granted within one year prior to the date of this Prospectus.
SEPTEMBER 30, 1997 ------------------------------------------------- (UNAUDITED) (IN THOUSANDS) PRO FORMA ACTUAL PRO FORMA(1) AS ADJUSTED(2) ------- -------------- -------------- BALANCE SHEET DATA: Cash and cash equivalents......................... $ 870 $ 1,100 $ 18,990 Working capital................................... 168 398 18,288 Total assets...................................... 1,437 1,667 19,557 Total shareholders' equity........................ (1,464) (1,464) 18,206
- --------------- (1) On a pro forma basis after giving effect to the issuance of $230,000 in Bridge Loans subsequent to September 30, 1997 as if the issuance of Bridge Loans occurred on September 30, 1997. (2) On a pro forma as adjusted basis to give effect to the receipt of net proceeds from the sale of 2,500,000 shares of Common Stock offered hereby after deducting underwriting discounts and commissions and estimated offering expenses. 21 26 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with the Financial Statements and related Notes contained elsewhere in this Prospectus. This Prospectus contains forward-looking statements which involve risks and uncertainties. Our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in "Risk Factors" at page 9. OVERVIEW Since inception, we have devoted substantially all of our resources to maintaining our research and development programs and supporting contract research agreements. To date, we have received limited revenues from the sale of our periodontal susceptibility test. Revenues received by us have historically been payments pursuant to contract research agreements. For the fiscal year ended December 31, 1996, we had a net loss of $789,000 and as of December 31, 1996 had a shareholder deficit of $700,000. We had two research contracts with Alpharma, Inc. ("Alpharma") for the clinical investigation of Alpharma's proprietary periodontitis antibiotic product. These contracts and the payments associated therewith ended in June 1996. We intend to enter into additional contract research agreements to assist in the funding of our own internal research projects. There can be no assurance that we will be able to enter into additional contract research agreements on terms acceptable to us. We could incur losses for at least the next several years, primarily due to expansion of our research and development programs, increasing staffing costs and expansion of our facilities. Additionally, we expect to incur substantial sales, marketing and other expenses in connection with launching our genetic susceptibility testing business. We expect that losses will fluctuate from quarter to quarter and that such fluctuations may be substantial. We devoted significant resources during the last fiscal year to the beta testing and validation of our genetic susceptibility test related to periodontitis, as well as building our sales and marketing force in preparation for the commercial launch of the periodontal susceptibility test. Additional outlays have been expended on the hiring of additional customer service personnel and the associated increase in use of test materials and commercial laboratory charges. We also incurred increased development expenses during the year related to work on developing our genetic susceptibility tests for osteoporosis, coronary artery disease and diabetic retinopathy. We expect research and development expenses to continue to increase as personnel and research and development facilities are expanded. Selling, general and administrative expenses for the year ended December 31, 1996 increased $407,000 from the year ended December 31, 1995. The increase was attributable to sales and marketing expenses related to the upcoming launch of our periodontal susceptibility test and salaries and benefits paid to existing and newly hired sales and marketing employees. We recently commercially launched our periodontal susceptibility test on October 3, 1997. Additionally, we expect that our general and administrative expenses will continue to increase in support of our research and development efforts and the anticipated growth of our genetic susceptibility testing business. RESULTS OF OPERATIONS NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996. Revenues for the nine months ended September 30, 1997 decreased by $1,753,000, from $1,905,000 for the nine months ended September 30, 1996 to $152,000 for the same period in 1997, due to the decrease in contract research agreements. In the summer of 1996, we changed our focus from providing pharmaceutical companies clinical trial and research services pursuant to contract research agreements to concentrating our resources on developing genetic susceptibility tests. This change in focus resulted in a significant decrease in revenue for the nine months ended September 30, 1997 compared to the same period for 1996. Research and development expenses of $785,000 for the nine months ended September 30, 1997 were comparable to the 22 27 $682,000 for the same period in 1996. The research and development expenses are attributed to development expenses related to work on developing our genetic susceptibility tests for periodontitis, osteoporosis, coronary artery disease and diabetic retinopathy. The increase of $103,000 in research and development is due to our focus on developing genetic susceptibility tests. Selling, general and administrative expenses increased by $1,388,000 from $776,000 for the nine months ended September 1996 to $2,164,000 for the same period in 1997. The increase in 1997 was primarily due to the hiring of additional sales and marketing personnel and costs related to the pre-commercial launch of our periodontal susceptibility test. Interest income for the nine months ended September 30, 1997 decreased by $6,000 primarily due to decreased funds available for investment. Interest expense for the nine months ended September 30, 1997, amounted to $99,000, an increase of $85,000 over the same period in 1996. The increase was due primarily to an increased working capital line of credit, a long term loan with Bank of America, the Bridge Loans and the additional interest expense resulting from the issuance of the Bridge Loan Warrants. The net loss for the nine months ended September 30, 1996 was $97,000 compared to $3,042,000 for the nine months ended September 30, 1997. The difference is a result of the increased research and development expenses, increased selling, general and administrative expenses and the decrease in research contract revenues. YEARS ENDED DECEMBER 31, 1996 AND 1995. Revenues for the year ended December 31, 1996 increased by $46,000. Research and development expenses increased to $958,000 for the year ended December 31, 1996 from $582,000 for the year ended December 31, 1995. The increase in research and development expenses is attributed to development expenses during the period related to work on developing our genetic susceptibility tests for periodontitis, osteoporosis, coronary artery disease and diabetic retinopathy. Selling, general and administrative expenses increased to $1,163,000 for the year ended December 31, 1996 from $756,000 for the year ended December 31, 1995. The increase in 1996 was primarily due to the hiring of additional personnel and costs related to the pre-commercial launch of our periodontal susceptibility test. Interest income for the year ended December 31, 1996 increased to $9,000 from $0 for the prior year, due to the increased funds available for investment. These funds were raised in our private placement of common stock in starting in November 1996 and through our contract research agreements with various companies. Interest expense for the year ended December 31,1996, amounting to $34,000, was due entirely to a working capital line of credit and a long term loan with Bank of America. The net income for the year ended December 31, 1995 was $150,000 compared to a net loss of $789,000 for the year ended December 31, 1996. The difference is a result of the increase in research and development expense, the increase in selling, general and administrative expenses and the decrease in research contract revenues. LIQUIDITY AND CAPITAL RESOURCES We have financed our operations from inception through contract research revenues and more recently through sales of common stock and borrowings. During 1997 we have received $1,882,000 in net proceeds from private placements of our Common Stock. We raised an additional $1,780,000 through a debt/warrant offering from August 1, 1997 through October 6, 1997. We have also, for working capital purposes, entered into term loans with a bank to effect borrowings originally in the amounts of $500,000 and $250,000. As of September 30, 1997, our borrowings under the term loans were $483,000 and $185,000, respectively. As a result of the private placements of debt and equity securities and the new loan agreements, our cash and cash equivalents has increased from $56,000 at December 31, 1996 to $870,000 at September 30, 1997. During the nine months ended September our Company spent $35,000 on furniture and equipment and $108,000 on patents. 23 28 During the nine months ended September 30, 1997 and 1996, and the fiscal years ended December 31, 1996 and 1995, our cash provided by (used in) operations used in was $(2,469,000), $(23,000), $(442,000) and $112,000, respectively. The cash used for operations was primarily to fund research and development and sales and marketing expenses related to the introduction and support of our genetic susceptibility tests. We expect to use a portion of the net proceeds of this offering for expanding sales and marketing efforts, funding of clinical studies, increasing production or commercialization capacity, customer service and funding research and development, the repayment of the investor Bridge Loans, as well as for working capital and general corporate purposes. A portion of the proceeds may also be used for investments in or acquisitions of complementary businesses, products or technologies. See "Use of Proceeds" at page 18. 24 29 BUSINESS GENERAL DESCRIPTION We provide genetic susceptibility testing services for common diseases that are treatable and preventable. We have focused on four diseases initially: periodontitis (gum disease), osteoporosis (bone disease), coronary artery disease (heart disease) and diabetic retinopathy (blindness associated with diabetes). Our tests identify genetic markers which, if present in a patient, increase the probability that such patient will be affected by the disease or that the disease will progress more rapidly and become more severe. Doctors and dentists will use our genetic susceptibility tests to assess the risk involved for individual patients and to adopt appropriate treatments or therapy, including preventive measures. Our genetic tests will allow early determination of genetic predisposition to these four diseases with the following potential benefits: (1) Patients with genetic predisposition to a disease may adopt health care and lifestyle changes that will delay or prevent onset of the disease or reduce disease severity; (2) Early detection of genetic predisposition will allow doctors and dentists to select the most appropriate (i) preventive strategy where no disease symptoms are present or (ii) course of treatment once the patient develops the disease; and (3) Earlier and better treatment selection will motivate patients and improve outcomes. Our tests assist doctors in the development of better preventive treatment strategies, aid patients in making more informed decisions, and help payers to target healthcare investments where they make the biggest difference. We believe that this will contribute to a better quality of life, while directing healthcare resources to individuals who derive the greatest benefit. Accordingly, our mission is to improve patient care and treatment outcomes by incorporating genetic information regarding disease susceptibility into overall risk assessment and treatment planning. SCIENTIFIC BACKGROUND Genetic Testing. For many years it was well accepted that genetics influenced much of our health and behavior. Scientists frequently noted that certain diseases "ran in families." The clear genetic influence on disease was only known, however, for a few uncommon or rare conditions such as Down's Syndrome or Tay-Sachs Disease. Such conditions involve either a major abnormality in a chromosome or a genetic defect that is strong enough by itself to cause a clinical problem. Both types of genetic abnormalities are so powerful that they are usually evident in childhood. Some diseases, such as Down's Syndrome, are essentially entirely genetic. Others are essentially entirely environmental, such as an infected cut. The purely genetic conditions tend to be rare, or at least uncommon. For example, the defects in the gene associated with breast cancer are involved in only 5% to 10% of all breast cancers. Accordingly, 90% to 95% of all breast cancers are caused by some other factor or factors. Most of the common chronic diseases that cause the greatest debilitation and cost for adults are diseases in which genetics interact with other factors, such as lifestyle or environmental challenges to the body. We refer to such diseases as "multi-factorial" because numerous factors contribute to the disease (Figure 1). For example, while it has been demonstrated that there is a genetic influence on the susceptibility to periodontitis, research has also shown that periodontitis is influenced by factors such as smoking and oral hygiene. 25 30 FIGURE 1 [CHART DEPICTING BIOLOGICAL AND BEHAVORIAL RISK FACTORS CONTRIBUTING TO DISEASE PROGRESSION] Source: Chart developed by Medical Science Systems, Inc. Copyright Medical Science Systems, Inc. In multi-factorial diseases the genetic influence is not due to a "genetic defect" but a normal variation within the population. For example, for a specific gene, 20% to 30% of the population may have a slight variation in the genetic code that alters the function of that gene just enough under certain environmental challenges that a specific disease is accelerated (Figure 1). Since these variations are multiple forms of the same gene, they are called genetic polymorphisms or genetic markers. If the genetic polymorphisms associated with a common disease can be identified, it is possible to predict those at high risk for disease and alter the individual's lifestyle or provide early medication to prevent clinical disease. If the polymorphism can be shown to actually be involved functionally in accelerating the disease, then that information may be used to develop innovative new treatments or preventive agents. For example, it is well established that two proteins, interleukin-1 ("IL-1") and tumor necrosis factor ("TNF") play a central role in many chronic diseases that have inflammatory components. We have discovered specific genetic variations that influence how much IL-1 and TNF are produced in the body. Our findings in periodontal disease provide an example of how this works. Normally, the body produces IL-1 and TNF in responses to a bacterial infection to help activate the inflammatory and immune responses that will fight the infection. This happens without producing any longlasting tissue damage. In a person where a certain genetic variation exists, excessive levels of IL-1 or TNF are produced. This causes an inflammatory response that may lead to tissue damage. Our research revealed that individuals with two specific polymorphisms in the IL-1 genes were predisposed to more severe periodontitis. Our periodontal susceptibility test determines whether an individual has such a genetic predisposition. In general, it may be said that the early detection of a predisposition to genetic diseases presents the best opportunity for medical intervention. Early genetic diagnosis may improve the prognosis for a patient through supervision and early intervention before the clinically detectable disorder occurs. 26 31 PRODUCTS AND SERVICES Genetic Susceptibility Test for Periodontal Disease (Patent Pending). DESCRIPTION OF PERIODONTAL DISEASE TEST. Our first genetic susceptibility test detects a genetic susceptibility to severe gum disease (periodontitis). Periodontitis is a bacterially-induced chronic inflammation that destroys the collagen fibers and bone that surround and support the teeth. Untreated, periodontitis will eventually result in tooth loss. Periodontitis results from a complex interplay of bacterial infection with the patient which can often be modified through behavioral factors. The fact that periodontal disease is both preventable and treatable makes predicting the host response (or one's susceptibility to the development of periodontal disease) "wanted information" for the patient and health care provider. Periodontists have attempted for years to understand why patients with similar plaque levels and oral bacterial profiles often show remarkably different clinical characteristics. It is now possible to integrate genetics into overall risk assessment so clinicians can identify that subset of patients who are highly susceptible to rapid disease progression and severe periodontitis. This discovery allows individual patients to be managed in a more targeted and proactive way. FIGURE 2 [BAR GRAPH DEPICTING DIFFERING SUSCEPTIBILITY TO PERIODONTITIS IN ADULTS] Source: K. Kornman et al., Journal of Clinical Periodontology, January 1997. 27 32 FIGURE 3 [BAR GRAPH DEPICTING DIFFERING BLEEDING RESPONSE ON PROBING IN ADULTS] Source: Unpublished data analysis based on data developed under the study reported by K. Kornman et. al, Journal of Clinical Periodontology, January 1997. Our periodontal susceptibility test is the result of a scientific breakthrough in which an association was discovered between a specific IL-1 genotype and severe periodontal disease (Figure 2). IL-1 is a cytokine or protein that is known to play a role in inflammation and the expression of periodontal disease. Patients with this specific genotype have been found to progress more rapidly towards severe periodontal disease and show increased bleeding on probing (Figure 3). It has also been determined that cells with this genotype produce as much as four times more IL-1 in response to the same bacterial challenge. Since IL-1 in high concentrations is known to be destructive to tissues, this may explain the more rapid progression of periodontal disease experienced by patients with this specific IL-1 genotype when faced with a bacterial challenge. Prevention or therapeutic intervention aimed at reducing the bacterial challenge should decrease the stimulus for IL-1 production and thereby protect the patient against the potentially destructive effects of this genotype. It is estimated that approximately 30% of the population will test positive for this genotype. We have developed our periodontal susceptibility test and continue to be governed by a project agreement between our company and Sheffield University. See "Competitive Advantages" at page 42. A patent application related to the detection of genetic predisposition to periodontal disease has been filed and assigned to us from Sheffield University, Dr. Gordon Duff and Dr. Kenneth Kornman. We have received a Notice of Allowance from the U.S. Patent and Trademark Office related to the patent's anticipated issuance. 28 33 MARKET FOR PERIODONTAL SUSCEPTIBILITY TEST. The American Academy of Periodontology estimates that: "$5 billion was spent in 1990 to treat gingivitis and periodontal disease, more than $10 billion is spent annually for the replacement of teeth lost to periodontal disease, that 80% of all employed American adults have some stage of periodontal disease and that periodontal disease is the primary cause of tooth loss in adults 35 years and older." In general, population based studies indicate that gingivitis (that is, mild gum disease) affects 50% of the adult population. Studies also show that periodontitis affects between 30% to 35% of U.S. adults and increases with age after 35. Many of the affected individuals have mild clinical disease, but it appears that 20% of the adult population have a level of periodontitis which requires professional treatment. The early identification of those individuals susceptible to severe periodontal disease would allow for more aggressive prevention and treatment of the disease. Early intervention is the key to preventing or stopping the progression of the disease in order to minimize permanent loss of bone that supports the teeth. Most periodontal disease is currently diagnosed only after significant damage has already occurred. The patient is frequently referred to a specialist if the patient does not respond to conventional cleaning therapy and continues to experience substantial additional bone loss. The current dilemma is the inability to differentiate between those patients likely to respond to the normal conservative approaches such as scaling and root planing, oral hygiene improvement and more regular dental visits, and those which will likely go rapidly downhill despite customary therapy. Those who have periodontal disease and are susceptible to the severe form of periodontitis need more aggressive care such as more frequent monitoring and periodontal cleanings, earlier treatment with drugs or even early surgical intervention in severe cases. Early identification of patients at high risk for periodontitis will allow general practitioner dentists, as well as periodontists, to better focus resources and confidently choose the most cost-effective therapy. Moreover, use of our periodontal susceptibility test will allow payors to better monitor resource utilization and to better design dental insurance plans. We commercially launched our periodontal susceptibility test on October 3, 1997. Genetic Susceptibility Test for Osteoporosis (Patent Pending). DESCRIPTION OF OSTEOPOROSIS SUSCEPTIBILITY TEST. The second genetic test we are currently developing is a test for susceptibility to osteoporosis. Osteoporosis, the most common bone disease, resulting in a decrease in the amount of normal bone which leaves the affected individual more susceptible to fractures. We have identified a genetic marker that in clinical trials was associated with a more severe loss of bone through osteoporosis. The osteoporosis susceptibility test is a genetic test capable of indicating a greater susceptibility to severe osteoporosis in postmenopausal women. This susceptibility appears to involve a more rapid loss of bone as estrogen levels decrease and menopause occurs. 29 34 We have completed three clinical trials of the osteoporosis susceptibility test. The first trial focused on the relationship of the genetic test to bone-mineral density ("BMD") in post-menopausal women with a history of bone fractures. All three trials confirmed the association between the specific genetic marker and the onset of osteoporosis (Figure 4). FIGURE 4 [BAR GRAPH DEPICTING SUSCEPTIBILITY TO POST - MENOPAUSAL OSTEOPOROSIS] Source: R. Eastell, G. Russell, G. W. Duff and co-workers, unpublished data on file, Medical Science Systems, Inc. Our test provides data that will allow practitioners to practice preventive medicine. Ideally, all females should be tested for this genetic trait by adolescence so that they are encouraged to develop healthy lifestyles to attain peak bone mass prior to the onset of menopause. These lifestyles include avoiding smoking, increasing the intake of calcium, and participating in regular weight-bearing exercise. Results of this test will also assist women who are approaching menopause in deciding whether to start treatment. On introduction into the marketplace, this test will be targeted at all women in their mid-thirties, the point in their lives when the estrogen level begins to decrease. This will enable counseling at a sufficiently early stage in the process that significant bone loss can be avoided through lifestyle modification and/or drug/hormone therapy. A patent application related to the method of testing for genetic predisposition to osteoporosis has been filed and assigned to Sheffield University. Sheffield University, has in turn, granted to us an exclusive worldwide license to utilize the underlying patent. Under the terms of our Project Agreement with Sheffield University, upon our commercialization of the osteoporosis susceptibility test, Sheffield University is obligated to assign the patent to us in its entirety. The U.S. Patent and Trademark Office has recently issued a Notice of Allowance with respect to the aforementioned patent. MARKET FOR OSTEOPOROSIS SUSCEPTIBILITY TEST. Twenty-eight million Americans suffer from osteoporosis, of which 85% are women. Post-menopausal osteoporosis, stemming from the loss of estrogen, affects more than one-half of all women over 65 years of age and has been detected in as many as 90% of women over age 75. Osteoporosis is responsible for a majority of the 1.5 million bone fractures each year, leading to disabilities costing more than $10 billion in medical, social and nursing home costs. In 1991, one out of three 30 35 American women were 50 years of age or older. The "baby boomer" generation began to enter this age group in 1996. In the past, a diagnosis of osteoporosis was made only after an elderly individual had suffered a bone fracture. The current definition requires that the individual has lost enough bone to put them at increased risk for fractures. Since the strength of bones is largely determined by the mineral density of the bones, an assessment of bone mineral density is currently the most reliable method for determining whether one has osteoporosis. The diagnosis may therefore be made by bone densitometry measurements that allow the calculation of the density of bone relative to normal individuals. The key problem with this approach is that it is directed at Those individuals who already have the disease and have manifested symptoms. Although new therapies reverse some bone loss, their primary benefit is in retarding future bone loss. Given that little can be done to reverse damage that has already occurred, it appears that the best management of osteoporosis will involve early detection and prevention. By identifying at-risk individuals before symptoms appear, the individual can be counseled to make appropriate life style changes or institute other treatments. For example, calcium supplements and exercise have been shown to be valuable preventive factors if used during a critical early age window. Hormone replacement therapy has also been used successfully to combat osteoporosis occurring after menopause. Hormone replacement therapy may be of greatest benefit if used early in the disease process before major bone loss has occurred. New treatment alternatives for osteoporosis include a class of drugs that has recently been approved called bisphosphonates. Didronel(TM), a bisphosphonate manufactured by Procter and Gamble Pharmaceuticals, is available in much of Europe. Fosamax(TM), another new bisphosphonate produced by Merck, has recently received FDA approval and is now marketed in the U.S. Historically, it has been very difficult to reliably identify those women who are at greater risk for developing severe osteoporosis. Although various risk factors are strongly associated with osteoporosis, assessment of risk factors in patients by means of questionnaires has not been a reliable means of identifying women with low bone density. New urine or blood tests can detect special chemical markers when the bone is actively being destroyed. However, these chemical markers, like the bone density measurements, primarily provide diagnostic information only after significant amounts of bone have been lost. Unfortunately, the opportunity for increasing bone density by nutrition or exercise occurs far before osteoporosis is detectable by such means. Since our marker is genetic, we may test patients at an early age and identify their risk. This provides the opportunity for disease prevention in the form of lifestyle changes early enough to make a difference. This test may also be valuable in selecting patients for early drug intervention to stop osteoporosis. Such drugs include earlier supplementation with estrogen or a preemptive use of a bisphosphonate-class drug such as Fosamax(TM). We anticipate initiating marketing efforts related to a pre-commercial phase for the osteoporosis susceptibility test in late 1997. See "Market Development Strategy for Other Susceptibility Tests" at page 39. The full commercial launch is anticipated to begin sometime in late 1998. Genetic Susceptibility Test for Coronary Artery Disease (Patent Pending). DESCRIPTION OF CAD TEST. The third genetic susceptibility test we are developing is the coronary artery disease test (the "CAD test"). The CAD test is a genetic test capable of detecting those individuals with a significantly higher level of susceptibility to coronary artery disease. When an individual has one copy of this specific genetic marker (i.e., is heterozygous) there is a 2.4 times greater chance of his developing coronary artery disease than the general population. An individual who has two copies of the genetic marker (i.e., is homozygous) has a 5.4 times greater chance of developing coronary artery disease than the general population. It follows that being homozygous for this particular genetic marker indicates a greater risk for coronary artery disease than any other single risk factor (Figure 5). 31 36 FIGURE 5 THE NEWLY IDENTIFIED GENETIC POLYMORPHISM IS A STRONG RISK-MARKER FOR CORONARY ARTERY DISEASE
INCREASED RISK RISK FACTOR/MARKER FOR CAD ------------------------------------ -------------- Smoking 1 pack/day 2.4 Sedentary lifestyle 1.9 Severe obesity 3.3 Hypertension 2.1 High cholesterol (>240) 2.4 1 copy of new marker 2.4 2 copies of new marker 5.4
Source: S. Francis, D. Crossman, G. W. Duff and co-workers. Submitted for publication, 1997. Data on file at Medical Science Systems, Inc. The availability of our CAD test will provide practitioners with a means of truly practicing preventive medicine with respect to coronary artery disease. The CAD test can be given to all individuals early in life because genetic risk factors do not change over time. Individuals who test positive for the genotype can be treated with more aggressive approaches to risk factor reduction. As these individual age, they can be provided with more regular: (i) monitoring of cholesterol levels; (ii) blood pressure testing; and (iii) early intervention to alter the level of blood lipids (i.e., fats). Such an approach allows for truly preventive medicine through early risk factor reduction and appropriate monitoring for early detection of any problems. A patent application related to the method of testing for genetic predisposition to coronary artery disease has been filed and assigned to the Sheffield University. Sheffield University, has in turn, granted to us an exclusive worldwide license to utilize the underlying patent. Under the terms of our Project Agreement with Sheffield University, upon our commercialization of the CAD test, Sheffield University is obligated to assign the patent to us in its entirety. MARKET FOR CAD TEST. More than one in four Americans, or about 60 million, have some form of cardiovascular disease. Cardiovascular diseases kill nearly one million Americans every year -- more than all forms of cancer (about 500,000), accidents (about 85,000), and AIDS (about 38,000) combined. Since 1900, cardiovascular disease has been the number one cause of death in the U.S. every year except 1918 (when there was a world-wide flu epidemic). If all forms of cardiovascular disease were eliminated, life expectancy would rise by 7.78 years. Atherosclerosis (or arteriosclerosis) refers to the progressive blockage of arteries by plaque accumulation. Atherosclerosis is the principle cause of heart attack, stroke and gangrene of the extremities. It is responsible for 50% of all deaths in the U.S., Europe and Japan. If atherosclerosis occurs in the arteries that supply blood to the heart, then the disease is often referred to as coronary artery disease ("CAD"). CAD results in heart attacks (myocardial infarctions) due to damage to the heart muscle when blood supply (and therefore oxygen) is cut off and heart muscle cells die. Approximately 13.5 million Americans suffer from coronary artery disease, and approximately half a million Americans die each year from this disease. Although many theories exist, the causes and mechanisms of this build-up are not completely understood. Because of this lack of understanding, prediction, diagnosis, and treatment of atherosclerosis has centered on the development of a set of risk factors that help to identify those individuals who are most at risk. The primary approach to treatment for atherosclerosis, once diagnosed, centers on controlling these risk factors. 32 37 Unfortunately, many of the classic risk factors, such as smoking, high cholesterol levels, and high blood pressure, only account for about half of the incidence of CAD. Because CAD is the leading cause of death among people in the U.S., a tremendous amount of research over the past four decades has been directed at CAD. Initially, serum lipids (e.g., triglycerides and total cholesterol) were linked with CAD during the 1940s and 1950s These observations have been refined to focus on high and low density lipoproteins (i.e., "HDLs" and "LDLs") as potential factors in the cause of the disease and as potential markers of the disease. Preventive treatment, including lifestyle changes and drug therapy, is directed primarily at reducing the risk factors. Treatment strategies usually involve coronary artery by-pass surgery or angioplasty (i.e., expansion of the blood vessel), both of which only treat the result and not the root cause(s) of the disease. Though an increasingly large number of risk factors have been identified, they still only account for slightly over half of the cases of atherosclerosis. The genetic susceptibility test that we are developing may offer a potential solution to this dilemma. The CAD test is based on a genetic marker that is associated with an increased susceptibility to coronary artery disease that substantially exceeded the increased risk of other commonly associated factors, such as smoking or high cholesterol. We anticipate initiating marketing efforts related to a pre-commercial phase for the CAD test in late 1998. See "Market Development Strategy for Other Susceptibility Tests" at page 39. The full commercial launch is anticipated to begin in 1999. Genetic Susceptibility Test for Retinopathy in Diabetics (Patent Pending). DESCRIPTION OF THE DIABETIC RETINOPATHY TEST. The fourth genetic susceptibility test we are developing is a test to determine the susceptibility to sight-threatening retinopathy in diabetics. This susceptibility involves a continued and increased risk of losing vision when an individual has been diagnosed with diabetes. The data from our first clinical trial involving over 500 diabetics is shown below (Figure 6). Of the individuals who did not have the specific genetic marker (genotype negative), approximately 10% developed sight-threatening retinopathy. The risk for this group remained low and relatively constant for many years. For genotype positive individuals, however, the risk continued to increase dramatically until nearly 50% ultimately developed sight-threatening diabetic retinopathy. 33 38 FIGURE 6 [GRAPH DEPICTING SUSCEPTIBILITY TO DIABETIC RETINOPATHY] Source: P. Richardson, I. Rennie, G. W. Duff and co-workers. Submitted for publication, 1997. Data on file at Medical Science Systems, Inc. Sight-threatening diabetic retinopathy refers to diabetic complications affecting the retina that predictably lead to severe loss of vision. Retinal disease is one of numerous problems related to diabetes. Retinal disease is primarily the result of the disruption of small blood vessels in the retina due to: (i) capillary leakage; and/or (ii) destruction or obstruction of capillaries causing damage to the tissues of the retina and the uncontrolled growth of new blood vessels. Such retinal changes are a leading cause of blindness in the western world. A patent application related to the method of testing for the genetic predisposition to retinopathy in patients with diabetes has been filed and assigned to Sheffield University. Sheffield University, in turn, has granted us an exclusive, worldwide license to utilize the underlying patent. Under the terms of our Project Agreement with Sheffield University, upon our commercialization of the diabetic retinopathy susceptibility test, Sheffield University is obligated to assign the patent to us in its entirety. MARKET FOR DIABETIC RETINOPATHY TEST. In the United States there are approximately 16 million people suffering from diabetes mellitus (or are diabetic). It is estimated that only half of this number have been diagnosed. There are two general categories of diabetes mellitus. Type I diabetes, or insulin-dependent diabetes mellitus, generally appears in patients under 20 years of age and is marked by severe insulin deficiency. Type I diabetes is generally detected at its onset and requires insulin treatment to control. Type II diabetes, or non-insulindependent diabetes mellitus, emerges in patients over 20, may remain undetected for years, and is marked by insulin resistance and an insulin deficiency. Dietary changes may be able to control Type II diabetes, however, insulin supplements (that is, injections) are often required. Ninety percent of all diabetics have Type II diabetes. Patients with either form of diabetes mellitus are at risk of developing complications such as problems with their nervous system, kidneys, vision and heart. Studies have shown that the duration of diabetes is 34 39 associated with the increasing incidence of diabetic complications. Accordingly, the longer an individual has diabetes, the greater his or her chances of developing complications. These complications are a major clinical burden in diabetes, but the origination and development of the disease are not well understood. Diabetic retinopathy is one of the most common complications of diabetes. It is the fourth leading cause of legal blindness in the U.S. and the leading cause of blindness in people ages 20 to 74. Each year 15,000 to 39,000 people lose their sight from diabetic retinopathy. Early detection of retinopathy is critical to the prevention of vision loss. The early stage of this disease is known as nonproliferative retinopathy. Nonproliferative retinopathy is somewhat difficult to detect but responds well to treatment. Nonproliferative retinopathy, if untreated, can deteriorate with a resultant loss of vision. Although treatment may arrest the condition, it will not restore lost vision. Proliferative retinopathy is the final state of the disease. At this point, the disease involves the production or growth of new tissue in and around the retina. These types of growths can lead to serious vision loss including blindness. Satisfactory treatment is difficult in advanced proliferative retinopathy. Surgical procedures used at this stage will themselves result in a loss of patient vision four percent of the time. Clearly, early treatment of diabetic retinopathy is desirable. We have identified a genetic marker that is correlated with an increased risk of developing diabetic retinopathy in patients who have diabetes. This correlation seems to indicate an earlier onset of retinopathy in patients who have diabetes thus putting such individuals at risk of losing their sight at an earlier age. The availability of such a test would allow practitioners to assess a patient's risk of losing his or her sight due to diabetes at the time that he or she is diagnosed with the disease. Preventive treatment would allow doctors to practice truly preventive medicine, providing a means of identifying susceptible patients early in the disease process. Enhanced assessment and monitoring can then be initiated from the start, allowing early detection of problems and preemptive treatment that will ultimately reduce the incidence of diabetes related vision loss. This would translate into improvements in patient quality of life and cost savings. Confirmatory clinical studies of the diabetic retinopathy susceptibility test are scheduled for completion in mid-1998. We anticipate initiating marketing efforts related to a pre-commercial phase for the diabetic retinopathy susceptibility test sometime in 1998. See "Market Development Strategy for Other Susceptibility Tests" at page 39. The full commercial launch is anticipated to begin sometime in 1999. Testing Procedure. Each of our four genetic susceptibility tests will require that the following single procedure be utilized. To conduct a genetic susceptibility test, the doctor will draw a blood sample and submit it to our customer service department. We will log in the sample and submit sample batches to the testing laboratory. The laboratory will perform the test following our specific protocol and inform us of the results. We, in turn, will advise the doctor of the results, who informs the patient and determines the appropriate course of action. At the time results are provided to the doctor, our billing service (which we presently "outsource") will invoice the patient directly for the test. The doctor will then invoice the patient for his or her professional services related to administration of the test. We are currently using Baylor University as our commercial laboratory. We will continue to use one or more sophisticated, certified, and fully validated laboratories, such as the Baylor facility, capable of providing consistent and high quality analysis. Customer service is handled via our toll free "888" numbers by our own staff who are knowledgeable about our genetic susceptibility tests, the procedural requirements of the testing system and the related diseases. Pre-Marketing Trials/Status of Susceptibility Tests. As an internal procedural standard, we conduct three categories of clinical trials in conjunction with our genetic susceptibility tests. The first trial is called a proof of principle trial, used to prove a laboratory finding. The results of this trial are utilized to support the initial patent application and therefore need to be completed before the patent application can be filed. The second trial is a confirmatory trial. The purpose of the confirmatory trial is to independently confirm the results of the proof of principle trial. The third category of trial relates to clinical utility. The clinical utility trial is conducted to learn what is the most effective utilization of the test in actual clinical practice. The 35 40 current trial status and actual and anticipated commercial launch date of each of our four genetic susceptibility tests is depicted below: STATUS OF CLINICAL TRIALS AND ACTUAL/ANTICIPATED LAUNCH DATES RELATED TO MSS' GENETIC SUSCEPTIBILITY TESTS
INITIAL PROOF ACTUAL/ANTICIPATED (PRIOR TO CONFIRMATORY COMMERCIAL PATENT FILING) TRIAL CLINICAL UTILITY LAUNCH -------------- ------------ ---------------- ------------------ Periodontal Disease................ Completed Completed Completed October 1997 Osteoporosis....................... Completed Completed Underway Late 1998 Coronary Artery Disease............ Completed Completed Underway 1999 Diabetic Retinopathy............... Completed Underway Not Yet Started 1999
Following confirmatory studies, additional trials are completed on larger populations to help develop broad scientific evidence supporting the clinical utility of each of our tests. Such additional trials not only strengthen the support for each tests' known use (i.e., detecting genetic susceptibility) but also lead to additional practical uses of the susceptibility tests (e.g., use of the susceptibility tests to determine a patient's responsiveness to a given drug). Product Development. Beyond our current four genetic susceptibility tests, we have on-going research to continue to identify other genetic markers that appear to be associated with certain other common diseases. We plan on filing additional patent applications to cover these discoveries. It is our intent to bring these discoveries to market in the form of additional genetic susceptibility tests. We have also come upon certain genetic markers that might be likely candidates to serve as therapeutic targets -- or in other words, be susceptible to influence by drug agents. We are considering certain collaborative long term relationships with pharmaceutical companies as a method to provide for either the licensing of our discoveries or to assist in the research and development of future products. There may be additional applications of either our testing services or the underlying technology that we use to develop and support our genetic testing services. We will seek to exploit opportunities to develop such additional applications in conjunction with other companies so long as our company's focus remains on genetic susceptibility testing. For example, we have recently granted a worldwide, nonexclusive, nontransferable license to Digisphere, LLC to market customized versions of our computer modeling technology to pharmaceutical companies. Previously, we had only used our computer modeling technology for the internal development of our genetic testing services. On August 1, 1997, Digisphere, LLC was formed, representing a joint venture between our company and Nelson Communications Inc. ("NCI"), one of the largest providers of health care marketing services to pharmaceutical companies in the United States. See "Transactions with Directors and Executive Officers" at page 52. Ownership of Digisphere, LLC is divided approximately equally between our company and NCI. Digisphere, LLC has a stated term which lasts until August 31, 2000, unless extended. However, the arrangement may be terminated upon mutual agreement or if certain performance goals are not met. The primary purpose of the joint venture is to market our computer modeling technology to pharmaceutical companies as a tool which provides medical education regarding disease progression. A secondary purpose of the joint venture is to provide marketing information to those patients who test positive on one of our tests and who subsequently send in a business reply card seeking more information. In both aspects of the joint venture, our company will be acting as the technology/information partner and NCI will be functioning as the marketing partner. As of September 30, 1997, we have not received any revenues from this joint venture. MARKET AND SELLING STRATEGIES General Strategy. Our strategy is to build a commercial operation based on the delivery of our genetic susceptibility testing services on a worldwide basis. Our testing services are aimed at multi-factorial diseases which are treatable and preventable. Our strategy assumes that genetic tests revealing susceptibility to preventable diseases will ultimately be highly valued by the public, by clinicians involved in prevention and 36 41 treatment planning, by industries involved in clinical trials and by healthcare payers and administrators who need to direct limited resources where they will make the biggest difference. We intend to utilize a sales and marketing approach which will aim to improve patient care and treatment outcomes by incorporating genetic information regarding disease susceptibility into overall risk assessment and treatment planning. We hope to accomplish this through educating doctors, managed care organizations, industry and the public about the value of targeting healthcare investments based on an individual's tendency to develop a specific disease. We will seek to influence attitudes and mindsets through clearly articulating the benefit for our customers and adopting a missionary sales approach in partnership with crusaders in the field. Emphasis will be placed on building strong relationships with key decision-makers and educators who will work with us to overcome the obstacles and influence the acceptance of genetic testing, especially testing that reveals wanted information, as part of the medical standard of care. Our initial goal will be to establish genetic tests such as our periodontal susceptibility test into overall risk assessment and treatment planning for patients. Ultimately, we envision these tests being used more broadly by healthcare administrators and practitioners as a screening tool to direct limited resources in a more targeted and proactive way. Market Strategy for Specific Tests. MARKET STRATEGY FOR PERIODONTAL SUSCEPTIBILITY TEST. We plan to develop the worldwide market for our periodontal susceptibility test directly through a number of centrally-driven tactics and thereby establish an environment in which locally appropriate, focused selling efforts will be most likely to succeed. The worldwide market will be segmented according to geography and customer groups, with appropriate emphasis being given to specific segments as the business grows. Wherever possible, we will initially sell our periodontal susceptibility test directly, anticipating that once demand has been created we may elect to work in partnership with other selling organizations that offer significantly greater access to the market and/or a better competitive position. GEOGRAPHIC SEGMENTATION PLAN. Initial emphasis will be placed on sales of our periodontal susceptibility test in North America. North America represents at least half of the worldwide opportunity for our periodontal susceptibility test. We intend to market directly in the U.S. and Canada, focusing on specific customer segments as outlined below. In a parallel effort, we will also begin to develop a sales program in Europe, in partnership with local sales organizations familiar with the periodontal market. Emphasis will be placed on Italy, since momentum and a customer base have already been established during our pre-commercial phase. In the meantime, European customers who want access to our periodontal susceptibility test are being serviced directly out of the U.S. The same is true for Asia and South America. It is anticipated that partners will be sought for sales efforts in these regions as well. CUSTOMER SEGMENTATION PLAN. There are several potential customers for our periodontal susceptibility test who need to be targeted in a specific order and with appropriate emphasis over time. Our study of the value-chain involved in making or influencing a purchasing decision for our periodontal susceptibility test revealed that some of the key players involved include: specialists (primarily periodontists), general dentists, hygienists, reimbursement groups (i.e., insurance companies, managed care organizations, etc.) and, of course, the individuals (and their families) who are being tested. The degree to which each of these groups embrace our periodontal susceptibility test will be influenced by how others in the value-chain view the value of the information. For example, initial feedback indicates that patients will be strongly influenced by their doctors. Whereas, generalists may be influenced by how specialists view the value of the test. Managed care organizations are likely to be influenced by how attractive the test is to their current or potential members. The influence diagram for the decision to purchase the test reveals a high degree of interdependence between all of the groups. For this reason, it is critical to develop the market in the right order and with the appropriate selling message for the specific group being targeted. It is important not to skip a step in the process or believe that, just because resistance to change in a specific segment may be great, such segment may be ignored. The initial segmentation plan we have developed will allow us to focus resources on the group most likely to generate early sales growth, while at the same time ensuring long-term sustainability and opportunity 37 42 for growth. In light of the foregoing, we will be targeting four customer groups: (i) Periodontists/ periodontally-oriented GPs; (ii) General Practitioners; (iii) Managed Care/Buying Groups; and (iv) Oral Care Companies with Dental Research Programs. Periodontist/Periodontally-oriented GPs. During the launch period and early adoption phase, emphasis will be placed on this segment in both North America and Europe. From a market development standpoint, we recognize that it is critical that our periodontal susceptibility test be understood and accepted by "periodontists" for it to gain broad acceptance in the other segments. Relationships with opinion leaders and professional organizations are already well established in this segment. Key opinion leaders have their own data to present, which can be further supported with educational materials that we have developed. Speakers will be engaged who can interpret the scientific message and translate the breakthrough and effectively convey its clinical value to others. Our goal is to be highly visible at major periodontal meetings (international, national and "large" regional) the first year, with educational information on our periodontal susceptibility test either incorporated into the main program, or as part of an associated continuing education program wherever possible. Our periodontal susceptibility test was recently featured at the last general session of the American Academy of Periodontology meeting in October 1997. From a selling standpoint, periodontists can be reached with a relatively small organization through attending their major meetings and sending targeted mail/fax communications. We initially expect periodontists to be our major source of revenue transitioning to dental general practitioners ("GPs") over the course of the first year. We will seek to convince/motivate periodontists, in addition to testing their own patients, to take the "genetic susceptibility testing/risk assessment message" to referring GPs, and in some cases, directly to patients to help build their practices. As such, we see periodontists as important multipliers and an integral part of the "selling effort." Support materials, such as updated referral slide shows and general dentist's brochures, patient brochures, "informatics" and press release packets, are already being provided to help periodontists to be more effective in this role. General Practitioners. We intend on developing this segment in a parallel manner, with emphasis switching from periodontists to GPs as the business grows. From a market development standpoint, we are working closely with leaders in the American Dental Association to help them understand the benefits of our periodontal susceptibility test to GPs, and to motivate then to educate their membership. Our periodontal susceptibility test is already scheduled to be presented at the American Dental Association's major fall meeting in Washington, D.C., where the test will also be included in an exhibit on dental innovations at the Smithsonian. Emphasis will be placed on translating the clinical value as it relates to a general practice, with appropriate opinion leaders from their own "camps" being identified for this purpose. GPs will be the target of mass mailings and advertising campaigns to increase brand recognition for our periodontal susceptibility test. In addition, we will seek to use periodontists as "advocates" to reach their GP referral base. As the need for additional sales activities within this segment grows, we will evaluate using a "co-marketing" arrangement with a large GP-oriented sales organization. Managed Care/Buying Groups. Initially, we expect most genetic tests to be paid for by the consumer, not insurance companies or other payors. Our contracted billing service will directly bill the patient who has utilized the test. We realize, however, that successful commercialization of our products and services may depend in part upon the availability of reimbursement or funding from third-party health care payors such as federal and state governmental agencies, private insurance plans and health maintenance organizations. Thus, In the longer term, we intend to target this managed care/buying group segment by building a sales and marketing organization aimed at understanding the value of genetic testing and risk assessment to large buying groups (including managed care organizations of all forms and governments in some countries) and "selling" through negotiating contracts with the decision makers (and gate keepers). This is clearly the trend in organized healthcare and presents an opportunity for susceptibility tests such our periodontal susceptibility test. As we grow, this capability should also generalize to other genetic tests. From a market development standpoint, we intend to better understand the needs of this segment, and tailor claim support 38 43 studies/educational activities to satisfy these needs. Our periodontal susceptibility test is already scheduled to be featured at the next meeting of the National Association of Dental Plans. Oral Care Companies with Dental Research Programs. An additional segment that we intend to target involves companies with clinical research programs. We have already sold some of our periodontal susceptibility tests to companies that are interested in having patients in their clinical studies genotyped. Due to the clear benefit of including this information in large clinical studies and our strong preexisting relationships with many of the companies in this segment, we view this as an opportunity to generate additional sales during the first year with a limited selling effort. However, there can be no assurance that future sales will be effected or that such sales will result in net income. Public Awareness/PR Plan. Initially most of our sales and marketing effort aimed at the general public will be indirect, primarily in the form of brochures and other tools that a doctor can use to explain the tests and their value to patients. We have initiated some public relations activities in order to increase public awareness of our specific tests and genetic susceptibility testing more generally through the popular media. For example, with our periodontal susceptibility test, we have initiated some publications in cooperation with a professional organization known as the American Association of Periodontology, which has its own vested interest in increasing public awareness about the disease and featuring significant discoveries that help validate the importance of the profession. We will begin to use PR in coordination with our other selling efforts aimed at each customer segment we approach. With the commercial introduction of the periodontal susceptibility test at the American Academy of Periodontology meeting in October 1997, we began a campaign aimed at reaching the periodontal and general dentists. Ultimately, we plan on marketing directly to the public in order to create consumer demand for our tests. Educational and Promotional Materials. As with any change of behavior product, we anticipate the sales and promotional effort for our genetic susceptibility test to be highly education-intensive and are planning to develop several materials to support this effort. In addition, some promotional materials will be developed that are primarily aimed at increasing brand/logo/company recognition and creating a "high tech/ high value" image for ourselves. Market Development Strategy for Other Susceptibility Tests. We are also preparing market development plans to implement the "pre-commercial phase" for our osteoporosis tests. We intend to implement a similar strategy as is currently being utilized with our periodontal susceptibility test. We will initially involve the current academic and research "thought leaders" in the development and verification of our tests results and clinical utility. We will then develop a speaker circuit where these thought leaders will begin to convey the clinical utility and importance of our tests to specialists within each testing area (e.g., cardiologist for the CAD test). As the thought leaders begin to reach and influence the specialists we will then begin to target generalists, who presumably will be or have been influenced by the specialists. At this point direct marketing can be introduced to complete the progression, resulting in consumer demand. This segmentation strategy has been proven to be effective with other medical devices and is already being implemented with respect to our periodontal susceptibility test. SELLING METHODS Direct Sales. We plan to build demand for our susceptibility tests using a small direct consultative sales organization specializing in genetic testing, risk assessment and change of behavior. We do not plan on building a large sales force capability in any specific market; however, when the need for additional sales force activity increases within a particular segment, we will consider "co-marketing" or other business arrangements with companies with a large sales organization in the field. Our direct sales capability will focus on the profession segment initially, then shift to institutional and large buying group sales. After a sales partner has been brought on, we will focus on sales partner support and trade/professional association meetings. We will thereafter continue to seek to establish corporate partnerships which will produce revenues, credibility and a market presence for our other services and products. Professional and Industry Meetings/Trade Associations. Initially, we will be present and market our products and services at all national and selected regional associations and meetings where a genetic 39 44 susceptibility test has applicability to the professionals in attendance. Over time, we anticipate our partners playing an increasingly important role in the specific disease markets where our tests are used. INTELLECTUAL PROPERTY Our commercial success will be dependent in part on our ability to obtain patent protection on genes, genetic sequences and/or their relationship to common diseases, or products or methods based on the association between particular genes and diseases, discovered by us and Sheffield University. We have ten patent applications pending, including applications covering each of our four genetic susceptibility tests. In June 1997, a Notice of Allowance was issued by the United States Patent and Trademark Office with respect to both our periodontal and osteoporosis susceptibility tests. A Notice of Allowance is granted by the Patent and Trademark Office, if, on examination of the application, the patent application is found to be allowable. Thereafter a fee for issuing the patent is due within three months from the date of the Notice of Allowance. When the issue fee is paid, the patent issues as soon as possible after the date of payment, dependent upon the backlog of patents at the Patent and Trademark Office. The patent is then delivered or mailed on the day of its grant, or as soon thereafter as possible. We paid the issue fee related to the application for the periodontal susceptibility test on July 18, 1997 and for the osteoporosis susceptibility test on September 8, 1997. While the issuance of these patents is likely, the exact date of issuance is not known. It is rather unlikely, but possible, that the United States Patent Trademark Commissioner could disallow the granting of our patents at any time prior to the date of issuance. We have filed and will continue to file foreign counterparts of our U.S. applications within the appropriate time frames. Where we have originally filed in another country, we plan to file U.S. and other foreign counterparts within the appropriate time frame. These applications seek to protect these gene markers and corresponding use of gene markers, and products derived therefrom and uses therefor. Some of these applications also identify possible biological functions for the genes and gene fragments based in part on a comparison to genes or gene fragments included in public databases but do not contain any laboratory or clinical data with respect to such biological functions. We own the patent application covering the genetic marker related to our periodontal susceptibility test. However, with each of the other tests, the Section of Molecular Medicine at Sheffield University holds the patent application but has granted us an exclusive worldwide, irrevocable, transferable license to make, have made, use, offer to sell, license and otherwise transfer products created under the applicable patents. Sheffield University has retained the right to carry on internal research related to the underlying patents. However, under the terms of our Project Agreements with Sheffield University, upon the commercialization of each test, Sheffield University is obligated to assign the patent to us in its entirety. We have filed three patents related to our computer modeling software technology, two of which are still pending and one of which has issued. We are continuing to identify and develop applications related to additional genetic markers. We have also applied for trademark protection for the name of our periodontal susceptibility test. Our proprietary technology is subject to numerous risks. See "Uncertain Ability to Protect Proprietary Technology" at page 11. ETHICAL, LEGAL AND SOCIAL IMPLICATIONS OF GENETIC SUSCEPTIBILITY TESTING The prospect of broadly available genetic susceptibility testing has raised issues which are currently being widely discussed by the medical and scientific communities, as well as other interested groups and organizations, regarding the appropriate utilization and the confidentiality of information provided by such testing. The recent movement towards discovery and commercialization of susceptibility tests for screening a person's likelihood of developing one or more chronic conditions has also focused public and legislative attention on the need to protect the privacy of genetic screening medical information. With the progression towards more comprehensive record keeping by health insurers and managed care firms, this need has led to a number of legal initiatives. The recently enacted federal health insurance reform law (Kassebaum-Kennedy of 1996) recognizes the comparability of information obtained by genetic means to other types of personal medical information. The law prohibits insurance companies from refusing health insurance coverage to individuals on the basis of their medical history, including "genetic information." This legislation also prohibits employees from discrimination in hiring practices on the same basis. This should serve as an example 40 45 of a trend to protect the privacy of patients, while allowing them to be screened for conditions which, as medicine progresses, can be prevented, reduced in severity, or cured. Although the current trend is pro-genetic testing, governmental authorities could, for social or other purposes, limit the use of genetic testing or prohibit testing for genetic susceptibility to certain conditions. We have attempted to take a proactive stance in the ethical arena. We have engaged Dr. Philip Reilly, who is both an M.D. (board certified specialist in clinical genetics) and an attorney to advise us in the area of genetic testing and its ethical, legal and clinical utility ramifications. Additionally, we are currently advising doctors who administer our genetic susceptibility tests to take special efforts to maintain the confidentiality of the test results. Our intent is to avoid information about test results being disclosed to insurers until issues regarding insurability have been fully analyzed and acted upon by the appropriate legislative bodies. On August 1, 1997, we formed a joint venture named Digisphere, LLC whose purpose, in part, will be to provide marketing information to those patients who test positive on one of our tests and who subsequently send in a business reply card seeking more information. See "Product Development" at page 36. The confidentiality of patient information is subject to regulation by state law. A variety of statutes and regulations exist safeguarding privacy and regulating the disclosure and use of medical information. State constitutions may provide privacy rights and states may provide private causes of action for violations of an individual's "expectation of privacy." Tort liability may result from unauthorized access and breaches of patient confidence. We intend to comply with state law and regulations governing medical information privacy. COMPETITION Although testing for major genetic defects, such as Down's Syndrome, has been available for years, genetic susceptibility testing for multi-factorial diseases is a newly emerging growth segment. Despite this segment's relatively young age, companies other than ours do exist have research programs seeking disease related genes for therapeutic and susceptibility testing purposes, including some that involve treatable/ preventable disease. Other companies with research programs include OncorMed, Inc. ("OncorMed"), Myriad Genetics, Inc. ("Myriad"), Genome Therapeutics Corp. ("GTC") and Sequana Therapeutics, Inc. ("Sequana"). Both GTC and Sequana have announced that they have research programs focusing on osteoporosis. Myriad has a test for breast cancer and has announced research programs for osteoporosis and coronary artery disease. OncorMed, while engaged in the development of genetic susceptibility tests, is focused solely on cancer. Additionally, some of our competitors receive data and funding from the Human Genome Project. The Human Genome Program is a federally funded program focused on sequencing the human DNA and enriching the sequence data with information about its biological function. To the extent our competitors receive data and funding from the Human Genome Project at no cost to them, they may have a competitive advantage over our company. Each of the above noted company's involvement with genetic susceptibility testing, together with large market capitalizations as public companies, validates this newly emerging market. In the case of newly introduced products requiring "change of behavior," (such as genetic susceptibility tests) multiple competitors may accelerate market acceptance and penetration through increasing awareness. Moreover, two different genetic susceptibility tests for the same disease may in fact test or measure different components, and thus actually be complementary when given in parallel as an overall assessment of risk, rather than being competitive with each other. Furthermore, with the exception of OncorMed, the primary focus of each of the above-referenced companies is performing gene-identifying research for pharmaceutical companies for therapeutic purposes, with genetic susceptibility testing being a secondary goal. On the other hand, our company's primary business focus is developing and commercializing genetic susceptibility tests for common diseases, with only an ancillary drug discovery program. Factors which further differentiate us from other companies are discussed below in "Competitive Advantages" at page 42. 41 46 COMPETITIVE ADVANTAGES Other companies have entered the market for genetic testing as medical research has increasingly recognized the advantages provided by early detection of genetic predisposition. Although many of these competitors have greater financial and other resources than us (see "Competition" at page 41), we believe that our company has many competitive advantages, including: (1) Alliance with The University of Sheffield, U.K. Our efforts in the genetic discovery and development process are complemented by a strategic alliance with the Section of Molecular Medicine at The University of Sheffield, U.K. Sheffield University is one of the world's leaders in genetic aspects of common diseases with an inflammatory component. Sheffield University's research is targeted around identifying and discovering genes and genetic markers which appear to correlate with a patient's susceptibility to common diseases. Our relationship with Sheffield University offers another significant advantage over our competitors in reducing the cost of genetics research. The gene discovery process uses and generates vast amounts of information. Such research is time consuming, costly, heavily dependent upon advanced computer technology and unpredictable. Sheffield University has an integrated genetics program consisting of approximately 46 M.D. and Ph.D. scientists and researchers focusing on molecular genetics. Sheffield University performs gene-identifying research for us, thereby reducing our costs and allowing us to focus our attention on developing and commercializing known genetic markers. Many of our competitors' primary focus and capital is spent on performing gene-identifying research. In exchange for Sheffield University's providing us with research and discoveries, the company has agreed to pay Sheffield University a share of the resultant net profits, with the percentage of net profits for our company and Sheffield University to be agreed upon separately under project agreements related to each test (each a "Project Agreement"). Pursuant to such Project Agreements, our share of the net profits ranges from 50% to 67%. See "Reliance on Collaborative Partners" at page 10. Net profits will be paid out to Sheffield University only after we have recovered the cost of goods sold, all marketing and sales costs and all operational costs related to each of the separate tests. (2) Identified Genetic Markers. While many of our competitors are currently seeking to identify diseaserelated genes, we have already identified four genetic markers that indicate a patient's genetic predisposition to certain diseases. Additionally, we are continuing to identify other genetic markers and intend to file patent applications related to the same. (3) Focus on Diseases that are Treatable and Preventable. We are one of the few companies that we know of that is focusing on genetic susceptibility testing services for diseases that are treatable and preventable. Most of our competitors have not focused on treatable/preventable diseases but have instead focused on drug development with a secondary emphasis on genetic testing. Other companies, such as Myriad and OncorMed are developing tests for breast cancer for which there is no known preventive treatment (except mastectomy). The value of this information is, as a result, often times "unwanted" by the patient. Our tests, on the other hand, when used in overall risk assessment, provide doctors and patients with information regarding a patient's risk for developing a potential future disease. Since the disease is treatable and preventable, this information is "wanted." Doctors and patients may use this wanted information to take preventive measures to slow down or avoid disease progression and develop treatment plans based on a patient's future risk for disease progression. (4) Focus on Developing and Commercializing Genetic Susceptibility Testing Services. Our company's primary business focus is to develop and commercialize genetic susceptibility testing services. We are committed to becoming one of the world's leaders in marketing and selling genetic susceptibility tests. We believe that broad market acceptance of genetic susceptibility testing, and any particular test, can be achieved only by educating consumers and professionals about the benefits of genetic testing and demonstrating how genetic testing can improve patient risk assessment and treatment. In order to commercialize our own products and prepare the markets we are entering, we have built and continue to expand a team with significant experience in the commercialization process and marketing high 42 47 technology medical and dental products which require a change of behavior. We have developed a focused marketing and sales strategy for our initial product that includes segmentation, thought leader development, educational marketing and consultative selling. See "Market and Selling Strategies" at page 36. (5) First to Market with a Genetic Susceptibility Test for a Disease That is Treatable and Preventable. We are the only company that we know of that has brought to market a test (our periodontal susceptibility test) that identifies a genetic marker which indicates a greater susceptibility to a disease which is treatable and preventable. As a result, we believe that we are well-positioned to become a market leader in the periodontal market and potentially in each of the other areas in which we have developed or are developing tests. (6) Computer Modeling Technology. We have developed a computer modeling technology that simulates the biology of specific diseases. These simulations include basic genetic, cellular and subcellular interactions, as well as systems-level information about the clinical symptoms involved in the disease process. They allow a comprehensive integration of gene-expression data, basic biochemistry, and cell biology such that disease-associated genetic findings may be linked to the clinical outcomes. These simulations give us a competitive advantage by allowing us to more accurately and efficiently: (i) evaluate the combined effects of genetic markers and other risk factors in order to establish risk assessment; (ii) link risk assessment profiles to treatment regimes; (iii) identify new candidate genes or genetic markers; and (iv) design clinical trials more effectively. (7) Integrated Risk Assessment and Treatment Planning Approach to Multi-Factorial Diseases. While we recognize the importance of our genetic susceptibility tests, we also acknowledge the reality of other risk factors contributing to the development of disease. Thus certain diseases are often referred to as "multi-factorial" given that several factors contribute to their causation. See "Genetic Testing" at page 25. We have attempted to take a holistic approach toward analyzing the disease process. Therefore our risk assessment strategy includes not only the results of our genetic susceptibility tests, but also other known risk factors. By combining our test results together with present risk factors we are able to develop a more accurate risk assessment tool. We then link patient testing criteria to possible treatment suggestions. We package this data together with our genetic susceptibility tests to enhance our tests' practical utility to clinicians actually administering the tests. (8) Experienced in Structuring Clinical Trials to Evaluate Discoveries. We have extensive experience in product development, including designing and conducting clinical trials to evaluate genetic and drug discoveries. In the past, we provided clinical research services to pharmaceutical and medical/dental device companies. We have performed contract research for many of the world's leading health care and pharmaceutical companies. Some of our representative clients have included: Proctor & Gamble; Alpharma/Dumex; Implant Innovations, Inc.; W. L. Gore & Associates; Teledyne WaterPik; and Oral B. Commencing in 1994, our research team has increasingly focused on the development of our own products. Our research capability expedites the development process and increases our knowledge about target diseases. Moreover, we have already successfully completed our initial proof trials on all four of our genetic susceptibility test and confirmatory trials on three out of four of these tests. See "Pre-Marketing Trials/Status of Susceptibility Tests" at pages 35 and 36. (9) Cost Effective Commercialization Process. Because we are focusing primarily on genetic susceptibility testing services and intend to develop at least four genetic susceptibility tests initially, with more tests in the future, we have designed our current product distribution and customer service operation in such a way that it can process, perform, track, bill and collect large volumes of genetic tests with appropriate quality and customer service support. We have carefully designed our product distribution and customer service operations to allow for multi-test or product capabilities. The design and functionality of our product distribution and customer service operations has been created in such a 43 48 way as to enable us to easily move from a company currently selling only one genetic susceptibility test to a company distributing a portfolio of four or more such tests in multiple markets on a worldwide basis. Further, our operations have the capability of processing additional tests or products at even greater volumes with little or no modifications or increases in capital outlays. Moreover, as each test or product is added into our distribution stream, the cost per test to us decreases allowing for increased profitability. GOVERNMENT REGULATION The sampling of blood, saliva or cheek scrapings from patients and subsequent analysis in a clinical laboratory does not, at the present time, require Federal Drug Administration ("FDA") or regulatory authority approval inside the U.S. for either the sampling procedure or the analysis itself. The samples are taken in the healthcare provider's office, using standard materials previously approved as medical devices, such as sterile lancets and swabs. The testing procedure itself is performed in one or more registered, certified clinical laboratories under the auspices of the Clinical Laboratory Improvement Amendments of 1988, administered by the Health Care Financing Administration. The federal regulations governing approval of the laboratory facilities and applicable state and local regulations governing the operation of clinical laboratories would also apply. Changes in such regulatory schemes could require advance regulatory approval of genetic susceptibility tests sometime in the future could have a material adverse effect on our business. In addition, while our main focus is on genetic susceptibility testing, we may, in the future, endeavor to partner with pharmaceutical companies in the area of drug development. Any drug products developed by us or our future collaborative partners, prior to marketing in the United States, would be required to undergo an extensive regulatory approval process by the FDA. The regulatory process, which includes preclinical testing and clinical trials of each therapeutic product in order to establish its safety and efficacy, can take many years and requires the expenditure of substantial resources. Data obtained from preclinical and clinical activities are susceptible to varying interpretations which could delay, limit or prevent regulatory agency approval. In addition, delays or rejections may be encountered during the period of therapeutic development, including delays during the period of review of any application. Delays in obtaining regulatory approvals could adversely affect the marketing of any therapeutics developed by us or our collaborative partners, impose costly procedures upon us and our collaborative partners' activities, diminish any competitive advantages that we or our collaborative partners may attain and adversely affect our ability to receive royalties. Once regulatory approval of a product is granted, such approval may impose limitations on the indicated uses for which it may be marketed. Further, even if such regulatory approval is obtained, a marketed product and its manufacturer are subject to continuing review. The discovery of previously unknown problems with a product or manufacturer may result in restrictions on such product or manufacturer. Such restriction could include withdrawal of the product from the market. FACILITIES Our company has offices in the following locations: Flagstaff, Arizona; San Antonio, Texas; and Newport Beach, California. Flagstaff, Arizona is the site of our global commercial operations, including our marketing, sales and customer service organization. The San Antonio Research Center is the principal site of our research and development and employs teams of top medical, dental and computer scientists. Newport Beach is the site of our corporate headquarters. Our commercial operations office located at 3100 N. West Street, Bldg. A, Flagstaff, Arizona, contains 6,000 square feet and is held under a three-year lease which expires in September 2000. Our research and development office, located at 100 N.E. Loop 410, San Antonio, Texas, contains 1,961 usable square feet and is held under a five-year lease that will convert into a month to month tenancy on December 1, 2000 unless either party gives a prior 30 day notice. Our corporate headquarters, located at 4400 MacArthur Boulevard, Suite 980, Newport Beach, California, contains 1,798 usable square feet and is held under a five-year lease which expires in April of 2001. We believe that our current facilities are adequate for the foreseeable future and that alternate facilities are readily available. 44 49 EMPLOYEES As of September 30, 1997, we had 27 full-time employees. Most of our employees are engaged directly in the development and commercialization of our tests. We believe that the success of our business will depend, in part, on our ability to attract and retain qualified personnel. Our employees are not covered by a collective bargaining agreement, and we consider our relations with our employees to be good. LEGAL PROCEEDINGS We are not a party to, nor is our property the subject of, any pending legal proceeding. 45 50 MANAGEMENT EXECUTIVE OFFICERS AND DIRECTORS The executive officers and directors of our company are:
NAME AGE POSITION SINCE - ------------------------------- --- --------------------------------------------- ----- Paul J. White, J.D., L.L.M.(1) 41 President, Chief Executive Officer and 1994 Chairman of the Board of Directors Kenneth S. Kornman, DDS, Ph.D. 50 Chief Scientific Officer and Director 1986 Michael G. Newman, DDS 50 Executive Vice President, Secretary and 1986 Director U. Spencer Allen, MS, MBA 55 Chief Financial Officer and Treasurer 1997 Jeanne Ambruster 40 Vice President, Global Business Operations 1997 Thomas A. Moore(1,2) 46 Director 1997 Ronald A. La Rosa(1,2,3) 40 Director 1997
- --------------- (1) Member of Compensation Committee. (2) Member of Audit Committee. (3) Mr. La Rosa will be appointed as a Director following the completion of this offering. Directors are elected to serve until the next annual meeting of shareholders. Directors serve without cash compensation or other remuneration. See "Principal Shareholders" at page 53. Officers are elected by the Board of Directors and serve until their successors are appointed by the Board of Directors. Biographical resumes of each officer and director are set forth below. Paul J. White, J.D., L.L.M. Mr. White joined the Company as President in 1994. Prior to joining our company, Mr. White was managing partner of White & Resnick, Irvine, California, a mid-size law firm servicing emerging companies. Mr. White was a business and corporate attorney and consultant to emerging health care companies for 15 years. Mr. White holds a B.A. (History/Political Science) from State University of New York at Brockport, a J.D. from Southwestern University and an L.L.M. (Taxation) from the University of San Diego. Kenneth S. Kornman, D.D.S., Ph.D. Dr. Kornman is a co-founder, officer and director of our company and currently serves as Chief Scientific Officer and Director. Prior to founding our company in 1986, he was a Department Chair and Professor at The University of Texas Health Science Center at San Antonio. He has also been a consultant and scientific researcher for many of the major oral care and pharmaceutical companies. Dr. Kornman currently holds academic appointments at The University of Texas Health Science Center and Harvard University. Dr. Kornman holds six patents in the pharmaceutical area, has published two books and more than 100 articles and abstracts and has lectured and consulted worldwide on the transfer of technology to clinical practice. Dr. Kornman holds a B.A. in Economics from Duke University. He obtained a D.D.S. from Emory University. Dr. Kornman also holds an M.S. (Periodontics) and a Ph.D. (Microbiology) from the University of Michigan. Michael G. Newman, D.D.S. Dr. Newman is a co-founder, officer and director of our company and currently serves as Executive Vice President, Secretary and Director. Prior to founding the Company in 1986, he was an adjunct Professor and former Director of the Periodontal Microbiology Laboratory at the University of California at Los Angeles (UCLA) and was president of the American Academy of Periodontology. Dr. Newman is currently a member of the American College of Dentists. Dr. Newman currently holds an academic appointment at UCLA. Dr. Newman has published more than 200 articles and abstracts and is the co-author of four books on microbiology, periodontitis and oral infections. Dr. Newman holds a B.A. and a D.D.S. from the University of California at Los Angeles. U. Spencer Allen, M.S., M.B.A. Mr. Allen joined the Company as Chief Financial Officer in January 1997. From September 1996 to January 1997, Mr. Allen functioned as an independent financial consultant. From August 1995 to August 1996, Mr. Allen was the Vice President (Finance) and Chief 46 51 Financial Officer of Promart Industries, Inc., a houseware products manufacturer. Mr. Allen worked as a self-employed financial consultant from January 1994 to August 1995. Prior to that time, Mr. Allen functioned as general manager of Slow Waltz Imports, Inc., a potpourri manufacturer. Mr. Allen holds B.S. (Engineering Science) from the U.S. Air Force Academy, an M.S. (Electrical Engineering) from the University of Southern California and an M.B.A. (Finance) from George Washington University. Jeanne Ambruster. Ms. Ambruster joined as Vice President, Global Business Operations in February 1997. Prior to joining our company, Ms. Ambruster served as Senior Manager of the Medical and Dental Technologies Business Division for 16 years with W.L. Gore & Associates. At W.L. Gore & Associates, she played a key role in the growth of this division and was the senior business leader responsible for building the company's dental product business. Ms. Ambruster holds a B.A. (Biology and Chemistry) from Pitzer College. Thomas A. Moore. Mr. Moore became a director of our company in 1997. Mr. Moore is the Chief Executive Officer and President of Nelson Communications Inc., one of the largest providers of health care marketing services in the United States. Prior to joining NCI as President in 1996, Mr. Moore was President of Procter & Gamble's $3 billion worldwide prescription and over-the-counter health care business and Group Vice President of the Procter & Gamble Company. He joined Procter & Gamble in 1973 and held positions of increasing responsibility in the company's cleaning products, beauty care, Richardson-Vicks and personal care divisions. He is Chairman of the American Health Foundation -- a nonprofit organization that researched the nutritional and environmental factors in cancer and other diseases. Mr. Moore holds a B.A. (History) from Princeton University. Ronald A. La Rosa, M.B.A. Mr. La Rosa will become a Director upon completion of this offering. Mr. La Rosa is the President and Chief Executive Officer of Delta Technical Coatings, Inc. ("Delta"), a privately-owned consumer product marketing company. Mr. La Rosa has been with Delta for over five years. Prior to joining Delta, Mr. La Rosa worked for over eleven years with various subsidiaries of The Mennon Company, a $600 million consumer products company. Mr. La Rosa's various job capacities included Vice President Finance, Controller, Director of Controls and Director International Finance. Mr. La Rosa is a member of both the American Institute of Certified Public Accountants and the New Jersey Society of Certified Public Accountants. Mr. La Rosa holds a B.S. (Accounting) and an M.B.A. (Finance) from Fairleigh Dickinson University. KEY EMPLOYEES Pamela K. Fink, Ph.D., Executive Director, Biologic Modeling Group. Dr. Fink has operational responsibility for our company's computer technology development. Dr. Fink is an expert in knowledge acquisition and simulation of complex systems. Dr. Fink joined the Company as Executive Director, Biologic Modeling Group in July 1994. She was formerly with the Southwest Research Institute for 10 years as a Section Manager and Staff Scientist. Dr. Fink holds a B.A. (Mathematics and Philosophy of Language) from Eckerd College and an M.A. and Ph.D. in Computer Science from Duke University. Debra J. Moore, M.S., Vice President, Product Development. Ms. Moore joined the Company as the Vice President, Product Development in September 1990. Ms. Moore has 19 years practical experience in identification and development of new health care products. Prior to joining us, Ms. Moore spent 13 years at Procter & Gamble Health Care where she was a Senior Manager in the Oral Care Product Development and Professional Relations Division. Ms. Moore was a leader in the research, development, manufacture and FDA approval of such products as Tartar Control Crest and Peridex, the first prescription drug approved by the FDA for the treatment of periodontal disease. Ms. Moore holds a B.S. (Chemistry) from Central Michigan University and an M.S. (Organic Chemistry) from the University of Wisconsin, Madison. Evan B. Siegel, M.Phil, Ph.D., Vice President, Regulatory Affairs. Dr. Siegel joined our company as Vice President of Regulatory Affairs in August 1996. From January 1994 to July 1996, Dr. Siegel was employed by Quintiles, Inc., a multinational contract research organization, where he held positions as Director, Regulatory Services, Director, Regulatory Consulting, and Principal Regulatory Scientist. From November 1991 until February 1994, he held senior management positions at Astra Pharmaceutical Products, 47 52 Inc. Previously, Dr. Siegel was Director, OTC Regulatory Affairs at Syntex, USA, Inc. and Chief of Special Services and Supervising Toxicologist at the California Food and Drug Branch and a reviewer at the U.S. Food and Drug Administration. Dr. Siegel holds a B.S. (Physics) from Bucknell University, an M.S. (Radiological Health), an M.Phil. (Virology) and a Ph.D. (Virology) from Rutgers University. Todd D. Snowden, Director of Worldwide Sales. Mr. Snowden joined our company as Director of Worldwide Sales, in April 1997. From 1986 until joining us, Mr. Snowden worked in the Regenerative Technologies division at W. L. Gore & Associates, selling surgical devices and regenerative materials and as a product manager with responsibility for all aspects of their products. Mr. Snowden holds a B.S. (Biomedical Engineering) from Catholic University of America. Nancy Whitley, Director of Market Development & Commercialization. Ms. Whitley is involved in transitioning products in the development phase into the marketplace, including leading pre and post-commercial product launches. Ms. Whitley has been the Director of Market Development & Commercialization for our company since February 1997. Prior to joining us, Ms. Whitley was a Senior Manager in the Medical and Dental Technologies Business Division of W. L. Gore & Associates where she worked for 19 years. Ms. Whitley holds a B.A. (Education) from Northern Arizona University. SCIENTIFIC EXPERTS We have engaged a number of scientific experts to render services. With the exception of one expert, we either (i) have entered into written agreements with the expert, each of which provides that we are the sole and exclusive owner of all proprietary rights to all genetic discoveries and related technology, whether developed by us or our consultant; or (ii) receive services from the consultant underneath existing agreements between our company and Sheffield University. We currently have no written agreement in place with Dr. Bailit. Some of our scientific experts are engaged on a project basis while others are kept on a retainer and utilized in accordance with our current needs. Set forth below is a brief description of each scientific expert's background. PROFESSOR GORDON W. DUFF, M.A., PH.D., FRCP Lord Florey Chair and Director of the Division of Molecular and Genetic Medicine The University of Sheffield, U.K. Professor Duff is internationally recognized as a leader and innovator in the genetic aspects of cytokines and the immuno-inflammatory response. He is a fellow of the Royal College of Physicians, Edinburgh. Professor Duff holds a B.A. (Animal Physiology), an M.A. (Physiology) and a B.M., B.Ch., all from the University of Oxford and a Ph.D. in Medicine from the University of London. FRANCESCO S. DI GIOVINE, M.D., PH.D. Head of the Section of Molecular Medicine in the Department of Molecular and Genetic Medicine The University of Sheffield, U.K. Dr. di Giovine is a molecular geneticist managing the Sheffield University Molecular Medicine research and development laboratory. Dr. di Giovine holds a M.D. from the University of Florence, Italy and a Ph.D. (Molecular Immunology) from the University of Edinburgh, U.K. PROFESSOR GRAHAM RUSSELL, M.B., CH.B, D.M., PH.D Director of Division of Biochemical and Musculoskeletal Sciences Professor of Human Metabolism and Clinical Biochemistry The University of Sheffield, U.K. Professor Russell is an internationally recognized researcher in the field of osteoporosis. Professor Russell holds a B.A. (Biochemistry), an M.A. (Biochemistry) and an M.B., Ch.B. (Pharmacology, Therapeutics and Toxicology) from Cambridge University. Dr. Russell also holds a Ph.D. (Chemical Pathology) from Leeds University, as well as a Doctor of Medicine (D.M.) from Oxford University. 48 53 PHILIP R. REILLY M.D., J.D. Eunice Shriver Center Dr. Reilly is an expert in the area of genetic testing and its ethical, legal and clinical utility ramifications. Dr. Reilly is a board certified specialist in clinical genetics and an attorney. Dr. Reilly holds a B.A. (Government) from Cornell University, a J.D. from Columbia University and a M.D. from Yale University. HOWARD L. BAILIT, D.M.D., PH.D. University of Connecticut Health Center Dr. Bailit is a former senior vice president of Medical Policies and Programs for Aetna Health Plans and was responsible for the assessment and acceptance of new medical technology. Dr. Bailit assists with the assessment of new product opportunities with understanding of third-party payor issues. Dr. Bailit holds a D.M.D. from Tufts Dental School, an M.A. (Anthropology) and a Ph.D. (Anthropology) from Harvard University. EXECUTIVE COMPENSATION The following table sets forth total compensation for the year ended December 31, 1996 for the Chief Executive Officer, and each of the other executive officers of our company for each of the last three fiscal years (the "Named Executive Officers"). SUMMARY COMPENSATION TABLE
LONG TERM COMPENSATION ------------------------------- AWARDS ANNUAL COMPENSATION --------------------- PAYOUTS --------------------------------- RESTRICTED SECURITIES ------- OTHER ANNUAL STOCK UNDERLYING LTIP ALL OTHER NAME AND PRINCIPAL SALARY BONUS COMPENSATION AWARD(S) OPTIONS/ PAYOUTS COMPENSATION POSITION YEAR ($) ($) ($) ($) SARS (#) ($) ($) - ------------------------ ---- ------- ----- ------------- ---------- -------- ------- ------------ Paul J. White 1996 138,332 -0- -0- -0- -0- -0- -0- CEO, President 1995 102,226 -0- -0- -0- -0- -0- -0- 1994 60,607 -0- -0- -0- -0- -0- -0- - ------------------------------------------------------------------------------------------------------------------ Kenneth S. Kornman 1996 154,886 -0- -0- -0- -0- -0- -0- Chief Scientific Officer 1995 103,735 -0- 23,797* -0- -0- -0- -0- 1994 217,629 -0- 30,000* -0- -0- -0- -0- - ------------------------------------------------------------------------------------------------------------------ Michael G. Newman 1996 141,695 -0- -0- -0- -0- -0- -0- Executive Vice President 1995 121,536 -0- 23,797* -0- -0- -0- -0- Secretary 1994 274,146 -0- 30,000* -0- -0- -0- -0-
- --------------- * These amounts reflect contributions made to our profit sharing plan. 49 54 OPTION GRANTS IN LAST FISCAL YEAR The following table provides information concerning each grant of options to purchase our Common Stock made during the year ended December 31, 1996 to the Named Executive Officers: OPTION/SAR GRANTS IN LAST FISCAL YEAR (INDIVIDUAL GRANTS)
NUMBER OF SECURITIES PERCENT OF TOTAL UNDERLYING OPTIONS/SARS OPTIONS/SARS GRANTED GRANTED TO EMPLOYEES EXERCISE OR BASE EXPIRATION NAME (#) IN FISCAL YEAR PRICE ($/SH) DATE - ----------------------------- -------------------- -------------------- ---------------- ---------- Paul J. White -0-* -0- -0- N/A Kenneth S. Kornman -0-** -0- -0- N/A Michael G. Newman -0-*** -0- -0- N/A
- --------------- * Does not reflect 25,000 stock options issued in 1997. Does not reflect 20,000 warrants purchased as part of a debt/warrant offering in 1997. See "Debt/Warrant Offering" at page 52. ** Does not reflect 22,000 stock options issued in 1997. Does not reflect 20,000 warrants purchased as part of a debt/warrant offering in 1997. See "Debt/Warrant Offering" at page 52. *** Does not reflect 35,125 stock options issued in 1997. Does not reflect 20,000 warrants purchased as part of a debt/warrant offering in 1997. See "Debt/Warrant Offering" at page 52. 1996 EQUITY INCENTIVE PLAN Our 1996 Equity Incentive Plan (the "Plan") was adopted by the Board of Directors and approved by the shareholders in June 1996. A total of 750,000 shares of Common Stock were originally reserved for issuance under the Plan. The Plan was later amended by vote of both the Board of Directors and the shareholders in May 1997 to increase the number of shares of Common Stock reserved for issuance under the Plan to 1,000,000. The Plan provides for grants of incentive stock options to employees (including officers and employee directors), nonstatutory stock options to employees (including officers and employee directors) and consultants (including non-employee directors), stock appreciation rights ("SARs"), stock awards and stock bonuses. The Plan allows for administration by either the Board of Directors or a committee thereunder, which determines optionees and the terms of options granted, including the exercise price, number of shares subject to the option and the exercisability thereof. The terms of options granted under the Plan generally may not exceed 10 years. The exercise price of options granted under the Plan is determined by the Board of Directors, but, in the case of an incentive stock option, cannot be less than 100% of the fair market value of the Common Stock on the date of grant. The exercise price of all nonstatutory stock options must equal at least 85% of the fair market value of the Common Stock on the date of grant. The exercise price of any stock option granted to an optionee who owns stock possessing more than 10% of the voting power of all classes of stock of our company must equal at least 110% of the fair market value of the Common Stock on the date of grant. The exercise price may be paid in such consideration as determined by the Board of Directors or a committee of the Board, including cash and promissory notes. Options granted under the Plan to employees and consultants have generally not been immediately exercisable and have vested over a thirty-six (36) month period (at the rate of 16.66% of the shares subject to the option at the end of six (6) months and 2.777% at the end of every full month thereafter). No option may be transferred by the optionee other than by will or the laws of descent or distribution. An optionee whose relationship with us or any related corporation ceases for any reason (other than by death or permanent and total disability) may exercise options in the three (3) month period following such cessation (unless such options terminate or expire sooner by their terms) or in such longer period determined by the Board of Directors, provided a period of five (5) years is not exceeded. Shares subject to options granted under the Plan which have lapsed or terminated may again be subject to options granted under the Plan. Furthermore, the Board of Directors may offer to exchange new options for 50 55 existing options, with the shares subject to the existing options again becoming available for grant under the Plan. Upon any merger or consolidation in which we are not the surviving corporation, all outstanding options shall either be assumed or substituted by the surviving entity. If the surviving entity determines not to assume or substitute such options, the options terminate as of the closing of the merger or consolidation. As of September 30, 1997, no shares of Common Stock had been issued upon the exercise of options granted under the Plan, options to purchase 800,579 shares of Common Stock at a weighted average exercise price of $4.37 per share were outstanding and 199,421 shares remained available for future options grants. Prior to this offering, no SARs or restricted stock awards had been given to our employees and consultants. The Plan will terminate in June 2006, unless terminated sooner by the Board of Directors. EMPLOYMENT AGREEMENTS In January 1996, we entered into employment contracts with all three of the Named Executive Officers. Mr. Paul J. White, the Chief Executive Officer and President, currently receives an annual base salary of $140,000 a year, which will increase to $170,000 for 1998. Drs. Kenneth S. Kornman and Michael G. Newman each currently receive an annual base salary of $135,000, which will increase to $165,000 for 1998. Each Named Executive Officer's employment contract has a five year term (beginning in January 1996) which is automatically renewed for an additional twelve months unless six-months prior written notice is given by either party. Each of the Named Executive Officers is also receiving a $600 a month automobile allowance. INDEMNIFICATION OF OFFICERS AND DIRECTORS Our company's Amended and Restated Articles of Incorporation eliminates the liability of directors for monetary damages for an act or omission in the director's capacity as a director, except for: (i) a breach of a director's duty of loyalty to our company or our shareholders; (ii) an act or omission not in good faith that constitutes a breach of duty of that director to our Company or an act or omission that involves intentional misconduct or a knowing violation of the law; (iii) a transaction from which a director received an improper benefit, whether or not the benefit resulted from an action taken within the scope of the director's office; or (iv) an act or omission for which the liability of a director is expressly provided for by an applicable statute. If the Texas Miscellaneous Corporation Laws Act or the Texas Business Corporation Act is amended to authorize action further eliminating or limiting the personal liability of directors, then the liability of a director of our company shall be eliminated or limited to the fullest extent permitted by such statutes, as so amended. Any amendment, repeal or modification of such provision shall be prospective only and shall not adversely affect any right or protection of a director of our company existing at the time of such amendment, repeal or modification. Additionally, it is the position of the Securities and Exchange Commission that indemnification of directors and officers for liabilities arising under the Securities Act of 1933 is against public policy and unenforceable pursuant to Section 14 of the Securities Act of 1933. 51 56 CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS We believe that the transactions set forth below were made on terms no less favorable to us than could have been obtained from unaffiliated third parties. All future transactions, including loans, between us and our officers, directors, principal shareholders and their affiliates will be approved by a majority of the Board of Directors, including a majority of the independent and disinterested outside directors, and will continue to be on terms no less favorable to us than could be obtained from unaffiliated third parties. PRIVATE PLACEMENT OF SECURITIES Between November 1996 and January 1997, we sold 189,188 shares of our Common Stock in a private placement at a price of $3.70 per share. Between March 1997 and September 1997, we sold 293,820 shares of our Common Stock in a second private placement transaction at a price of $5.00 per share. Except for Thomas Moore, who subsequently became one of our directors, all investors in both such private placements were unrelated third party investors who purchased in arms'-length transactions. DEBT/WARRANT OFFERING From August 1, 1997 through October 6, 1997, we borrowed an aggregate of $1,780,000 from a group of lenders evidenced by promissory notes bearing interest at 10% interest rate and due the earlier of fourteen months from the date of the notes or the closing date of an initial public offering (the "Bridge Loans"). As additional consideration for the Bridge Loans, we issued one warrant for each $5.00 loaned to the Company for a total of 356,545 warrants (the "Bridge Warrants"). Each Bridge Warrant entitles the holder to purchase one share of Common Stock at $5.50 per share for a period of five years from the date of issuance. The following officers and directors subscribed to the Bridge Loans in the principal amount indicated after their names: Paul J. White ($100,000/20,000 Bridge Warrants); Kenneth S. Kornman ($100,000/20,000 Bridge Warrants); Michael G. Newman ($100,000/20,000 Bridge Warrants); U. Spencer Allen ($50,000/10,000 Bridge Warrants); Jeanne Ambruster ($50,000/10,000 Bridge Warrants); and Thomas A. Moore ($75,000/15,000 Bridge Warrants). TRANSACTIONS WITH DIRECTORS AND EXECUTIVE OFFICERS Our shareholders have elected Thomas A. Moore to serve as a director. Mr. Moore is also the CEO and President of Nelson Communications, Inc. ("NCI"). We have recently formed a joint venture with NCI. The primary purpose of the joint venture is to market our computer modeling technology to pharmaceutical companies as a tool which provides medical education regarding disease progression. A secondary purpose of the joint venture is to provide marketing information to those patients who test positive on one of our tests and who subsequently send in a business reply card seeking more information. In both aspects of the joint venture, our company will be acting as the technology/information partner and NCI will be functioning as the marketing partner. See "Product Development" at page 36. We believe that the terms of the joint venture are at least as favorable to us as would be available from a company other than NCI in an arm's-length transaction. The disinterested members of the Board of Directors have unanimously approved the execution of this agreement. EMPLOYEE SALARY REDUCTION PLAN In May 1997, in order to reduce our overhead and as an additional incentive to our employees, we instituted a voluntary salary reduction plan where our employees could choose to receive stock options instead of salary. Employees were offered options to purchase 600 shares of Common Stock for every $1,000 their salary was reduced. Most of our employees participated, including all of our officers. A total of 267,079 options to purchase Common Stock at an exercise price of $5.00 or $5.50 per share were issued to employees. 52 57 PRINCIPAL SHAREHOLDERS As of September 30, 1997, we have issued 3,738,007 shares of Common Stock to 72 holders of record. The following table sets forth certain information regarding the beneficial ownership of shares of our Common Stock as of September 30, 1997 by (i) each of our company's directors and executive officers, (ii) each person who beneficially owns more than 5% of the outstanding shares of Common Stock, and (iii) all directors and officers of our company as a group. Unless otherwise indicated, the shareholders listed below may be reached at 4400 MacArthur Boulevard, Suite 980, Newport Beach, California 92660.
PERCENTAGE BENEFICIALLY OWNED(1) SHARES --------------------------------- NAME BENEFICIALLY OWNED BEFORE OFFERING AFTER OFFERING - ---------------------------------------------------- ------------------ --------------- -------------- Kenneth S. Kornman(2)............................... 1,131,235 30.26% 18.13% 100 N.E. Loop 410 San Antonio, Texas 78216 Paul J. White(3).................................... 1,121,110 29.99% 17.97% Michael G. Newman(4)................................ 1,072,110 28.68% 17.19% U. Spencer Allen(5)................................. 62,783 1.68% 1.01% Jeanne Ambruster(6)................................. 38,999 1.04% * 3100 N. West St., Bldg. A Flagstaff, Arizona 86004 Thomas A. Moore(7).................................. 75,998 2.03% 1.22% 41 Madison Avenue, Ste. 27 New York, New York 10010 Ronald A. LaRosa(8)................................. -- * * 231 S. Francisco Place Anaheim Hills, California 92807 All Officers and Directors as a Group (7 persons)(9)....................................... 3,502,235 93.69% 56.14%
- --------------- * Less than one percent. (1) Percentage of ownership for each holder is based on 3,738,007 shares of Common Stock outstanding on September 30, 1997 together with applicable options and warrants for such shareholder. Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission and generally includes shares over which the holder has voting or investment power, subject to community property laws. Shares of Common Stock subject to options and warrants that are currently exercisable or exercisable within 60 days are deemed to be beneficially owned by the person holding the option or warrants for computing such person's percentage, but are not treated as outstanding for computing the percentage of any other person. (2) Includes 983,333 shares held in Rocklyn, Ltd., a Texas limited partnership created for the benefit of the Kornman family, including Mr. Kornman. Includes 27,902 shares issuable pursuant to options exercisable within 60 days of September 30, 1997 and 20,000 shares issuable pursuant to warrants which are immediately exercisable. (3) Mr. Paul J. White and Mrs. Suzette White, as trustees of the White Family Trust, have voting power over 1,022,333 of such shares. The White Family Trust was established for the benefit of members of the White family, including Mr. White. Includes 60,000 shares held in irrevocable trusts created for the benefit of the White's children. Mr. White disclaims beneficial ownership of such shares. Includes 17,777 shares issuable pursuant to options exercisable within 60 days of September 30, 1997 and 20,000 shares pursuant to warrants which are immediately exercisable. (4) Mr. Michael G. Newman and Mrs. Susan L. Newman, as trustees of the Newman Family Trust, have voting power over 806,556 of such shares. The Newman Family Trust was created for the benefit of the family of Michael G. Newman and Mrs. Susan L. Newman. Mr. and Mrs. Newman, as general partners of The Michael and Susan Newman Family L.P., a Delaware limited partnership, have voting power over 196,000 shares included therein. Mr. Newman disclaims beneficial ownership of such shares. Includes 53 58 14,777 shares issuable pursuant to options exercisable within 60 days of September 30, 1997 and 20,000 shares issuable pursuant to warrants which are immediately exercisable. (5) Includes 52,783 shares issuable pursuant to options which are exercisable within 60 days of September 30, 1997 and 10,000 shares issuable pursuant to warrants which are immediately exercisable. (6) Includes 28,999 shares issuable pursuant to options which are exercisable within 60 days of September 30, 1997 and 10,000 shares issuable pursuant to warrants which are immediately exercisable. (7) Includes 6,944 shares issuable pursuant to options which are exercisable within 60 days of September 30, 1997 and 15,000 shares issuable pursuant to warrants which are immediately exercisable. (8) Mr. LaRosa will be appointed as a Director of our company upon completion of this offering. Mr. LaRosa currently holds no beneficial interest in our company. (9) Includes all shares deposited in trust by the officers and directors of our company, in which shares such officers and directors disclaim any beneficial ownership interest. DESCRIPTION OF SECURITIES We are authorized to issue up to 10,000,000 shares of no par value Common Stock and 5,000,000 shares of Preferred Stock. As of September 30, 1997, there were outstanding 3,738,007 shares of Common Stock held of record by 72 persons. No shares of Preferred Stock were issued or outstanding. COMMON STOCK Holders of Common Stock are entitled to one vote per share on all matters to be voted upon by the shareholders. Holders of Common Stock are entitled to receive ratably such dividends, if any, as may be declared by the Board of Directors out of funds legally available therefor. Upon the liquidation, dissolution, or winding up of our company, the holders of Common Stock are entitled to share ratably in all of our assets which are legally available for distribution, after payment of all debts and other liabilities and the liquidation preference of any outstanding Common Stock. Holders of Common Stock have no preemptive, subscription, redemption or conversion rights. The outstanding shares of Common Stock are, and the shares being sold by us in this offering will be, when issued and delivered, validly issued, fully paid and nonassessable. Based upon the number of shares outstanding as of that date, and after giving effect to the sale of the Common Stock offered hereby, there will be 6,238,007 shares of Common Stock outstanding (assuming no exercise of outstanding options, warrants or the Underwriters' over-allotment option). PREFERRED STOCK Our company is authorized to issue up to 5,000,000 shares of Preferred Stock. No shares of Preferred Stock are outstanding. The Board has the authority without any further action by our shareholders to issue any or all of the authorized shares of Preferred Stock in one or more series and to establish the rights, preferences, privileges and restrictions thereof, including dividend rights, conversion rights, voting rights, terms of redemption, liquidation preferences, sinking fund terms and the number of shares constituting any series or the designation of such series. The issuance of Preferred Stock could adversely affect the holders of Common Stock and could have the effect of delaying, deferring or preventing a change in our control. We have no present plans to issue any shares of Preferred Stock. See "Effect of Preferred Stock and Director Removal Provisions" at page 16. OPTIONS AND WARRANTS Options. As of September 30, 1997, 800,579 options to purchase our Common Stock had been issued under our 1996 Equity Incentive Plan. These options vest over time and have a per share exercise price from $3.70 to $5.00. See "1996 Equity Incentive Plan" at page 50. Underwriters' Warrants. Upon completion of this offering, we will have granted to the Underwriters warrants (the "Underwriters' Warrants") to purchase 250,000 shares of Common Stock. The Underwriters' Warrants are exercisable at a price per share equal to 165% of the initial public offering price for a four-year 54 59 period, commencing one year from the effective date of this offering. The Underwriters' Warrants contain anti-dilution provisions providing for adjustments of the exercise price and the number of shares underlying the Underwriters' Warrants upon the occurrence of certain events, including any recapitalization, reclassification, stock dividend, stock split, stock combination or similar transaction. The Underwriters' Warrants grant to the holders thereof certain registration rights which are described below. See "Registration Rights" at page 55 and "Underwriting" at page 57. Bridge Warrants. From August 1, 1997 through October 6, 1997, we borrowed an aggregate of $1,780,000 from a group of lenders evidenced by promissory notes bearing interest at 10% interest rate and due the earlier of fourteen months from the date of the notes or the closing date an initial public offering (the "Bridge Loans"). The Bridge Loans are subordinate to the prior payment in full of all of our secured obligations currently existing or those created in the future. As additional consideration for the Bridge Loans, we issued one warrant for each $5.00 loaned to the Company for a total of 356,545 warrants (the "Bridge Warrants"). Each Bridge Warrant entitles the holder to purchase one share of Common Stock at $5.50 per share for a period of five years from the date of issuance. We can call the Bridge Warrants if the Common Stock is listed on a national market or Nasdaq system and has had a closing price of at least $12.00 per share for thirty (30) consecutive trading days. REGISTRATION RIGHTS In connection with the Underwriters' Warrants, the holders of the Common Stock issuable upon exercise of the Underwriters' Warrants have the right to notice and inclusion in any registration statement filed by us for a period of six (6) years commencing one year after our initial public offering closes solely at our expense (but excluding fees and expenses of the holder's counsel and any underwriting or selling commissions). Additionally, we agreed to allow one demand registration for a period of four years from the effective date of the registration statement, upon written demand of holder(s) representing a majority of the outstanding Underwriters' Warrants, solely at our expense (but excluding fees and expenses of the holder's counsel and any underwriting or selling commissions). Additionally, the Bridge Warrant holders are permitted one (1) S-3 demand registration upon request of holders of fifty percent (50%) of the outstanding Bridge Warrants. TRANSFER AGENT AND REGISTRAR U.S. Stock Transfer Corporation will act as transfer agent and registrar for our Common Stock. SHARES ELIGIBLE FOR FUTURE SALE Upon completion of this offering, we will have 6,238,007 outstanding shares of Common Stock (assuming no exercise of outstanding options, warrants or Underwriters' over-allotment option). Of these shares, the 2,500,000 shares sold to the public in this offering will be freely tradeable without restrictions or further registration under the Securities Act, except for any shares purchased by our "affiliates" within the meaning of the Securities Act, which will be subject to the resale limitations of Rule 144. The remaining 3,738,007 shares held by existing shareholders were issued by us in private transactions in reliance upon one or more exemptions under the Securities Act, are "restricted securities" as that term is defined in Rule 144 promulgated under the Securities Act. Such restricted securities may be sold in compliance with such Rule, pursuant to registration under the Securities Act or pursuant to an exemption therefrom. Generally, under Rule 144, each person holding restricted securities for a period of one year may, every three months after such one year holding period, sell in ordinary brokerage transactions or to market makers an amount of shares equal to the greater of one percent of our then outstanding Common Stock or the average weekly trading volume during the four weeks prior to the proposed sale. In addition, sales under Rule 144 may be made only through unsolicited "broker's transactions" or to a "market maker" and are subject to various other conditions. The limitation on the number of shares which may be sold under Rule 144 and the "broker's transaction" requirement do not apply to restricted securities sold for the account of a person who is not and has not been our "affiliate" (as that term is defined in the Act) during the three months prior to the proposed sale and who has beneficially owned the securities for at least two years. 55 60 Prior to the offering, there has been no market for the Common Stock, and no predictions can be made as to the effect, if any, that sales of shares under Rule 144 or the availability of shares for sale will have on the market prices prevailing from time to time. Sales of substantial amounts of Common Stock in the public market following this offering could lower the market price of the Common Stock. Of the 6,238,007 shares of Common Stock to be outstanding after this offering (assuming no exercise of outstanding options, warrants or the overallotment option), 2,500,000 shares will be freely tradeable without restriction. Upon expiration of the lock-up agreements entered into by the officers and directors of our company, an additional 3,258,053 shares will become eligible for sale one year from the close of this offering, subject to the provisions of Rule 144. Of the remaining 479,954 shares of Common Stock, 5,000 shares will be eligible for resale under Rule 144 following this offering. The remaining 474,954 shares will have been held for less than one year and will become eligible for sale at various dates as the one-year holding period under Rule 144 is satisfied. In addition, we intend to file a registration statement on Form S-8 with respect to the shares of Common Stock issuable upon exercise of options under the 1996 Equity Incentive Plan (the "Plan"). The Plan authorizes the issuance of options relating to up to 1,000,000 shares of Common Stock. Currently, there are 800,579 options that have been issued under the Plan which generally vest over three years. See "1996 Equity Incentive Plan" at page 50. Upon filing of such registration statement, the holders of such options may, subject to vesting requirements, exercise and sell their shares immediately without restriction, except affiliates who are subject to certain volume limitations and manner of sale requirements of Rule 144. Holders of 356,545 warrants to purchase shares are entitled to certain registration rights with respect to such shares. Upon registration, such shares may be sold in the market without limitation. See "Registration Rights" at page 55. Sales of such shares may decrease the market price for our Common Stock. See "Underwriting" at page 57 and "Arbitrary Offering Price of the Common Stock; Possible Volatility of Common Stock Price" at page 16. 56 61 UNDERWRITING CERTAIN PERSONS WHO PARTICIPATE IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS THAT STABILIZE, MAINTAIN OR OTHERWISE AFFECT THE PRICE OF THE SHARES, INCLUDING PURCHASES OF SHARES TO MAINTAIN THEIR MARKET PRICE OR PURCHASES TO COVER SOME OR ALL OF THE UNDERWRITERS' SHORT POSITION IN THE SHARES. Subject to the terms and conditions set forth in the underwriting agreement (the "Underwriting Agreement"), we have agreed to sell to each of the underwriters named below (the "Underwriters"), and each of the Underwriters, for whom Nutmeg Securities, Ltd. is acting as representative (the "Representative"), has severally agreed to purchase, the number of shares of Common Stock set forth opposite its name below. Under certain circumstances, the commitments of nondefaulting Underwriters may be increased as set forth in the Agreement Among Underwriters.
NUMBER UNDERWRITER OF SHARES ------------------------------------------------------------------ ---------- Nutmeg Securities, Ltd............................................ Millennium Financial Group, Inc................................... Total........................................................ 2,500,000 =========
The Underwriting Agreement provides that the obligations of the Underwriters thereunder are subject to approval of certain legal matters by counsel and to various other conditions. The nature of the Underwriters' obligations is such that they are committed to purchase and pay for all of the above shares of Common Stock if any are purchased. The Underwriters propose to offer the shares of Common Stock directly to the public at the public offering price set forth on the cover page of this Prospectus. We have granted to the Underwriters a 30-day over-allotment option to purchase up to 375,000 additional shares of Common Stock at the public offering price less the underwriting discount. The Underwriters may exercise such option only to cover over-allotments made in connection with the sale of the shares of Common Stock offered hereby. We have also agreed to sell to the Underwriters, for nominal consideration, warrants (the "Underwriters' Warrants") to purchase the number of shares of our Common Stock equal to 10% of the total number of shares of Common Stock sold in this offering at a price per share equal to 165% of the initial public offering price of the Common Stock. The Underwriters' Warrants will be exercisable for a period of four years commencing one year from the effective date of this offering and will contain certain demand and "piggyback" registration rights with respect to the Common Stock issuable upon the exercise of the Underwriters' Warrants. The Underwriters' Warrants are not transferable (except to members of the syndicate and their affiliates). The exercise price and the number of shares issuable upon exercise may, under certain circumstances, be subject to adjustment pursuant to antidilution provisions. We have agreed to allow the Underwriters a commission of eight percent (8%) of the public offering price of the shares of Common Stock. Additionally, we will be paying the Underwriters, following the closing of this offering, a nonaccountable expense allowance equal to three percent (3%) of the aggregate public offering price of the shares of Common Stock, less any applicable deposits. We have further agreed to indemnify the Underwriters against certain liabilities, losses and expenses, including liabilities under the Securities Act, or to contribute to payments that the Underwriters may be 57 62 required to make in respect thereof. We also have agreed to reimburse the Underwriters for certain out-of-pocket expenses incurred in connection with the offering. The Underwriters have advised us that they do not intend to make sales to discretionary accounts. Our officers and directors who in the aggregate beneficially own 3,258,053 shares of Common Stock have agreed not to, directly or indirectly, sell, offer, contract to sell, make any short sale, pledge or otherwise dispose of such shares for a period of 12 months after the date of the closing of this offering. In connection with this offering certain underwriters may engage in passive market making transactions in the shares in accordance with Rule 103 of Regulation M. Further, the Underwriters' selling group members and their respective affiliates may engage in transactions that stabilize, maintain or otherwise affect the market price of our shares. These transactions may include stabilization transactions permitted by Rule 104 of Regulation M, under which persons may bid for or purchase shares to stabilize the market price. The Underwriters may also create a "short position" for their own account by selling more shares in the offering than they are committed to purchase, and in that case they may purchase shares in the open market after this offering is completed to cover all or a part of their short position. The Representative may also cover all or a portion of their short position, up to 375,000 shares, by exercising their over-allotment option described above and on the cover of this prospectus. LEGAL MATTERS Certain legal matters with respect to the legality of the issuance of the Common Stock offered hereby will be passed upon for us by Jeffers, Wilson, Shaff & Falk, LLP, Irvine, California. Certain legal matters in connection with the offering will be passed upon for the Underwriters by William M. Prifti, Esq., Lynnfield, Massachusetts. EXPERTS The audited consolidated financial statements included in this Prospectus and elsewhere in the Registration Statement have been audited by Singer Lewak Greenbaum & Goldstein LLP, Los Angeles, California, independent public accountants, as indicated in their reports with respect thereto, and are included herein in reliance upon the authority of said firm as experts in giving said reports. ADDITIONAL INFORMATION We have filed with the Securities and Exchange Commission (the "Commission") a Registration Statement (the "Registration Statement") under the Securities Act with respect to the securities offered hereby. This Prospectus does not contain all of the information set forth in the Registration Statement, certain parts of which are omitted in accordance with the rules and regulations of the Commission. For further information with respect to us and this offering, reference is made to the Registration Statement, including the exhibits and schedules filed therewith, copies of which may be obtained at prescribed rates from the Commission at its principal office at 450 Fifth Street N.W., Washington, D.C. 20549, and at the following regional offices of the Commission: 75 Park Place, New York 10007, and Northwestern Atrium Center, 500 West Madison Street, Suite 1400 Chicago, Illinois 60604. In addition, the Commission maintains a World Wide Web site on the Internet at http://www.sec.gov that contains reports, proxy and information statements and other documents filed electronically with the Commission, including the Registration Statement. Descriptions contained in this Prospectus as to the contents of any agreement or other documents filed as an exhibit to the Registration Statement are not necessarily complete and each such description is qualified by reference to such agreement or document. We intend to furnish to our shareholders annual reports containing financial statements audited and reported upon by our independent public accountants. 58 63 INDEX TO FINANCIAL STATEMENTS OF MEDICAL SCIENCE SYSTEMS, INC.
PAGE ----------- REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS............................... F-2 FINANCIAL STATEMENTS Balance Sheets................................................................. F-3 Statements of Operations....................................................... F-4 Statements of Shareholders' Deficit............................................ F-5 Statements of Cash Flows....................................................... F-6 Notes to Financial Statements.................................................. F-7 - F-17
F-1 64 REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors and Shareholders Medical Science Systems, Inc. We have audited the accompanying balance sheet of Medical Science Systems, Inc. as of December 31, 1996 and the related statements of operations, shareholders' deficit, and cash flows for each of the two years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Medical Science Systems, Inc. as of December 31, 1996, and the results of its operations and its cash flows, for each of the two years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. SINGER LEWAK GREENBAUM & GOLDSTEIN LLP Los Angeles, California September 26, 1997 F-2 65 MEDICAL SCIENCE SYSTEMS, INC. BALANCE SHEETS AS OF DECEMBER 31, 1996 AND SEPTEMBER 30, 1997 (UNAUDITED) ASSETS (Note 4)
DECEMBER 31, SEPTEMBER 30, 1996 1997 ------------- ------------- (UNAUDITED) Current assets Cash and cash equivalents (Note 2).............................. $ 55,966 $ 869,627 Accounts receivable............................................. 12,359 6,365 Inventories..................................................... -- 6,721 Due from shareholder............................................ 6,565 -- Deposits........................................................ -- 17,816 ------------ ------------ Total current assets......................................... 74,890 900,529 Furniture and equipment, net (Note 3)............................. 82,877 188,458 Patents........................................................... 154,195 261,475 Deferred offering costs........................................... -- 87,000 ------------ ------------ Total assets............................................ $ 311,962 $ 1,437,462 ============ ============ LIABILITIES AND SHAREHOLDERS' DEFICIT Current liabilities Revolving line of credit (Note 4)............................... $ 353,723 $ -- Accounts payable................................................ 219,669 320,922 Accrued expenses................................................ 44,384 202,539 Accrued officer compensation (Note 11).......................... 127,500 -- Deferred rent................................................... 12,703 10,217 Deferred income................................................. -- 10,400 Current portion of long-term debt (Note 4)...................... 44,489 147,648 Current portion of capitalized lease obligations (Note 10)...... 8,408 40,311 ------------ ------------ Total current liabilities.................................... 810,876 732,037 Promissory notes (Note 5)......................................... 1,550,000 Long-term debt, less current portion (Note 4)..................... 173,798 524,176 Capitalized lease obligations, less current portion (Note 10)..... 27,036 94,790 ------------ ------------ Total liabilities............................................ 1,011,710 2,901,003 ------------ ------------ Commitments and contingencies (Note 10) Shareholders' deficit (Notes 7 and 9) Preferred stock, no par value 5,000,000 shares authorized none issued and outstanding... -- -- Common stock, no par value 10,000,000 shares authorized; 3,295,539 and 3,738,007 (unaudited) shares issued and outstanding.................................................. 171,500 2,450,036 Accumulated deficit............................................. (871,248) (3,913,577) ------------ ------------ Total shareholders' deficit.................................. (699,748) (1,463,541) ------------ ------------ Total liabilities and shareholders' deficit............. $ 311,962 $ 1,437,462 ============ ============
The accompanying notes are an integral part of these financial statements. F-3 66 MEDICAL SCIENCE SYSTEMS, INC. STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 (UNAUDITED)
FOR THE YEARS ENDED FOR THE NINE MONTHS ENDED DECEMBER 31, SEPTEMBER 30, ------------------------ -------------------------- 1996 1995 1997 1996 ---------- ---------- ----------- ----------- (UNAUDITED) (UNAUDITED) Sales....................................... $1,918,879 $1,872,932 $ 152,476 $ 1,905,380 Cost of sales............................... 547,766 367,520 149,702 538,172 ---------- ---------- ----------- ----------- Gross profit................................ 1,371,113 1,505,412 2,774 1,367,208 ---------- ---------- ----------- ----------- Expenses Research and development.................. 958,249 582,595 784,722 681,871 Selling, general, and administrative...... 1,162,768 755,785 2,164,141 776,064 ---------- ---------- ----------- ----------- Total expenses......................... 2,121,017 1,338,380 2,948,863 1,457,935 ---------- ---------- ----------- ----------- Income (loss) from operations............... (749,904) 167,032 (2,946,089) (90,727) ---------- ---------- ----------- ----------- Other income (expense) Interest income........................... 8,561 35 2,417 7,918 Interest expense.......................... (34,229) (14,300) (98,657) (13,728) Loss on disposal of assets................ (6,934) -- -- -- ---------- ---------- ----------- ----------- Total other income (expense)........... (32,602) (14,265) (96,240) (5,810) ---------- ---------- ----------- ----------- Income (loss) before provision for income taxes..................................... (782,506) 152,767 (3,042,329) (96,537) Provision for income taxes.................. 6,040 2,755 -- ---------- ---------- ----------- ----------- Net income (loss)........................... $ (788,546) $ 150,012 $(3,042,329) $ (96,537) ========== ========== =========== =========== Earnings (loss) per common share............ $ (.18) $ .03 $ (.71) $ (.02) ========== ========== =========== =========== Weighted average common shares outstanding............................... 4,288,436 4,288,436 4,288,436 4,288,436 ========== ========== =========== ===========
The accompanying notes are an integral part of these financial statements. F-4 67 MEDICAL SCIENCE SYSTEMS, INC. STATEMENTS OF SHAREHOLDERS' DEFICIT FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 (UNAUDITED)
COMMON STOCK ----------------------- ACCUMULATED SHARES AMOUNT DEFICIT TOTAL --------- ---------- ----------- ----------- Balance, December 31, 1994.................. 3,249,999 $ 3,000 $ (100,714) $ (97,714) Distribution to shareholders................ (132,000) (132,000) Net income.................................. 150,012 150,012 --------- ---------- ----------- ----------- Balance, December 31, 1995.................. 3,249,999 3,000 (82,702) (79,702) Sale of common stock (Note 7)............... 40,540 150,000 150,000 Common stock issued for services rendered... 5,000 18,500 18,500 Net loss.................................... (788,546) (788,546) --------- ---------- ----------- ----------- Balance, December 31, 1996.................. 3,295,539 171,500 (871,248) (699,748) Sale of common stock (unaudited) (Note 7)... 148,648 550,000 550,000 Sale of common stock (unaudited) (Note 7)... 293,820 1,469,100 1,469,100 Offering costs (unaudited).................. (136,975) (136,975) Stock options issued for reduction in salary (unaudited) (Note 9)...................... 370,943 370,943 Issuance of warrants resulting in additional interest expense (unaudited) (Note 5)..... 25,468 25,468 Net loss (unaudited)........................ (3,042,329) (3,042,329) --------- ---------- ----------- ----------- Balance, September 30, 1997 (unaudited)..... 3,738,007 $2,450,036 $(3,913,577) $(1,463,541) ========= ========== =========== ===========
The accompanying notes are an integral part of these financial statements. F-5 68 MEDICAL SCIENCE SYSTEMS, INC. STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 (UNAUDITED)
FOR THE YEARS ENDED FOR THE NINE MONTHS ENDED DECEMBER 31, SEPTEMBER 30, --------------------- -------------------------- 1996 1995 1997 1996 --------- -------- ----------- ----------- (UNAUDITED) (UNAUDITED) CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss)................................................ $(788,546) $150,012 $(3,042,329) $ (96,537) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities Loss on sale of assets......................................... 6,934 -- -- -- Depreciation and amortization.................................. 27,330 14,118 48,610 20,446 Issuance of common stock for services.......................... 18,500 -- -- 18,500 Issuance of stock options in exchange for a reduction in salary....................................................... -- -- 370,943 -- Issuance of warrants resulting in additional interest expense...................................................... -- 25,468 (Increase) decrease in Accounts receivable............................................ 315,241 (324,376) 5,994 286,746 Inventories.................................................... -- (6,721) Prepaid expenses............................................... -- 900 -- -- Due from shareholder........................................... (6,565) 394 6,565 (42,000) Deposits....................................................... -- (17,816) Increase (decrease) in Accounts payable............................................... 198,090 (69,143) 101,253 28,779 Accrued expenses............................................... 140,323 (25,497) 158,155 127,377 Accrued officer compensation................................... -- (127,500) Unearned revenues.............................................. (366,051) 366,051 -- (366,051) Deferred rent.................................................. 12,703 -- (2,486) -- Deferred income................................................ -- 10,400 --------- --------- ----------- --------- Net cash provided by (used in) operating activities................ (442,041) 112,459 (2,469,464) (22,740) --------- --------- ----------- --------- CASH FLOWS FROM INVESTING ACTIVITIES Purchase of furniture and equipment.............................. (31,942) (35,743) (35,194) (7,268) Increase in patents.............................................. (128,559) (25,636) (107,601) (37,500) Proceeds from sale of assets..................................... 13,000 -- -- -- --------- --------- ----------- --------- Net cash used in investing activities.............................. (147,501) (61,379) (142,795) (44,768) --------- --------- ----------- --------- CASH FLOWS FROM FINANCING ACTIVITIES Sale of common stock............................................. 150,000 -- 1,882,125 -- Issuance of promissory notes..................................... -- 1,550,000 Increase in deferred offering costs.............................. -- -- (87,000) -- Distribution to shareholders..................................... -- (132,000) -- -- Proceeds from note payable....................................... 250,000 -- -- 250,000 Principal payments on long-term debt............................. (31,713) -- (46,463) (21,244) Borrowings on line of credit, net................................ 209,723 144,000 146,277 105,990 Principal payments on capital lease obligations.................. (5,120) -- (19,019) (4,104) --------- -------- ----------- ----------- Net cash provided by financing activities.......................... 572,890 12,000 3,425,920 330,642 --------- -------- ----------- ----------- Net increase (decrease) in cash.................................... (16,652) 63,080 813,661 263,134 Cash and cash equivalents, beginning of period..................... 72,618 9,538 55,966 72,618 --------- -------- ----------- ----------- Cash and cash equivalents, end of period........................... $ 55,966 $ 72,618 $ 869,627 $ 335,752 ========== ========= ============ ========== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Interest paid.................................................... $ 29,549 $ 14,300 $ 59,194 $ 13,728 ========== ========= ============ ========== Income taxes paid................................................ $ 6,040 $ 2,755 $ -- $ -- ========== ========= ============ ==========
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES During the year ended December 31, 1996 and the nine months ended September 30, 1997 and 1996, the Company acquired furniture and equipment of $40,564, $118,676 (unaudited), and $40,564 (unaudited), respectively, under capitalized lease obligations. The accompanying notes are an integral part of these financial statements. F-6 69 MEDICAL SCIENCE SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 (UNAUDITED) (THE INFORMATION WITH RESPECT TO THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 IS UNAUDITED.) NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization and Line of Business Medical Science Systems, Inc., a Texas corporation, (the "Company") originally operated under two separate corporations, known as Oral Science Systems and Oral Science Technologies. In 1995 Oral Science Systems was merged into Oral Science Technologies and Oral Science Technologies was renamed Medical Science Systems, Inc. The merger was accounted for in a manner similar to a pooling of interest, accordingly, the results of operations for the year ended December 31, 1995 include Oral Science Systems from January 1, 1995 to the date of the merger. The Company is currently developing a line of genetic susceptibility tests and therapeutic targets for common diseases. As of December 31, 1996, the Company has commercially introduced one such product and is in various stages of development for several others. The Company also provides clinical trials and research services under contract to pharmaceutical companies, and such services generated substantially all of the Company's revenues for the years ended December 31, 1996 and 1995. Interim Financial Information The unaudited financial information furnished herein reflects all adjustments, consisting only of normal recurring adjustments, which in the opinion of management, are necessary to fairly state the Company's financial position, the results of its operations, and cash flows for the periods present. The results of operations for the nine months ended September 30, 1997 are not necessarily indicative of results for the entire fiscal year ending December 31, 1997. Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reported periods. Actual results could differ from those estimates. Fair Value of Financial Instruments The Company measures its financial assets and liabilities in accordance with generally accepted accounting principles. For certain of the Company's financial instruments including cash, accounts receivable, accounts payable, accrued expenses, and accrued officer compensation, the carrying amounts approximate fair value due to their short maturities. The amounts shown for line of credit, long-term debt, and capital lease obligations also approximate fair value because current interest rates and terms offered to the Company for similar debt and lease agreements are substantially the same. F-7 70 MEDICAL SCIENCE SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 (UNAUDITED) (THE INFORMATION WITH RESPECT TO THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 IS UNAUDITED.) NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Furniture and Equipment Furniture and equipment, including equipment under capital leases, are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are provided using the straight-line method over the estimated useful lives of three to five years as follows: Computer equipment.................................. 3 years Furniture and fixtures.............................. 5 years Computer software................................... 3 years Equipment under capital leases...................... 3 years
Betterments, renewals, and extraordinary repairs that extend the life of the asset are capitalized; other repairs and maintenance charges are expensed as incurred. The cost and related accumulated depreciation applicable to assets retired are removed from the accounts, and the gain or loss on disposition is recognized in the statement of operations. Patents The cost of acquiring patents, which consists principally of legal fees, is being amortized using the straight-line method of their useful lives of ten years beginning from the time the patents are awarded. The Company was issued a patent in August 1997 and currently has ten patents pending; accordingly, the Company had not recognized any amortization related to the ten pending patents as of September 30, 1997. The Company recognized $321 (unaudited) in amortization expense for the nine months ended September 30, 1997 related to the patent issued in August 1997. Deferred Offering Costs Amounts paid for costs associated with an anticipated initial public offering ("IPO") are capitalized and will be recorded as a reduction to common stock upon the completion of the IPO. In the event that the IPO is not successful, the deferred offering costs will be charged to expense. Revenue Recognition Contract revenues are recognized ratably as services are provided based on a fixed contract price or on negotiated hourly rates. The Company has no unbilled accounts receivable under any contracts at December 31, 1996 and September 30, 1997 (unaudited). Provision for anticipated losses on fixed-price contracts is made in the period such losses are identified. Revenue from genetic susceptibility tests is recognized when the tests have been completed and the results reported to the doctors. Concentrations of Credit Risk The Company sells products and provides contract services for customers primarily in the United States and extends credit based on an evaluation of the customer's financial condition, generally without requiring collateral. Exposure to losses on receivables is principally dependent on each customer's financial condition. The Company monitors its exposure for credit losses and maintains allowances for anticipated losses. F-8 71 MEDICAL SCIENCE SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 (UNAUDITED) (THE INFORMATION WITH RESPECT TO THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 IS UNAUDITED.) NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) During the year ended December 31, 1996, the Company did business with three customers whose sales comprised approximately 99% of revenues. Amounts due from these customers represented 100% of accounts receivable at December 31, 1996. During the year ended December 31, 1995, the Company did business with two customers whose sales comprised approximately 85% of revenues. During the nine months ended September 30, 1996, the Company did business with three customers whose sales comprised approximately 100% of revenues. Research and Development Research and development costs related to the development of new products are expensed as incurred. Income Taxes Prior to September 30, 1996, the Company had elected to be treated as an "S" corporation for federal and state tax purposes. Effective September 30, 1996, the Company terminated such election and became taxable as a "C" corporation. The Company will not realize any future tax benefits of net operating losses incurred prior to September 30, 1996. The Company accounts for income taxes under the liability method required by Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." Deferred tax assets and liabilities reflect the expected future tax consequences of events that have been included in the financial statements and tax returns. Deferred tax assets and liabilities are determined based upon the difference between the financial statement and tax bases of assets and liabilities, using the enacted tax rates in effect for the year in which the differences are expected to reverse. The Company has not recorded any deferred tax assets related to operating loss carryforwards generated subsequent to September 30, 1996 due to the uncertainty of the Company's ability to ultimately recognize the benefits of such carryforwards. Net Income (Loss) Per Share Net income (loss) per share is based on the weighted average number of common and common equivalent shares outstanding during the period. In connection with the Company's IPO, common stock issued for consideration below the IPO per share price (assuming an IPO price of $9.00) during the twelve months before the filing of the registration statement, plus options and warrants to purchase the Company's common stock issued for consideration below the IPO per share price during the same period (using the treasury stock method), have been included in the calculation of common shares outstanding as if they had been outstanding for all periods presented. Cash and Cash Equivalents For purposes of the statements of cash flows, the Company considers all highly-liquid investments purchased with original maturities of three months or less to be cash equivalents. F-9 72 MEDICAL SCIENCE SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 (UNAUDITED) (THE INFORMATION WITH RESPECT TO THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 IS UNAUDITED.) NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Risks and Uncertainties Commercial success of genetic susceptibility tests will depend upon their acceptance as medically useful and cost-effective by patients, physicians, dentists, other members of the medical and dental community, and third-party payers. The Company plans to expend substantial financial resources to promote the benefits of the Company's susceptibility tests. It is uncertain whether current genetic susceptibility tests or others that the Company may develop will gain acceptance on a timely basis. Research in the field of disease predisposing genes and genetic markers is intense and highly competitive. The Company has many competitors in the United States and abroad which have considerably greater financial, technical, marketing, and other resources available. If the Company does not discover disease predisposing genes or genetic markers and develop susceptibility tests and launch such services or products before their competitors, then sales and earnings will be reduced or eliminated. The Company's ability to successfully commercialize genetic susceptibility tests depends on obtaining adequate reimbursement for such products and related treatment from government and private health care insurers and other third-party payers. Doctors' decisions to recommend genetic susceptibility tests will be influenced by the scope and reimbursement for such tests by third-party payors. If both third-party payors and individuals are unwilling to pay for the test, then the number of tests performed will significantly decrease, therefore resulting in a reduction of revenues. The Company entered into an agreement with Sheffield University, whereby the Company will undertake the development and commercialization of any discoveries resulting from Sheffield University's research. The agreement may be terminated with or without cause by either party upon six-months notice. If Sheffield University terminated the agreement, such termination could make the discovery and commercial introduction of new products more difficult or unlikely. Recently Issued Accounting Pronouncement The Financial Accounting Standards Board ("FASB") issued SFAS No. 128, "Earnings Per Share," which is effective for financial statements issued for periods ending after December 15, 1997, including interim periods. SFAS No. 128 requires public companies to present basic earnings per share and, if applicable, diluted earnings per share instead of primary and fully-diluted earnings per share. The Company does not believe that diluted earnings per share in accordance with SFAS No. 128 will be materially different from the earnings per share previously reported. SFAS No. 129, "Disclosure of Information about Capital Structures," issued by FASB is effective for financial statements ending after December 15, 1997. The new standard reinstates various securities disclosure requirements previously in effect under Accounting Principles Board ("APB") Opinion No. 15, "Computing Earnings per Share," which has been superseded by SFAS No. 128. The Company does not expect adoption of SFAS No. 129 to have a material effect, if any, on its financial position or results of operations. SFAS No. 130, "Reporting Comprehensive Income," issued by FASB is effective for financial statements with fiscal years beginning after December 15, 1997. SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. The Company does not expect adoption of SFAS No. 130 to have a material effect, if any, on its financial position or results of operations. F-10 73 MEDICAL SCIENCE SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 (UNAUDITED) (THE INFORMATION WITH RESPECT TO THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 IS UNAUDITED.) NOTE 2 -- CASH The Company maintains cash deposits at several banks. Deposits at each bank are insured by the Federal Deposit Insurance Corporation up to $100,000. As of December 31, 1996 and September 30, 1997, uninsured portions of balances held at these financial institutions totaled $0 and $866,985 (unaudited), respectively. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk on cash and cash equivalents. NOTE 3 -- FURNITURE AND EQUIPMENT Furniture and equipment consisted of the following:
DECEMBER 31, SEPTEMBER 30, 1996 1997 ------------ ------------- (UNAUDITED) Computer equipment................................ $113,470 $ 132,542 Furniture and fixtures............................ 9,053 18,626 Computer software................................. 20,531 27,080 Equipment under capitalized leases................ 40,564 159,240 -------- --------- 183,618 337,488 Less accumulated depreciation and amortization.... 100,741 149,030 -------- --------- Total................................... $ 82,877 $ 188,458 ======== =========
NOTE 4 -- NOTES PAYABLE AND REVOLVING LINE OF CREDIT WITH BANK In March 1996, the Company entered into a revolving line of credit agreement with a bank to borrow up to $250,000, and a note payable of $250,000, for working capital purposes and to repay the outstanding borrowings under certain promissory notes. In October 1996, the line of credit was increased to provide for total borrowings of up to $500,000. The line of credit originally matured in March 1997 and was extended to June 1997 at which time all outstanding principal was converted into a five-year note payable, payable in sixty monthly installments of $8,334 (unaudited) plus interest. The line of credit bore interest at the bank's prime rate plus 1.75% (effectively 10% at December 31, 1996) which was payable monthly in arrears. At December 31, 1996, the Company had outstanding borrowings of $353,723 under the revolving line of credit and at September 30, 1997 had outstanding borrowings of $671,824 (unaudited) under the notes payable. The $250,000 note payable matures in March 2001 and requires monthly payments of principal and interest of $5,222. The $250,000 note payable bears interest at a fixed rate of 9.125% per annum. Required principal payments under the notes payable are as follows:
YEAR ENDING YEAR ENDING DECEMBER 31, SEPTEMBER 30, ------------ ------------- (UNAUDITED) 1997............................................ $ 44,489 $ -- 1998............................................ 48,724 147,648 1999............................................ 53,361 154,432 2000............................................ 58,439 157,126 2001............................................ 13,274 129,284 2002............................................ -- 83,334 -------- --------- 218,287 671,824 Less current portion.............................. 44,489 147,648 -------- --------- Long-term portion............................ $173,798 $ 524,176 ======== =========
F-11 74 MEDICAL SCIENCE SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 (UNAUDITED) (THE INFORMATION WITH RESPECT TO THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 IS UNAUDITED.) NOTE 4 -- TERM LOAN AND REVOLVING LINE OF CREDIT WITH BANK (CONTINUED) Both the notes payable and the revolving line of credit are secured by substantially all of the Company's assets and accounts receivable. In addition, three of the Company's officers have personally guaranteed the Company's obligations under the notes payable and the revolving line of credit. The agreements also include certain covenants which restrict, among other things, the occurrence of new indebtedness. NOTE 5 -- PROMISSORY NOTES In August and September 1997, the Company entered into several subscription agreements to sell subordinated Promissory Notes ("Notes"). In addition, the Company granted one warrant to purchase common stock at an exercise price of $5.50 per share for each $5.00 loaned. The Company issued Notes in the amount of $1,550,000 and issued 310,545 warrants to purchase the Company's common stock. The Notes accrue interest at 10% per annum, and all unpaid principal and interest are due the earlier of 14 months from the date of issuance or the sale of equity securities which results in gross proceeds in excess of $6,000,000. The warrants expire the earlier of five years from the date of issuance or upon the occurrence of the Company's common stock traded on a national or regional stock exchange and the closing price of the common stock equals or exceeds $12.00 per share for thirty consecutive trading days. In connection with the issuance of such warrants, the Company will recognize additional interest expense of $310,545 over the 14-month term of the Notes with the unamortized portion at the closing of the Company's IPO being charged to interest expense immediately. NOTE 6 -- INCOME TAXES Prior to September 30, 1996, the Company elected to be taxed as an "S" corporation for federal and state income tax purposes; the Company's income or loss for such periods was allocated among its shareholders. Consequently, the Company has not recorded any tax provision for any period prior to such date. Effective September 30, 1996, the Company terminated such election and became taxable as a "C" corporation. The Company has not recorded a current or deferred provision for federal income taxes for the period from October 1, 1996 to December 31, 1996 due to losses incurred during that period. The provision for income taxes represents the minimum required for state franchise taxes. To reconcile from the federal statutory tax rate of 34% to the Company's effective tax rate of approximately 1%, the deferred tax asset valuation reserve is deducted. At December 31, 1996, the Company had net operating loss carryforwards of approximately $590,000 and $295,000 for federal and state income tax purposes, respectively, expiring in varying amounts through the year 2012, which are available to offset future federal and state taxable income. The Company also had a research tax credit of $14,400 at December 31, 1996 that expires in 2012. The ability of the Company to utilize the federal and state net operating loss carryforwards may be subject to annual limitations under certain provisions of the Internal Revenue Code as a result of the private placements of common stock and issuance of stock options. F-12 75 MEDICAL SCIENCE SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 (UNAUDITED) (THE INFORMATION WITH RESPECT TO THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 IS UNAUDITED.) NOTE 6 -- INCOME TAXES (CONTINUED) Deferred tax assets (liabilities) consisted of the following:
YEAR ENDED DECEMBER 31, 1996 ------------ Deferred tax assets Net operating loss carryforwards............ $219,900 Research tax credit carryforwards............................. 14,400 Accrual to cash adjustments................................... 82,900 Accrued payroll related costs................................. 71,800 -------- Total deferred tax assets............................. 389,000 Valuation allowance for deferred tax assets..................... 327,300 -------- 61,700 Deferred tax liabilities Patents................................ 61,700 -------- Net deferred tax assets............................... $ -- ========
The valuation allowance increased by $276,900 from September 30, 1996 (the date the Company elected to be taxed as a "C" corporation) to December 31, 1996. NOTE 7 -- CAPITAL STOCK Stock Split In June 1996, the Company's shareholders approved a 1,083.333 for 1 stock split which was completed in July 1996. All references in the financial statements to numbers of common shares and per common share amounts have been restated to reflect the stock split. All disclosures related to sales of common stock, warrants, employee stock plans, and other common stock transactions for all periods presented have also been restated to reflect the stock split. Private Placements of Common Stock In September 1996, the Company's Board of Directors authorized the private offering of shares of the Company's common stock at $3.70 per share up to an aggregate of $5,250,000. For the year ended December 31, 1996 and the nine months ended September 30, 1997, the Company sold 40,540 and 148,648 (unaudited) shares, respectively, of its common stock in private placement transactions at a price of $3.70 per share. The gross proceeds of the sale were approximately $150,000 and $550,000 (unaudited), respectively. During the nine months ended September 30, 1997, the Company sold 293,820 (unaudited) shares of the Company's common stock at $5.00 (unaudited) per share in a private placement. Gross proceeds from the sale were $1,469,100 (unaudited). NOTE 8 -- EMPLOYEE BENEFIT PLAN In 1988, the Company adopted a profit sharing plan covering substantially all of its employees. Under the profit sharing plan, the Company may, at the discretion of the Board of Directors, contribute a portion of the Company's current or accumulated earnings. Company contributions, if any, are credited to participant accounts and are immediately vested. During the years ended December 31, 1996 and 1995 and the nine F-13 76 MEDICAL SCIENCE SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 (UNAUDITED) (THE INFORMATION WITH RESPECT TO THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 IS UNAUDITED.) NOTE 8 -- EMPLOYEE BENEFIT PLAN (CONTINUED) months ended September 30, 1997 (unaudited) and 1996 (unaudited), no contributions were made to the profit sharing plan. NOTE 9 -- STOCK OPTION PLAN In June 1996, the Company's shareholders approved the adoption of the Medical Science Systems, Inc. 1996 Equity Incentive Plan (the "Plan"). The Plan provides for the award of nonqualified and incentive stock options, restricted stock, and stock bonuses to employees, directors, officers, and consultants of the Company. The Plan provides for the grant of nonqualified and incentive stock options to all directors, officers, and employees of the Company. A total of 1,000,000 shares of the Company's common stock have been reserved for award under the amended Plan. Nonqualified and incentive stock options are granted at exercise prices equal to the fair market value of the common stock on the date of grant. One-sixth of the options are generally available for exercise at the end of six months which the remainder of the grant is exercisable ratably over the next 30-month period provided the optionee remains in service to the Company. The Company may also awardshare appreciation rights ("SARs") either in tandem with stock options or independently. At December 31, 1996 and September 30, 1997 (unaudited), no SARs has been awarded under the Plan. The Company has adopted only the disclosure provisions of SFAS No. 123, "Accounting for Stock-Based Compensation." It applies Accounting Principles Bulletin ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related Interpretations in accounting for its plans and does not recognize compensation expense for its stock-based compensation plans other than for restricted stock and options issued to outside third parties. If the Company had elected to recognize compensation expense based upon the fair value at the grant date for awards under this plan consistent with the methodology prescribed by SFAS 123, the Company's net loss and loss per share would be reduced to the pro forma amounts indicated below:
YEAR ENDED DECEMBER 31, 1996 ------------ Net loss As reported................................... $ (788,546) Pro forma..................................... $ (894,437) Loss per common share As reported................................... $ (0.18) Pro forma..................................... $ (0.21)
The fair value of these options was estimated at the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions for the years ended December 31, 1996: dividend yields of 0%; expected volatility of 70%; risk-free interest rates of 6.0%; and expected life of 3 years. The weighted average fair value of options granted during the year ended December 31, 1996 was $1.87, and the weighted average exercise price was $3.70. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the F-14 77 MEDICAL SCIENCE SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 (UNAUDITED) (THE INFORMATION WITH RESPECT TO THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 IS UNAUDITED.) NOTE 9 -- STOCK OPTION PLAN (CONTINUED) Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
WEIGHTED AVERAGE NUMBER GRANTED PRICE OF SHARES PER SHARE --------- ---------------- Outstanding, December 31, 1995..................... -- $ -- Granted.......................................... 142,500 $ 3.70 Exercised........................................ -- $ -- Canceled......................................... -- $ -- ------- Outstanding, December 31, 1996..................... 142,500 $ 3.70 Granted (unaudited).............................. 658,079 $ 4.52 Exercised (unaudited)............................ -- $ -- Canceled (unaudited)............................. -- $ -- ------- Outstanding, September 30, 1997 (unaudited)........ 800,579 $ 4.37 =======
The weighted average remaining contractual life of options outstanding issued under the Plan is ten years at December 31, 1996. The Plan also provides for the award of restricted stock to eligible persons. Such awards may be at prices not less than 85% of the fair market value of the Company's common stock as determined by the Board of Directors. In addition, stock bonuses may be awarded to certain employees or officers of the Company at the discretion of the Board of Directors. In September 1996, the Company's Board of Directors issued a stock bonus of 5,000 shares to a consultant of the Company. The estimated fair value of such shares at the date of the award was charged to expense in 1996. As of September 30, 1997, the Company has not awarded any restricted stock awards. In May 1997, the Company offered to its employees the opportunity to receive stock options to acquire shares of the Company's common stock at $5.00 to $5.50 per share in an exchange for a reduction of salary. Employees elected to reduce their salaries up to 50% for the period from May 1997 to October 1997 in exchange for 600 stock options for each $1,000 of salary reduction. As a result the Company issued 267,079 stock options in exchange for salary reductions of $445,132. The Company will record an expense relating to the issuance of these stock option in the amount of $74,189 per month for each of the six months from May 1997 to October 1997. F-15 78 MEDICAL SCIENCE SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 (UNAUDITED) (THE INFORMATION WITH RESPECT TO THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 IS UNAUDITED.) NOTE 10 -- COMMITMENTS AND CONTINGENCIES The Company leases its office space under non-cancelable operating leases expiring through April 2001. The Company also leases certain office furniture and equipment under capitalized lease obligations. Future minimum rental commitments under lease agreements with initial or remaining terms of one year or more at December 31, 1996 are as follows:
YEAR ENDING OPERATING CAPITAL DECEMBER 31, LEASES LEASES ------------------------------------------------------ -------- ------- 1997................................................ $ 86,316 $11,376 1998................................................ 151,116 11,376 1999................................................ 151,116 11,376 2000................................................ 129,516 8,121 2001................................................ 9,440 891 -------- ------- $527,504 43,140 ======== Less amount representing interest..................... 7,696 ------- 35,444 Less current portion.................................. 8,408 ------- Long-term portion................................ $27,036 =======
Included in furniture and equipment are capitalized leased equipment of $40,564 and $159,240 (unaudited) with accumulated depreciation of $7,615 and $34,010 (unaudited) at December 31, 1996 and September 30, 1997, respectively. Rent expense was $59,594 and $30,943 for the years ended December 31, 1996 and 1995, respectively, and $64,247 (unaudited) and $33,472 (unaudited) for the nine months ended September 30, 1997 and 1996, respectively. Employment Agreements The Company entered into employment agreements with certain key employees of the Company which range from one to five years. Sheffield University Master Agreement In July 1996, the Company entered into a ten-year, exclusive agreement with Sheffield University, whereby the Company will take the lead in the development and commercialization of any discoveries resulting from Sheffield University's research. The proceeds distributed to Sheffield University from the sale or license of products or technologies developed or commercialized under this agreement will be determined on a case-by-case basis. Either party may terminate the agreement with no less than six-months notice. NOTE 11 -- RELATED PARTIES During 1996, three officers of the Company agreed to defer a portion of their salaries totaling $127,500. The Company intends to pay such amounts of deferred compensation in 1997, and accordingly, they are presented as current liabilities in the accompanying balance sheet as of December 31, 1996. F-16 79 MEDICAL SCIENCE SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 (UNAUDITED) (THE INFORMATION WITH RESPECT TO THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996 IS UNAUDITED.) NOTE 11 -- RELATED PARTIES (CONTINUED) Unaudited During the nine months ended September 30, 1997, the Company paid the deferred salaries of $127,500. NOTE 12 -- SUBSEQUENT EVENTS (UNAUDITED) From October 1, 1997 through October 6, 1997, the Company entered into several subscription agreements to sell subordinated Promissory Notes ("Notes"). In addition, the Company granted one warrant to purchase common stock at an exercise price of $5.50 per share for each $5.00 loaned. The Company issued Notes in the amount of $230,000 and issued 46,000 warrants to purchase the Company's common stock. The Notes accrue interest at 10% per annum, and all unpaid principal and interest are due the earlier of fourteen months from the date of issuance or the sale of equity securities which results in gross proceeds in excess of $6,000,000. The warrants expire the earlier of five years from the date of issuance or upon the occurrence of the Company's common stock traded on a national or regional stock exchange and the closing price of the common stock equals or exceeds $12.00 per share for 30 consecutive trading days. In connection with the issuance of such warrants, the Company will recognize additional interest expense of $46,000 over the fourteen month term of the Notes with the unamortized portion at the closing of the Company's IPO being charged to interest expense immediately. F-17 80 ====================================================== We have not authorized any dealer, salesperson or any other person to give any information or to represent anything not contained in this Prospectus. You must not rely on any unauthorized information. This Prospectus does not offer to sell or buy any shares in any jurisdiction where it is unlawful. The information in this Prospectus is current as of November , 1997. ------------------------ TABLE OF CONTENTS PROSPECTUS
PAGE ---- Summary............................... 1 Risk Factors.......................... 9 The Company........................... 17 Use of Proceeds....................... 18 Dividend Policy....................... 19 Capitalization........................ 19 Dilution.............................. 20 Selected Financial Data............... 21 Management's Discussion and Analysis of Financial Condition and Results of Operations....................... 22 Business.............................. 25 Management............................ 46 Certain Relationships and Related Party Transactions.................. 52 Principal Shareholders................ 53 Description of Securities............. 54 Shares Eligible for Future Sale....... 55 Underwriting.......................... 57 Legal Matters......................... 58 Experts............................... 58 Additional Information................ 58 Index to Financial Statements......... F-1
UNTIL , 199 , (25 DAYS AFTER THE DATE OF THIS PROSPECTUS) ALL DEALERS THAT BUY, SELL OR TRADE THESE SECURITIES, WHETHER OR NOT PARTICIPATING IN THIS OFFERING, MAY BE REQUIRED TO DELIVER A PROSPECTUS. THIS IS IN ADDITION TO THE DEALERS' OBLIGATION TO DELIVER A PROSPECTUS WHEN ACTING AS UNDERWRITERS AND WITH RESPECT TO THEIR UNSOLD ALLOTMENTS OR SUBSCRIPTIONS. ====================================================== ====================================================== 2,500,000 SHARES [MEDICAL SCIENCE LOGO] COMMON STOCK ------------------------ PROSPECTUS ------------------------ NUTMEG SECURITIES, LTD. MILLENIUM FINANCIAL GROUP, INC. ====================================================== 81 PART II -- INFORMATION NOT REQUIRED IN PROSPECTUS ITEM 24. INDEMNIFICATION OF DIRECTORS AND OFFICERS. Our company's Amended and Restated Articles of Incorporation eliminates the liability of directors for monetary damages for an act or omission in the director's capacity as a director, except for: (1) a breach of a director's duty of loyalty to our company or our shareholders; (2) an act or omission not in good faith that constitutes a breach of duty of that director to our company or an act or omission that involves intentional misconduct or a knowing violation of the law; (3) a transaction from which a director received an improper benefit, whether or not the benefit resulted from an action taken within the scope of the director's office; or (4) an act or omission for which the liability of a director is expressly provided for by an applicable statute. If the Texas Miscellaneous Corporation Laws Act or the Texas Business Corporation Act is amended to authorize action further eliminating or limiting the personal liability of directors, then the liability of a director of our company shall be eliminated or limited to the fullest extent permitted by such statutes, as so amended. Any amendment, repeal or modification of such provision shall be prospective only and shall not adversely affect any right or protection of a director of our company existing at the time of such amendment, repeal or modification. ITEM 25. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION. The following table sets forth the expenses in connection with this Registration Statement. All of such expenses are estimates, other than the filing fees payable to the Securities and Exchange Commission. Filing Fee -- Securities and Exchange Commission................ $ 8,966.00 Exchange Listing Fee............................................ 35,000.00 Fees and Expenses of Accountants................................ 45,000.00 Fees and Expenses of Counsel.................................... 120,000.00 Printing and Engraving Expenses................................. 75,000.00 Blue Sky Fees and Expenses...................................... 20,000.00 Transfer Agent Fees............................................. 4,000.00 Miscellaneous Expenses.......................................... 47,034.00 ------------ Total................................................. $ 355,000.00 ============
ITEM 26. RECENT SALES OF UNREGISTERED SECURITIES 1. Between November 1996 and January 1997, we sold 189,188 shares of our Common Stock to seven (7) investors in a private placement at a price of $3.70 per share. No commissions or finder's fees were paid. Within the 12 month period preceding such private placement, the Company did not make any offer or sales of securities. These securities were issued in reliance upon the exemption set forth in Rule 504 of Regulation D of the Securities Act. 2. Between March 1997 and September 1997, we sold 292,060 shares of our Common Stock to forty-six (46) investors in a second private placement transaction at a price of $5.00 per share. We issued 1,760 shares of our Common Stock as a finder's fee with respect to such private placement. Fewer than 35 purchasers in such offering were unaccredited. Each purchaser executed subscription agreements representing that such purchaser either alone or with his representatives had knowledge and experience sufficient to evaluate the merits and risks of the investment. These securities were issued in reliance upon the exemption set forth in Rule 506 of Regulation D of the Securities Act. 3. From December 1996 through May 1997, our company has issued a total of 800,579 incentive and non-qualifying stock options to thirty-seven (37) employees and consultants under our 1996 Equity Incentive Plan. Of the total issued, 533,500 were issued in exchange for services rendered to our company. These options generally vest over 36 months and have a per share exercise price from $3.70 to $5.00. The balance of II-1 82 the options (267,079) were issued in May 1997. In order to reduce our overhead and as an additional incentive to our employees, we instituted a voluntary salary reduction plan where our employees could choose to receive stock options instead of salary. Employees were offered options to purchase 600 shares of Common Stock for every $1,000 their salary was reduced. Most of our employees participated, including all of our officers. A total of 267,079 options to purchase Common Stock at an exercise price of $5.00 or $5.50 per share were issued. These options vested immediately. The offer of these securities was made solely to directors and employees of the Company. The offering was made without any public advertisement. These securities were issued in reliance upon the exemptions set forth in Section 4(2) of the Securities Act on the basis that they were issued under circumstances not involving a public offering. It should also be noted that in December 1996, a permit was issued by the California Department of Corporations qualifying grants of options or common stock under the company's 1996 Equity Incentive Plan. 4. From August 1, 1997 through October 6, 1997, we borrowed an aggregate of $1,780,000 from twenty-eight (28) lenders evidenced by promissory notes bearing interest at 10% interest rate and due the earlier of fourteen months from the date of the notes or the closing date of an initial public offering (the "Bridge Loans"). As additional consideration for the Bridge Loans, we issued one warrant for each $5.00 loaned to the Company for a total of 356,000 warrants (the "Bridge Warrants"). Each Bridge Warrant entitles the holder to purchase one share of Common Stock at $5.50 per share for a period of five years from the date of issuance. An additional 545 Bridge Warrants were issued as a finder's fee. The following officers and directors subscribed to the Bridge Loans in the principal amount indicated after their names: Paul J. White ($100,000/20,000 Bridge Warrants); Kenneth S. Kornman ($100,000/20,000 Bridge Warrants); Michael G. Newman ($100,000/20,000 Bridge Warrants); U. Spencer Allen ($50,000/10,000 Bridge Warrants); Jeanne Ambruster ($50,000/10,000 Bridge Warrants); and Thomas A. Moore ($75,000/15,000 Bridge Warrants). The other twenty-one investors were outside private parties. Other than the 545 Bridge Warrants referenced above, no commissions or finder's fees were paid by the Company. Fewer than 35 purchasers in such offering were unaccredited. Each purchaser executed subscription agreements representing that such purchaser either alone or with his representatives had knowledge and experience sufficient to evaluate the merits and risks of the investment. These securities were issued in reliance upon the exemption set forth in Rule 506 of Regulation D of the Securities Act. ITEM 27. EXHIBITS. 1.1 Form of Underwriting Agreement. 1.2 Form of Agreement Among Underwriters. 1.3 Form of Selected Dealers Agreement. 3.1 Amended and Restated Articles of Incorporation.* 3.2 Articles of Amendment to the Amended and Restated Articles of Incorporation.* 3.3 Amended and Restated Bylaws of the Company.* 3.4 Amendment to the Amended and Restated Bylaws.* 4.1 Form of Stock Certificate.* 4.2 Form of Underwriters' Warrant. 4.3 Form of Subordinated Promissory Note.* 4.4 Form of Security Agreement.* 4.5 Form of Warrant Agreement.* 4.6 Form of Warrant Certificate.* 4.7 $500,000 Term Loan with Bank of America.* 4.8 $250,000 Term Loan with Bank of America.* 4.9 Form of Lock-up Agreement.*
II-2 83 5.1 Opinion of Jeffers, Wilson, Shaff & Falk, LLP. 10.1 Master Agreement for Technology Evaluation, Sheffield University.*(1) 10.2 Research Support Agreement and Amendments to Various Existing Project Agreements, Sheffield University.*(1) 10.3 Development and Commercialization Project Agreement (Atherosclerosis including Coronary Artery Disease), Sheffield University.*(1) 10.4 Development and Commercialization Project Agreement (Eye Disease Among Diabetics), Sheffield University.*(1) 10.5 Development and Commercialization Project Agreement (Osteoporosis), Sheffield University.*(1) 10.6 Joint Project Agreement Between Gordon Duff and Medical Science Systems, Inc. Governing the Periodontal Susceptibility Test.*(1) 10.7 Employment Agreement with Paul J. White.* 10.8 Amendment of Employment Agreement with Paul J. White.* 10.9 Employment Agreement with Kenneth S. Kornman.* 10.10 Amendment of Employment Agreement with Kenneth S. Kornman.* 10.11 Employment Agreement with Michael G. Newman.* 10.12 Amendment of Employment Agreement with Michael G. Newman. * 10.13 Service Agreement Relating to Laboratory Services with Baylor University.*(1) 10.14 Lease Agreement dated March 21, 1996 between Koll Center Newport Number 9 and Company. * 10.15 Lease Agreement dated March 31, 1997 between Jim Jamison and Richard Henderson and Company. * 10.16 Lease Agreement dated October 23, 1995 between Diamond Shamrock Leasing, Inc. and Company. * 10.17 1996 Equity Incentive Plan. * 10.18 Amendment to the 1996 Equity Incentive Plan. * 10.19 Form of Stock Option Agreement. * 10.20 Stock Option Exercise Agreement. * 10.21 Operating Agreement of Disisphase, LLC.*(1) 10.22 Disease Progression Explorer Development and License Agreement.*(1) 23.1 Consent of Singer Lewak Greenbaum & Goldstein LLP. 23.2 Consent of Counsel (previously filed under Exhibit 5.1). 24.1 Power of Attorney (included in signature page). 27.1 Financial Data Schedule.* 99.1 Consent of Ronald A. La Rosa to Being Named as a Future Director.
- --------------- * Previously filed. (1) Confidential treatment has been requested with respect to portions of this document. Omitted portions have been filed separately with the Securities and Exchange Commission. II-3 84 ITEM 28. UNDERTAKINGS. The undersigned small business issuer hereby undertakes: (1) Insofar as indemnification for liabilities arising under the Securities Act of 1933 (the "Act") may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, we will, unless in the opinion of our counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. (2) The undersigned registrant hereby undertakes that: (i) For purposes of determining any liability under the Securities Act of 1933, the information omitted from the form of prospectus filed as part of this registration statement in reliance upon Rule 430A and contained in a form of prospectus filed by the registrant pursuant to Rule 424(b)(1) or (4) or 497(h) under the Securities Act shall be deemed to be part of this registration statement as of the time it was declared effective. (ii) For the purpose of determining any liability under the Securities Act of 1933, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. II-4 85 SIGNATURES In accordance with the requirements of the Securities Act of 1933, the registrant certifies that is has reasonable grounds to believe that it meets all of the requirements of filing on Form SB-2 and authorized this registration statement to be signed on its behalf by the undersigned, in the City of Newport Beach, State of California, on November 13, 1997. MEDICAL SCIENCE SYSTEMS, INC. By: /s/ PAUL J. WHITE ------------------------------------ Paul J. White, President and Chief Executive Officer POWER OF ATTORNEY We, the undersigned directors and officers of Medical Science Systems, Inc. do hereby constitute and appoint Paul J. White and U. Spencer Allen, or either of them, acting individually, our true and lawful attorneys and agents, to do any and all acts and things in our name and behalf in our capacities as directors and officers and to execute any and all instruments for us and in our names in the capacities indicated below, which said attorneys and agents, or any one of them, may deem necessary or advisable to enable said corporation to comply with the Securities Act of 1933, as amended, and any rules, regulations, and requirements of the Securities and Exchange Commission, in connection with this Registration Statement, including specifically, but without limitation, power and authority to sign for us or any of us in our names and in the capacities indicated below, any and all amendments (including post-effective amendments) hereof; and we do hereby ratify and confirm all that the said attorneys and agents, or any of them, shall do or cause to be done by virtue hereof. In accordance with the requirements of the Securities Act of 1933, this Registration Statement was signed by the following persons in the capacities and on the dates stated.
NAME TITLE DATE - --------------------------------------------- -------------------------- ------------------ /s/ PAUL J. WHITE President, Chief November 13, 1997 - --------------------------------------------- Executive Officer and Paul J. White Director /s/ U. SPENCER ALLEN Principal Accounting November 13, 1997 - --------------------------------------------- Officer and Treasurer U. Spencer Allen /s/ KENNETH S. KORNMAN Chief Scientific Officer November 13, 1997 - --------------------------------------------- and Director Kenneth S. Kornman /s/ MICHAEL G. NEWMAN Executive Vice November 13, 1997 - --------------------------------------------- President, Secretary and Michael G. Newman Director /s/ THOMAS A. MOORE Director November 13, 1997 - --------------------------------------------- Thomas A. Moore
II-5 86 INDEX TO EXHIBITS
EXHIBIT NUMBER DESCRIPTION ------ ------------------------------------------------------------------------------ 1.1 Form of Underwriting Agreement. 1.2 Form of Agreement Among Underwriters. 1.3 Form of Selected Dealers Agreement. 3.1 Amended and Restated Articles of Incorporation.* 3.2 Articles of Amendment to the Amended and Restated Articles of Incorporation.* 3.3 Amended and Restated Bylaws of the Company.* 3.4 Amendment to the Amended and Restated Bylaws.* 4.1 Form of Stock Certificate.* 4.2 Form of Underwriters' Warrant. 4.3 Form of Subordinated Promissory Note.* 4.4 Form of Security Agreement.* 4.5 Form of Warrant Agreement.* 4.6 Form of Warrant Certificate.* 4.7 $500,000 Term Loan with Bank of America.* 4.8 $250,000 Term Loan with Bank of America.* 4.9 Form of Lock-up Agreement.* 5.1 Opinion of Jeffers, Wilson, Shaff & Falk, LLP. 10.1 Master Agreement for Technology Evaluation, Sheffield University.*(1) 10.2 Research Support Agreement and Amendments to Various Existing Project Agreements, Sheffield University.*(1) 10.3 Development and Commercialization Project Agreement (Atherosclerosis including Coronary Artery Disease), Sheffield University.*(1) 10.4 Development and Commercialization Project Agreement (Eye Disease Among Diabetics), Sheffield University.*(1) 10.5 Development and Commercialization Project Agreement (Osteoporosis), Sheffield University.*(1) 10.6 Joint Project Agreement Between Gordon Duff and Medical Science Systems, Inc. Governing the Periodontal Susceptibility Test.*(1) 10.7 Employment Agreement with Paul J. White.* 10.8 Amendment of Employment Agreement with Paul J. White.* 10.9 Employment Agreement with Kenneth S. Kornman.* 10.10 Amendment of Employment Agreement with Kenneth S. Kornman.* 10.11 Employment Agreement with Michael G. Newman.* 10.12 Amendment of Employment Agreement with Michael G. Newman.* 10.13 Service Agreement Relating to Laboratory Services with Baylor University.*(1) 10.14 Lease Agreement dated March 21, 1996 between Koll Center Newport Number 9 and Company.* 10.15 Lease Agreement dated March 31, 1997 between Jim Jamison and Richard Henderson and Company.* 10.16 Lease Agreement dated October 23, 1995 between Diamond Shamrock Leasing, Inc. and Company.* 10.17 1996 Equity Incentive Plan.* 10.18 Amendment to the 1996 Equity Incentive Plan.* 10.19 Form of Stock Option Agreement.* 10.20 Stock Option Exercise Agreement.* 10.21 Operating Agreement of Digisphere, LLC.*(1) 10.22 Disease Progression Explorer Development and License Agreement.*(1) 23.1 Consent of Singer Lewak Greenbaum & Goldstein LLP. 27.1 Financial Data Schedule.* 99.1 Consent of Ronald A. La Rosa to Being Named as a Future Director.
- --------------- * Previously filed. (1) Confidential treatment has been requested with respect to portions of this document. Omitted portions have been filed separately with the Securities and Exchange Commission. EX-1.1 2 FORM OF UNDERWRITING AGREEMENT 1 EXHIBIT 1.1 MEDICAL SCIENCE SYSTEMS, INC. 2,500,000 SHARES OF COMMON STOCK UNDERWRITING AGREEMENT ---------------------- , 19 -------------- --- Nutmeg Securities ,Ltd. 495 Post Road East Westport, CT 06880 Dear Sirs: Medical Science Systems, Inc., a Texas corporation (the "Company"), proposes to issue and sell to the several Underwriters named in Schedule I hereto (the "Underwriters"), two million five hundred thousand shares of common stock of the Company (the "Securities"). The Company hereby confirms the agreement made by it with respect to the purchase of the Securities by the Underwriter, which Securities are more fully described in the Registration Statement referred to below. Nutmeg Securities, Ltd. is referred to herein as the "Underwriter" or the "Representative." You have advised the Company that the Underwriters desire to act on a firm commitment basis to publicly offer and sell the Securities for the Company and that you are authorized to execute this Agreement. The Company confirms the agreement made by it with respect to the relationship with the Underwriters as follows: 1. Filing of Registration Statement with S.E.C. and Definitions. A Registration Statement and Prospectus on Form SB-2 (File No. 333-37441) with respect to the Securities has been carefully and accurately prepared by the Company in conformity with the requirements of the Securities Act of 1933, as amended (the "Act"), and the published rules and regulations (the "Rules and Regulations") thereunder or under the Securities Exchange Act of 1934, as amended (the "Exchange Act") and has been filed with the Securities and Exchange Commission (the "Commission") and such other states that the Underwriter deems necessary in its discretion to so file to permit a public offering and trading thereunder. Such registration statement, including the prospectus, Part II, and all financial schedules and exhibits thereto, as amended at the time when it shall become effective, is herein referred to as the "Registration Statement," and the prospectus included as part of the Registration Statement on file with the Commission that discloses all the information that was omitted from the prospectus on the effective date pursuant to Rule 430A of the Rules and Regulations with any changes contained in any prospectus filed with the Commission by the Company with the Underwriters consent after the effective date of the Registration Statement, is herein referred to as the "Final Prospectus." The prospectus included as part of the Registration Statement of the Company and in any amendments thereto prior to the effective date of the Registration Statement is referred to herein as a "Preliminary Prospectus." 2. Discount, Delivery, and Sale of the Securities. (a) Subject to the terms and conditions of this Agreement, and on the basis of the representations, warranties, and agreements herein contained, the Company agrees to sell to, and the Underwriters agree to buy from the Company at a purchase price of $ per share before any underwriter expense allowances, an aggregate of 2,500,000 shares of Common Stock, on a firm commitment basis (the "Initial Securities"). It is understood that the Underwriters propose to offer the Securities to be purchased hereunder to the public upon the terms and conditions set forth in the Registration Statement, after the Registration Statement becomes effective. 1 2 (b) Delivery of the Securities against payment of the purchase price therefor by certified or official bank check or checks or wire transfer in next-day funds, payable to the order of the Company shall take place at the offices of the clearing broker for the Underwriter at New York City, within three (3) business days after the Securities are first traded (or such other place as may be designated by agreement between you and the Company) at 11:00 A.M., New York time or such time and date as you and the Company may agree upon in writing, such time and date of payment and delivery for the Securities being herein called (the "Initial Closing Date"). The Company will make the certificates for the shares of Common Stock and Underwriters' Warrants (as defined herein) to be purchased by the Underwriters hereunder available to the Underwriter for inspection and packaging at least one (1) full business day prior to the Initial Closing Date. The certificates shall be in such names and denominations as the Underwriter may request to the Company in writing at least two (2) full business days prior to any closing date. (c) In addition, subject to the terms and conditions of this Agreement and on the basis of the representations, warranties and agreements herein contained, the Company grants an option to the Underwriters to purchase up to an additional 375,000 shares of Common Stock ("Option Securities") at the same terms as the Underwriters shall pay for the Initial Securities being sold by the Company pursuant to the provisions of Section 2(a) hereof. This option may be exercised from time to time, for the purpose of covering overallotments, within thirty (30) days after (i) the effective date of the Registration Statement if the Company has elected not to rely on Rule 430A under the Rules and Regulations or (ii) the date of this Agreement if the Company has elected to rely upon Rule 430A under the Rules and Regulations, upon written notice by the Underwriter setting forth the number of Option Securities as to which the Underwriter is exercising the option and the time and date at which such certificates are to be delivered. Such time and date shall be determined by the Underwriter but shall not be earlier than four (4) nor later than ten (10) full business days after the date of the exercise of said option. Nothing herein shall obligate the Underwriter to make any overallotment. (d) Definitive certificates in negotiable form for the Securities to be purchased by the Underwriter hereunder will be delivered at the closing by the Company to the Underwriters against payment of the purchase price by the Underwriters by certified or bank cashier's checks or wire transfer in next day funds payable to the order of the Company. (e) The information set forth under "Underwriting" in any preliminary prospectus and Prospectus relating to the Securities and the information set forth in the last paragraph on the front cover page, under the last paragraph on page 2 concerning stabilization and over-allotment by the Underwriters, and (insofar as such information relates to the Underwriters) constitutes the only information furnished by the Underwriter to the Company for inclusion therein, and you represent and warrant to the Company that the statements made therein are correct. (f) On the Initial Closing Date, the Company shall issue and sell to the Underwriters, warrants (the "Underwriters' Warrants") at a purchase price of $.001 per Underwriters' Warrant, which shall entitle the holders thereof to purchase an aggregate of 250,000 shares of Common Stock. The shares of common stock issuable upon the exercise of the Underwriters' Warrants are hereinafter referred to as the "Warrant Shares" (collectively with the Underwriters' Warrants, the "Underwriters' Securities"). The Underwriters' Warrants shall be exercisable for a period of four (4) years commencing one (1) year from the effective date of the Registration Statement at a price equaling one hundred sixty five percent (165%) of the initial public offering price of the Securities. The form of Underwriters' Warrant shall be substantially in the form filed as an Exhibit to the Registration Statement. Payment for the Underwriters' Warrants shall be made on the Initial Closing Date. 2 3 3. Representations and Warranties of the Company. (a) The Company represents and warrants to you as follows: (i) The Company has prepared and filed with the Commission a registration statement, and an amendment or amendments thereto, on Form SB-2 (No. 333-37441), including any related preliminary prospectus ("Preliminary Prospectus"), for the registration of the Securities, the Underwriters' Warrant and the Warrant Shares (sometimes referred to herein collectively as the "Registered Securities"), under the Act, which registration statement and amendment or amendments have been prepared by the Company in conformity with the requirements of the Act, and the Rules and Regulations. The Company will promptly file a further amendment to said registration statement in the form heretofore delivered to the Underwriter and will not file any other amendment thereto to which the Underwriter shall have objected verbally or in writing after having been furnished with a copy thereof. Except as the context may otherwise require, such registration statement, as amended, on file with the Commission at the time the registration statement becomes effective (including the prospectus, financial statements, any schedules, exhibits and all other documents filed as a part thereof or that may be incorporated therein (including, but not limited to those documents or information incorporated by reference therein) and all information deemed to be a part thereof as of such time pursuant to paragraph (b) of Rule 430(A) of the Rules and Regulations), is hereinafter called the "Registration Statement," and the form of prospectus in the form first filed with the Commission pursuant to Rule 424(b) of the Rules and Regulations, is hereinafter called the "Prospectus." (ii) Neither the Commission nor any state regulatory authority has issued any order preventing or suspending the use of any Prospectus or the Registration Statement and no proceeding for an order suspending the effectiveness of the Registration Statement or any of the Company's securities has been instituted or is pending or threatened. Each such Prospectus and/or any supplement thereto has conformed in all material respects with the requirements of the Act and the Rules and Regulations and on its date did not include any untrue statement of a material fact or omit to state a material fact necessary to make the statements therein not misleading, in light of the circumstances under which they were made and (i) the Prospectus and/or any supplement thereto will contain all statements which are required to be stated therein by the Act and Rules and Regulations, and (ii) the Prospectus and/or any supplement thereto will not include any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary to make the statements therein not misleading, in light of the circumstances under which they were made; provided, however, that no representations, warranties or agreements are made hereunder as to information contained in or omitted from the Prospectus in reliance upon, and in conformity with, the written information furnished to the Company by you as set forth in Section 2(e) above. (iii) The Company has been duly incorporated and is validly existing as a corporation in good standing under the laws of the state of its incorporation, with full power and authority (corporate and other) to own its properties and conduct its businesses as described in the Prospectus and is duly qualified to do business as a foreign corporation in good standing in all other jurisdictions in which the nature of its business or the character or location of its properties requires such qualification, except where the failure to so qualify would not have a material adverse effect on the business, properties or operations of the Company and the subsidiaries as a whole. (iv) The Company has full legal right, power and authority to authorize, issue, deliver and sell the Securities, the Option Securities and the Underwriters' Securities and to enter into both this Agreement and the Underwriters' Warrant, and to consummate the transactions provided for in such agreements, and each of such agreements has been duly and properly authorized, and on the Initial Closing Date will be duly and properly executed and delivered by the Company. This Agreement constitutes, and on the Initial Closing Date the Underwriters' Warrant will then constitute, valid and binding agreements, enforceable in accordance with their respective terms (except as the enforceability thereof may be limited by bankruptcy or other similar laws affecting the rights of creditors generally or by general equitable principles and except as the enforcement of indemnification provisions may be limited by federal or state securities laws). (v) Except as disclosed in the Prospectus, the Company is not in violation of its respective certificate or articles of incorporation or bylaws or in default in the performance or observance of any material obligation, agreement, covenant or condition contained in any material bond, debenture, note or other evidence of indebtedness or in any material contract, indenture, mortgage, loan agreement, lease, joint venture, partnership or other agreement or 3 4 instrument to which the Company is a party or by which it may be bound or is not in material violation of any law, order, rule, regulation, writ, injunction or decree of any governmental instrumentality or court, domestic or foreign; and the execution and delivery of this Agreement, the Underwriters' Warrant Agreement; and the consummation of the transactions contemplated therein and in the Prospectus and compliance with the terms of each such agreement will not conflict with, or result in a material breach of any of the terms, conditions or provisions of, or constitute a material default under, or result in the imposition of any material lien, charge or encumbrance upon any of the property or assets of the Company pursuant to, any material bond, debenture, note or other evidence of indebtedness or any material contract, indenture, mortgage, loan agreement, lease, joint venture, partnership or other agreement or instrument to which the Company is a party nor will such action result in the material violation by the Company of any of the provisions of its respective certificate or articles of incorporation or bylaws or any law, order, rule, regulation, writ, injunction, decree of any government, governmental instrumentality or court, domestic or foreign, except where such violation will not have a material adverse effect on the financial condition of the Company. (vi) The authorized, issued and outstanding capital stock of the Company is as set forth in the Prospectus and the Company will have the adjusted capitalization set forth therein on the Initial Closing Date; all of the shares of issued and outstanding capital stock of the Company set forth therein have been duly authorized, validly issued and are fully paid and nonassessable; the holders thereof do not have any rights of rescission with respect therefor and are not subject to personal liability for any obligations of the Company by reason of being stockholders under the laws of the State in which the Company is incorporated; none of such outstanding capital stock is subject to or was issued in violation of any preemptive or similar rights of any stockholder of the Company; and such capital stock (including the Securities, the Option Securities and the Underwriters' Securities) conforms in all material respects to all statements relating thereto contained in the Prospectus. (vii) The Company is not a party to or bound by any instrument, agreement or other arrangement providing for it to issue any capital stock, rights, warrants, options or other securities, except for this Agreement or as described in the Prospectus. The Securities, the Option Securities and the Underwriters' Securities are not and will not be subject to any preemptive or other similar rights of any stockholder, have been duly authorized and, when issued, paid for and delivered in accordance with the terms hereof, will be validly issued, fully paid and non-assessable and will conform to the respective descriptions thereof contained in the Prospectus; except for payment of the applicable purchase price paid upon exercise of the options or warrants, as the case may be the holders thereof will not be subject to any liability solely as such holders; all corporate action required to be taken for the authorization, issue and sale of the Securities, the Option Securities and the Underwriters' Securities has been duly and validly taken; and the certificates representing the Securities, the Option Securities and the Underwriters' Securities will be in due and proper form. Upon the issuance and delivery pursuant to the terms hereof of the Securities, the Option Securities and the Underwriters' Securities to be sold by the Company hereunder, the Underwriter will acquire good and marketable title to such Securities, Option Securities and Underwriters' Securities free and clear of any lien, charge, claim, encumbrance, pledge, security interest, defect or other restriction of any kind whatsoever other than restrictions as may be imposed under the securities laws. (viii) The Company has good and marketable title to all properties and assets described in the Prospectus as owned by it, free and clear of all liens, charges, encumbrances or restrictions, except such as are described or referred to in the Prospectus or which are not materially significant or important in relation to its business or which have been incurred in the ordinary course of business; except as described in the Prospectus all of the leases and subleases under which the Company holds properties or assets as lessee or sublessee as described in the Prospectus are in full force and effect, and the Company is not in material default in respect of any of the terms or provisions of any of such leases or subleases, and no claim has been asserted by anyone adverse to the Company's rights as lessor, sublessor, lessee or sublessee under any of the leases or subleases mentioned above or affecting or questioning the Company's right to the continued possession of the leased or subleased premises or assets under any such lease or sublease; and the Company owns or leases all such properties as are necessary to its operations as now conducted and as contemplated to be conducted, except as otherwise stated in the Prospectus. (ix) The financial statements, together with related notes, set forth in the Prospectus fairly present the financial position and results of operations of the Company at the respective dates and for the respective periods to which they apply. Said statements and related notes have been prepared in accordance with generally accepted 4 5 accounting principles applied on a basis which is consistent in all material respects during the periods involved but any stub period has not been audited by an independent accounting firm. There has been no material adverse change or material development involving a prospective change in the condition, financial or otherwise, or in the prospects, value, operation, properties, business or results of operations of the Company whether or not arising in the ordinary course of business, since the date of the financial statements included in the Registration Statement and the Prospectus. (x) Subsequent to the respective dates as of which information is given in the Prospectus as it may be amended or supplemented, and except as described in the Prospectus, the Company has not, directly or indirectly, incurred any liabilities or obligations, direct or contingent, not in the ordinary course of business or entered into any transactions not in the ordinary course of business, which are material to the business of the Company as a whole and there has not been any change in the capital stock of, or any incurrence of long term debts by, the Company or any issuance of options, warrants or rights to purchase the capital stock of the Company or declaration or payment of any dividend on the capital stock of the Company or any material adverse change in the condition (financial or other), net worth or results of operations of the Company as a whole and the Company has not become a party to, any material litigation whether or not in the ordinary course of business. (xi) To the knowledge of the Company, there is no pending or threatened, action, suit or proceeding to which the Company is a party before or by any court or governmental agency or body, which might result in any material adverse change in the condition (financial or other), business or prospects of the Company as a whole or might materially and adversely affect the properties or assets of the Company as a whole nor are there any actions, suits or proceedings against the Company related to environmental matters or related to discrimination on the basis of age, sex, religion or race which might be expected to materially and adversely affect the conduct of the business, property, operations, financial condition or earnings of the Company as a whole; and no labor disturbance by the employees of the Company individually exists or is, to the knowledge of the Company, imminent which might be expected to materially and adversely affect the conduct of the business, property, operations, financial condition or earnings of the Company as a whole. (xii) Except as may be disclosed in the Prospectus, the Company has properly prepared and filed all necessary federal, state, local and foreign income and franchise tax returns, has paid all taxes shown as due thereon, has established adequate reserves for such taxes which are not yet due and payable, and does not have any tax deficiency or claims outstanding, proposed or assessed against it. (xiii) The Company has sufficient licenses, permits, right to use trade or service marks and other governmental authorizations currently required for the conduct of its business as now being conducted and as contemplated to be conducted and the Company is in all material respects complying therewith. Except as set forth in the Prospectus, the expiration of any such licenses, permits, or other governmental authorizations would not materially affect the Company's operations. To its knowledge, none of the activities or businesses of the Company are in material violation of, or cause the Company to materially violate any law, rule, regulations, or order of the United States, any state, county or locality, or of any agency or body of the United States or of any state, county or locality. (xiv) The Company has not at any time (i) made any contributions to any candidate for political office in violation of law, or failed to disclose fully any such contribution, or (ii) made any payment to any state, federal or foreign governmental officer or official, or other person charged with similar public or quasi public duties, other than payments required or allowed by applicable law. (xv) Except as set forth in the Prospectus the Company knows of no outstanding claims for services either in the nature of a finder's fee, brokerage fee or otherwise with respect to this financing for which the Company or the Underwriters may be responsible, or which may affect the Underwriters' compensation as determined by the National Association of Securities Dealers, Inc. ("NASD") except as otherwise disclosed in the Prospectus or known by the Underwriters. 5 6 (xvi) The Company has its property adequately insured against loss or damage by fire and maintains such other insurance as is customarily maintained by companies in the same or similar business. (xvii) The Underwriters' Warrants herein described are duly and validly authorized and upon delivery to the Representative in accordance herewith will be duly issued and legal, valid and binding obligations of the Company, except as the enforceability thereof may be limited by bankruptcy or other similar laws affecting the rights of creditors generally or by equitable principles, and except as the enforcement of indemnification provisions may be limited by federal or state securities laws. The Underwriters' Securities issuable upon exercise of any of the Underwriters' Warrants have been duly authorized, and when issued upon payment of the exercise price therefor, will be validly issued, fully paid and nonassessable. (xviii) Except as set forth in the Prospectus, no default exists in the due performance and observance of any term, covenant or condition of any material license, contract, indenture, mortgage, installment sale agreement, lease, deed of trust, voting trust agreement, stockholders agreement, note, loan or credit agreement, purchase order, or any other agreement or instrument evidencing an obligation for borrowed money, or any other material agreement or instrument to which the Company is a party or by which the Company may be bound or to which the property or assets (tangible or intangible) of the Company is subject or affected. (xix) To the best of the Company's knowledge it has generally enjoyed a satisfactory employer-employee relationship with its employees and, to the best of its knowledge, is in substantial compliance in all material respects with all federal, state, local, and foreign laws and regulations respecting employment and employment practices, terms and conditions of employment and wages and hours. To the best of the Company's knowledge, there are no pending investigations involving the Company, by the U.S. Department of Labor, or any other governmental agency responsible for the enforcement of such federal, state, local, or foreign laws and regulations. To the best of the Company's knowledge, there is no unfair labor practice charge or complaint against the Company pending before the National Labor Relations Board or any strike, picketing, boycott, dispute, slowdown or stoppage pending or threatened against or to its knowledge involving the Company, or any predecessor entity, and none has ever occurred. To the best of the Company's knowledge, no representation question is pending respecting the employees of the Company, and no collective bargaining agreement or modification thereof is currently being negotiated by the Company. To the best of the Company's knowledge, no grievance or arbitration proceeding is pending or to its knowledge threatened under any expired or existing collective bargaining agreements of the Company. No labor dispute with the employees of the Company is pending, or, to its knowledge is imminent; and the Company is not aware of any pending or imminent labor disturbance by the employees of any of its principal suppliers, manufacturers or contractors which may result in any material adverse change in the condition, financial or otherwise, or in the earnings, business affairs, position, prospects, value, operation, properties, business or results of operations of the Company. (xx) Except as may be set forth in the Registration Statement, the Company does not maintain, sponsor or contribute to any program or arrangement that is an "employee pension benefit plan," an "employee welfare benefit plan," or a "multiemployer plan" as such terms are defined in Sections 3(2), 3(l) and 3(37), respectively, of the Employee Retirement Income Security Act of 1974, as amended ("ERISA") ("ERISA Plans"). The Company does not maintain or contribute, now or at any time previously, to a defined benefit plan, as defined in Section 3(35) of ERISA. No ERISA Plan (or any trust created thereunder) has engaged in a "prohibited transaction" within the meaning of Section 406 of ERISA or Section 4975 of the Internal Revenue Code (the "Code"), which could subject the Company to any tax penalty on prohibited transactions and which has not adequately been corrected. Each ERISA Plan is in compliance with all material reporting, disclosure and other requirements of the Code and ERISA as they relate to any such ERISA Plan. Determination letters have been received from the Internal Revenue Service with respect to each ERISA Plan which is intended to comply with Code Section 401 (a), stating that such ERISA Plan and the attendant trust are qualified thereunder. The Company has never completely or partially withdrawn from a "multiemployer plan." 6 7 (xxi) None of the Company, or any of its employees, directors, stockholders, or affiliates (within the meaning of the Rules and Regulations) has taken or will take, directly or indirectly, any action designed to or which has constituted or which might be expected to cause or result in, under the Exchange Act, or otherwise, stabilization or manipulation of the price of any security of the Company to facilitate the sale or resale of the Securities, Option Securities, Underwriters' Securities or otherwise. (xxii) None of the patents, patent applications, trademarks, service marks, trade names, copyrights, and licenses and rights to the foregoing presently owned or held by the Company, are in dispute or, to the best knowledge of the Company's management are in any conflict with the right of any other person or entity. The Company (i) except as disclosed in the Prospectus owns or has the right to use, all patents, trademarks, service marks, trade names and copyrights, technology and licenses and rights with respect to the foregoing, used in the conduct of its business as now conducted or proposed to be conducted without infringing upon or otherwise acting adversely to the right or claimed right of any person, corporation or other entity under or with respect to any of the foregoing, and except as set forth in the Prospectus or otherwise disclosed to the Underwriters in writing, to the best knowledge of the Company's management is not obligated or under any liability whatsoever to make any material payments by way of royalties, fees or otherwise to any owner or licensee of, or other claimant to, any patent, trademark, service mark, trade name, copyright, know-how, technology or other intangible asset, with respect to the use thereof or in connection with the conduct of its business or otherwise. (xxiii) Except as disclosed in the Prospectus the Company owns and has adequate right to use to the best knowledge of the Company's management all trade secrets, know-how (including all other unpatented and/or unpatentable proprietary or confidential information, systems or procedures), inventions, designs, processes, works of authorship, computer programs and technical data and information (collectively herein "intellectual property") required for or incident to the development, manufacture, operation and sale of all products and services sold or proposed to be sold by the Company. The Company is not aware of any such development of similar or identical trade secrets or technical information by others. The Company has valid and binding confidentiality agreements with all of its officers, covering its intellectual property (subject to the equitable powers of any court), which agreements have remaining terms of at least two years from the effective date of the Registration Statement except where the failure to have such agreements would not materially and adversely effect the Company's business taken as a whole. The Company has good and marketable title to, or valid and enforceable leasehold estates in, all items of real and personal property stated in the Prospectus, to be owned or leased by it free and clear of all liens, charges, claims, encumbrances, pledges, security interests, defects, or other restrictions or equities of any kind whatsoever, other than those referred to in the Prospectus and liens for taxes not yet due and payable. (xxiv) Singer Lewak Greenbaum & Goldstein LLP, whose reports are filed with the Commission as a part of the Registration Statement, are independent certified public accountants as required by the Act and the Rules and Regulations. (xxv) The Company has agreed to cause to be duly executed agreements pursuant to which each of the Company's officers and directors have agreed not to, directly or indirectly, sell, assign, transfer, or otherwise dispose of any shares of Common Stock or securities convertible into, exercisable or exchangeable for or evidencing any right to purchase or subscribe for any shares of Common Stock (either pursuant to Rule 144 of the Rules and Regulations or otherwise) for a period of not less than twelve (12) months following such effective date without the prior written consent of the Underwriter. The Company will cause the Transfer Agent, as defined below, to mark an appropriate legend on the face of stock certificates representing all of such securities and to place "stop transfer" orders on the Company's stock ledgers. (xxvi) The Registered Securities have been approved for listing on NASDAQ or an Exchange. 7 8 (xxvii) Except as set forth in the Prospectus or disclosed in writing to the Underwriter (which writing specifically refers to this Section), no officer or director of the Company, holder of 5% or more of securities of the Company or any "affiliate" or "associate" (as these terms are defined in Rule 405 promulgated under the Rules and Regulations) of any of the foregoing persons or entities has or has had, either directly or indirectly, (i) an interest in any person or entity which (A) furnishes or sells services or products which are furnished or sold or are proposed to be furnished or sold by the Company, or (B) purchases from or sells or furnishes to the Company any goods or services, or (ii) a beneficiary interest in any contract or agreement to which the Company is a party or by which it may be bound or affected. Except as set forth in the Prospectus under "Certain Relationships and Related Party Transactions" or disclosed in writing to the Underwriter (which writing specifically refers to this Section) there are no existing agreements, arrangements, understandings or transactions, or proposed agreements, arrangements, understandings or transactions, between or among the Company, and any officer, director, principal stockholder of the Company, or any partner, affiliate or associate of any of the foregoing persons or entities. (xxviii) Any certificate signed by any officer of the Company, and delivered to the Underwriters or to the Underwriters' counsel (as defined herein) shall be deemed a representation and warranty by the Company to the Underwriters as to the matters covered thereby. (xxix) Each of the minute books of the Company has been made available to the Underwriters and contains a complete summary of all meetings and actions of the directors and stockholders of the Company, since the time of its incorporation and reflect all transactions referred to in such minutes accurately in all respects. (xxx) Intentionally left blank. (xxxi) Except and only to the extent described in the Prospectus or disclosed in writing to the Underwriter (which writing specifically refers to this Section), no holders of any securities of the Company or of any options, warrants or other convertible or exchangeable securities of the Company have the right to include any securities issued by the Company in the Registration Statement or any registration statement to be filed by the Company or to require the Company to file a registration statement under the Act and no person or entity holds any anti-dilution rights with respect to any securities of the Company. Except as disclosed in the Prospectus, all rights so described or disclosed have been waived or have not been triggered with respect to the transactions contemplated by this Agreement and the Representatives' Warrant Agreement (including the warrants issuable thereunder). (xxxii) The Company has not entered into any employment agreements with its executive officers, except as disclosed in the Prospectus. (xxxiii) No consent, approval, authorization or order of, and no filing with, any court, regulatory body, government agency or other body, domestic or foreign, is required for the issuance of the Registered Securities pursuant to the Prospectus and the Registration Statement, the issuance of the Underwriters' Warrants, the performance of this Agreement, the Underwriters' Warrant, and the transactions contemplated hereby and thereby, including without limitation, any waiver of any preemptive, first refusal or other rights that any entity or person may have for the issue and/or sale of any of the Securities, the Option Securities and the Underwriters' Securities, except such as have been or may be obtained under the Act, otherwise or may be required under state securities or blue sky laws in connection with the Underwriters' purchase and distribution of the Securities, the Option Securities and the Underwriters' Securities to be sold by the Company hereunder or may be required by the Rules of the National Association of Securities Dealer, Inc. ("NASD"). (xxxiv) All executed agreements, contracts or other documents or copies of executed agreements, contracts or other documents filed as exhibits to the Registration Statement to which the Company is a party or by which it may be bound or to which its assets, properties or businesses may be subject have been duly and validly authorized, executed and delivered by the Company and constitute the legal, valid and binding agreements of the Company, enforceable against the Company, in accordance with their respective terms. The descriptions in the Registration Statement of agreements, contracts and other documents are accurate and fairly present the information required to be 8 9 shown with respect thereto by Form SB-2, and there are no contracts or other documents which are required by the Act to be described in the Registration Statement or filed as exhibits to the Registration Statement which are not described or filed as required, and the exhibits which have been filed are complete and correct copies of the documents of which they purport to be copies. (xxxv) Within the past five (5) years, none of the Company's independent public accountants has brought to the attention of the Company's management any "material weakness" as defined in the Statement of Auditing Standard No. 60 in any of the Company's internal controls. 4. Covenants of the Company. The Company covenants and agrees with you that: (a) It will cooperate in all respects in making the Prospectus effective and will not at any time, whether before or after the effective date, file any amendment to or supplement to the Prospectus of which you shall not previously have been advised and furnished with a copy or to which you or your counsel shall have reasonably objected or which is not in material compliance with the Act and the Rules and Regulations or applicable state law. As soon as the Company is advised thereof, the Company will advise you, and confirm the advice in writing, of the receipt of any comments of the Commission or any state securities department, when the Registration Statement becomes effective if the provisions of Rule 430A promulgated under the Act will be relied upon, when the Prospectus has been filed in accordance with said Rule 430A, of the effectiveness of any post-effective amendment to the Registration Statement or Prospectus, or the filing of any supplement to the Prospectus or any amended Prospectus, of any request made by the Commission or any state securities department for amendment of the Prospectus or for supplementing of the Prospectus or for additional information with respect thereto, of the issuance of any stop order suspending the effectiveness of the Prospectus or any order preventing or suspending the use of any Prospectus or any order suspending trading in the Common Stock of the Company, or of the suspension of the qualification of the Securities, the Option Securities or the Underwriters' Securities for offering in any jurisdiction, or of the institution of any proceedings for any such purposes, and will use its best efforts to prevent the issuance of any such order and, if issued, to obtain as soon as possible the lifting or dismissal thereof. The Company has caused to be delivered to you copies of such Prospectus, and the Company has consented and hereby consents to the use of such copies for the purposes permitted by law. The Company authorizes you and the dealers to use the Prospectus and such copies of the Prospectus in connection with the sale of the Securities, the Option Securities and the Underwriters' Securities for such period as in the opinion of your counsel and our counsel the use thereof is required to comply with the applicable provisions of the Act and the Rules and Regulations. The Company will prepare and file with the states, promptly upon your request, any such amendments or supplements to the Prospectus, and take any other action, as, in the opinion of your counsel, may be necessary or advisable in connection with the initial sale of the Securities, the Option Securities and the Underwriters' Securities and will use its best efforts to cause the same to become effective as promptly as possible. The Company shall file the Prospectus (in form and substance satisfactory to the Underwriter) or transmit the Prospectus by a means reasonably calculated to result in filing with the Commission pursuant to rule 424(b)(1) or pursuant to Rule 424(b)(3) not later than the Commission's close of business on the earlier of (i) the second business day following the execution and delivery of this Agreement, and (ii) the fifth business day after the effective date of the Registration Statement. In case of the happening, at any time within such period as a Prospectus is required under the Act to be delivered in connection with the initial sale of the Securities, the Option Securities and the Underwriters' Securities, of any event of which the Company has knowledge and which materially affects the Company, or the securities thereof, and which should be set forth in an amendment of or a supplement to the Prospectus in order to make the statements therein not then misleading, in light of the circumstances existing at the time the Prospectus is required under the Act to be delivered, or in case it shall be necessary to amend or supplement the Prospectus to comply with the Act, the Rules and Regulations or any other law, the Company will forthwith prepare and furnish to you copies of such 9 10 amended Prospectus or of such supplement to be attached to the Prospectus, in such quantities as you may reasonably request, in order that the Prospectus, as so amended or supplemented, will not contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary to make the statements therein not misleading in light of the circumstances under which they are made. The preparation and furnishing of any such amendment or supplement to the Prospectus or supplement to be attached to the Prospectus shall be without expense to you. The Company will to the best of its ability comply with the Act, the Exchange Act and applicable state securities laws so as to permit the initial offer and sales of the Securities, the Option Securities and the Underwriters' Securities under the Act, the Rules and Regulations, and applicable state securities laws. (b) It will cooperate to qualify the Securities and the Option Securities and the Underwriters' Securities for initial sale under the securities laws of such jurisdictions as you may designate and will make such applications and furnish such information as may be required for that purpose, provided the Company shall not be required to qualify as a foreign corporation or a dealer in securities. The Company will, from time to time, prepare and file such statements and reports as are or may be required to continue such qualification in effect for so long as the Underwriter may reasonably request. (c) So long as any of the Securities, the Option Securities or the Underwriters' Securities remain outstanding in the hands of the public, the Company, at its expense, will annually furnish to its shareholders a report of its operations to include financial statements audited by independent public accountants, and will furnish to the Underwriter as soon as practicable after the end of each fiscal year, a balance sheet of the Company as at the end of such fiscal year, together with statements of operations, shareholders' equity, and changes in cash flow of the Company for such fiscal year, all in reasonable detail and accompanied by a copy of the certificate or report thereon of independent public accountants. (d) It will deliver to you at or before the Initial Closing Date three signed copies of the Registration Statement including all financial statements and exhibits filed therewith, whether or not incorporated by reference. The Company will deliver to you, from time to time until the effective date of the Prospectus, as many copies of the Prospectus as you may reasonably request. The Company will deliver to you on the effective date of the Prospectus and thereafter for so long as a Prospectus is required to be delivered under the Act and the Rules and Regulations as many copies of the Prospectus, in final form, or as thereafter amended or supplemented, as you may from time to time reasonably request. (e) The Company will apply the net proceeds from the sale of the Securities and the Option Securities substantially in the manner set forth under "Use of Proceeds" in the Prospectus. No portion of the proceeds shall be used, directly or indirectly, to acquire any securities issued by the Company, without the prior written consent of the Underwriter. (f) As soon as it is practicable, but in any event not later than the first (1st) day of the fifteenth (15th) full calendar month following the effective date of the Registration Statement, the Company will make available to its security holders and the Underwriter an earnings statement (which need not be audited) covering a period of at least twelve (12) consecutive months beginning after the effective date of the Registration Statement, which shall satisfy the requirements of Section 11(a) of the Act and Rule 158(a) of the Rules and Regulations. (g) Non-Accountable Expense Allowance and other Costs and Expenses. The Company shall pay to the Underwriter at each closing date, and to be deducted from the purchase price for the Securities and the Option Securities, an amount equal to three percent (3%) of the gross proceeds received by the Company from the sale of the Securities and the Option Securities at such closing date less in the case of the Initial Closing Date, the sum of $50,000 previously paid by the Company. If the sale of the Securities by the Underwriter is not consummated for any reason not attributable to the Underwriter, or if (i) the Company withdraws the Registration Statement from the Commission or does not proceed with the public offering, or (ii) the representations in Section 3 hereof are not correct or the covenants cannot be complied with, or (iii) there has been a 10 11 materially adverse change in the condition, prospects or obligations of the Company or a materially adverse change in stock market conditions from current conditions, all as determined by the Underwriter, then the Company shall reimburse the Underwriter for its out of pocket expenses including without limitation, its legal fees and disbursements all on an accountable basis but not to exceed $75,000 (less the $50,000 previously paid by the Company), and if any excess remains from the advance previously paid, such excess will be returned to the Company. (h) Costs and Expenses. Subject to the provisions above the Company will pay all costs and expenses incident to the performance of this Agreement by the Company including, but not limited to, the fees and expenses of counsel to the Company and of the Company's accountants; the costs and expenses incident to the preparation, printing, filing and distribution under the Act of the Registration Statement and Prospectus (including the fee of the Commission, any securities exchange and the NASD in connection with the filing required by the NASD relating to the offering of the Securities contemplated hereby); all expenses, including fees of counsel, which shall be due and payable on the Closing Date in connection with the qualification of the Securities under the state securities or blue sky laws; the cost of furnishing to you copies of the Prospectus, this Agreement, the cost of printing the certificates representing the Securities and of preparing and photocopying the Underwriting Agreement and related Underwriting documents, the cost of three Underwriters' bound volumes, any advertising costs and expenses, including but not limited to the Company's expenses on "road show" information meetings and presentations, prospectus memorabilia, issue and transfer taxes, if any. The Company will also pay all costs and expenses incident to the furnishing of any amended Prospectus of or any supplement to be attached to the Prospectus. (i) As a condition of the closing, the Company shall obtain from its officers and directors of the Company written commitments restricting the sale of 100% of their common stock for (12) months after the closing. (j) During a date five years after the date hereof, the Company will make available to its shareholders, as soon as practicable, and deliver to the Underwriter: (1) as soon as they are available, copies of all reports (financial or other) mailed to shareholders; (2) as soon as they are available, copies of all reports and financial statements furnished to or filed with the Commission, the NASD or any securities exchange; (3) every press release and every material news item or article of interest to the financial community in respect of the Company or its affairs which was prepared and released by or on behalf of the Company; and (4) any additional information of a public nature concerning the Company (and any future subsidiaries) or its businesses which the Underwriter may request. During such five-year period, if the Company has active subsidiaries, the foregoing financial statements will be on a consolidated basis to the extent that the accounts of the Company and its subsidiaries are consolidated, and will be accompanied by similar financial statements for any significant subsidiary which is not so consolidated. (k) The Company will maintain a Transfer Agent and, if necessary under the jurisdiction of incorporation of the Company, a Registrar (which may be the same entity as the Transfer Agent) for its Common Stock. (l) The Company will furnish to the Underwriters or on the Underwriters' order, without charge, at such place as the Underwriters may designate, copies of each Preliminary Prospectus, the Final Prospectus, the Registration Statement and any pre-effective or post-effective amendments thereto (two of which copies will be signed and will include all financial statements and exhibits), the Prospectus and all amendments and supplements thereto, including any prospectus prepared after the effective date of the Registration Statement, in each case as soon as available and in such quantities as the Underwriters may request. 11 12 (m) Neither the Company nor any of its officers, directors, stockholders or any of its affiliates will take, directly or indirectly, any action designed to, or which might in the future reasonably be expected to cause or result in stabilization or manipulation of the price of any of the Company's securities. (n) The Company shall timely file all such reports, forms or other documents as may be required from time to time, under the Act, the Exchange Act, and the Rules and Regulations, and all such reports, forms and documents filed will comply as to form and substance with the applicable requirements under the Act, the Exchange Act, and the Rules and Regulations. (o) The Company shall cause the Securities to be listed on the NASDAQ Small Cap Market or on an exchange for a period of five (5) years from the date hereof, and use its best efforts to maintain the listing of the Securities to the extent they are outstanding. (p) As soon as practicable, (i) before the effective date of the Registration Statement, file a Form 8-A with the Commission providing for the registration under the Exchange Act of the Securities and (ii) but in no event more than 30 days from the effective date of the Registration Statement, take all necessary and appropriate actions to be included in Standard and Poor's Corporation Descriptions and/or Moody's OTC Manual and to continue such inclusion for a period of not less than five years if the securities are not listed on an exchange. (q) Until the completion of the distribution of the Securities, the Company shall not without the prior written consent of the Underwriter and its counsel which consent shall not be unreasonably withheld or delayed, issue, directly or indirectly, any press release or other communication or hold any press conference with respect to the Company or its activities or the offering contemplated hereby, other than trade releases issued in 'the ordinary course' of the Company's business consistent with past practices with respect to the Company's operations. (r) Until the earlier of (i) five (5) years from the date hereof or (ii) the sale to the public of the Warrant Shares, the Company will not take any action or actions which may prevent or disqualify the Company's use of Form SB-2 (or other appropriate form) for the registration under the Act of the Warrant Shares and the Underwriters' Securities. 5. Conditions of the Underwriters' Obligations. The obligation of the Underwriters to offer and sell the Securities and the Option Securities is subject to the accuracy (as of the date hereof, and as of the Closing Dates) of and compliance with the representations and warranties of the Company to the performance by it of its agreement and obligations hereunder and to the following additional conditions: (a) The Registration Statement shall have become effective as and when cleared by the Commission, and you shall have received notice thereof, on or prior to any closing date no stop order suspending the effectiveness of the Prospectus shall have been issued and no proceedings for that or similar purpose shall have been instituted or shall be pending, or, to your knowledge or to the knowledge of the Company, shall be contemplated by the Commission; any request on the part of the Commission for additional information shall have been complied with to the reasonable satisfaction of counsel to the Underwriter; and qualification, under the securities laws of such states as you may designate, of the issue and sale of the Securities upon the terms and conditions herein set forth or contemplated and containing no provision unacceptable to you shall have been secured, and no stop order shall be in effect denying or suspending effectiveness of such qualification nor shall any stop order proceedings with respect thereto be instituted or pending or threatened under such law. (b) On any closing date and, with respect to the letter referred to in subparagraph (iii), as of the date hereof, you shall have received: (i) the opinion, together with such number of signed or photostatic copies of such opinion as you may reasonably request, addressed to you by Jeffers, Wilson, Shaff & Falk, LLP, counsel for the Company, in form 12 13 and substance reasonably satisfactory to the Underwriter and William M. Prifti, Esq., counsel to the Underwriter, dated each such closing date, to the effect that: (A) The Company has been duly incorporated and is a validly existing corporation in good standing under the laws of the jurisdiction in which it is incorporated and has all necessary corporate power and authority to carry on its business as described in the Prospectus. (B) The Company is qualified to do business in each jurisdiction in which conducting its business requires such qualification, except where the failure to be so qualified would not have a material adverse effect on the Company's business or assets. (C) The Company has the full corporate power and authority to enter into this Agreement, the Underwriters' Warrant and to consummate the transactions provided for therein and each such Agreement has been duly and validly authorized, executed and delivered by the Company. Each of this Agreement and the Underwriters' Warrant, assuming due authorization, execution and delivery by each other party thereto, constitutes a legal, valid and binding agreement of the Company enforceable against the Company in accordance with its terms, subject to bankruptcy, insolvency or similar laws governing the rights of creditors and to general equitable principles, and provided that no opinion need be given as to the enforceability of any indemnification or contribution provisions, and none of the Company's execution or delivery of this Agreement, or the Underwriters' Warrant, its performance hereunder or thereunder, its consummation of the transactions contemplated herein or therein, or the conduct of its business as described in the Registration Statement, the Prospectus, and any amendments or supplements thereto, conflicts with or will conflict with or results or will result in any material breach or violation of any of the terms or provisions of, or constitutes or will constitute a material default under, or result in the creation or imposition of any material lien, charge, claim, encumbrance, pledge, security interest, defect or other restriction of any kind whatsoever upon, any property or assets (tangible or intangible) of the Company pursuant to the terms of (A) the articles of incorporation or by-laws of the Company, (B) to the knowledge of such counsel, any material license, contract, indenture, mortgage, deed of trust, voting trust agreement, stockholders' agreement, note, loan or credit agreement or any other agreement or instrument to which the Company is a party or by which it is or may be bound, or (C) to the knowledge of such counsel, any statute, judgment, decree, order, rule or regulation applicable to the Company, whether domestic or foreign. (D) The Company had authorized and outstanding capital stock as set forth in the Prospectus under the heading "Capitalization" as of the date set forth therein, and all of such issued and outstanding shares of capital stock have been duly and validly authorized and issued, and to the knowledge of such counsel are fully paid and nonassessable, and to the knowledge of such counsel no stockholder of the Company is entitled to any preemptive rights to subscribe for, or purchase shares of the capital stock and to the knowledge of such counsel none of such securities were issued in violation of the preemptive rights of any holders of any securities of the Company. (E) To the knowledge of such counsel, the Company is not a party to or bound by any instrument, agreement or other arrangement providing for it to issue any capital stock, rights, warrants, options or other securities, except for this Agreement, the Underwriters' Warrant, and except as described in the Prospectus. The Common Stock, the warrants and the Underwriters' Warrants each conforms in all material respects to the respective descriptions thereof contained in the Prospectus. The outstanding shares of Common Stock, the Underwriters' Warrants and the Warrant Shares, upon issuance and delivery and payment therefore in the manner described herein, in the Underwriters' Warrant and in the Underwriters' Agreement, as the case may be, will be duly authorized, validly issued, fully paid and nonassessable. There are no preemptive or other rights to subscribe for or to purchase, or any restriction upon the voting or transfer of, any shares of Common Stock pursuant to the Company's articles of incorporation, by-laws, other governing documents or any agreement or other instrument known to such counsel to which the Company is a party or by which it is bound. (F) The certificates representing the Securities comprising the Common Stock are in due and proper form and the Underwriters' Warrants have been duly authorized and reserved for issuance and when issued and delivered 13 14 in accordance with the terms of the Underwriters' Warrant, will be duly and validly issued, fully paid and nonassessable. (G) To the knowledge of such counsel, there are no claims, suits or other legal proceedings pending or threatened against the Company in any court or before or by any governmental body which might materially affect the business of the Company or the financial condition of the Company as a whole, except as set forth in or contemplated by the Prospectus. (H) Based on oral and/or written advice from the staff of the Commission, the Registration Statement has become effective and, to the knowledge of such counsel, no stop order suspending the effectiveness of the Prospectus is in effect and no proceedings for that purpose are pending before, or threatened by, federal or by a state securities administrator. (I) To the knowledge of such counsel, there are no legal or governmental proceedings, actions, arbitrations, investigations, inquiries or the like pending or threatened against the Company of a character required to be disclosed in the Prospectus which have not been so disclosed, questions the validity of the capital stock of the Company or this Agreement or the Underwriters' Warrant or might adversely affect the condition, financial or otherwise, or the prospects of the Company or which could adversely affect the Company's ability to perform any of its obligations under this Agreement, or the Underwriters' Warrant. (J) To such counsel's knowledge, there are no material agreements, contracts or other documents known to such counsel required by the Act to be described in the Registration Statement and the Prospectus and filed as exhibits to the Registration Statement other than those described in the Registration Statement and the Prospectus and filed as exhibits thereto, and to such counsel's knowledge (A) the exhibits which have been filed are correct copies of the documents of which they purport to be copies; (B) the descriptions in the Registration Statement and the Prospectus and any supplement or amendment thereto of contracts and other documents to which the Company is a party or by which it is bound, including any document to which the Company is a party or by which it is bound incorporated by reference into the Prospectus and any supplement or amendment thereto, are accurate in all material respects and fairly represent the information required to be shown by Form SB-2. (K) No consent, approval, order or authorization from any regulatory board, agency or instrumentality having jurisdiction over the Company, or its properties (other than registration under the Act or qualification under state or foreign securities law or approval by the NASD) is required for the valid authorization, issuance, sale and delivery of the Securities, the Option Securities or the Underwriters' Warrant. (L) The statements in the Prospectus under "Risk Factors- Dependence on Key Personnel and Consultants, Control by Existing Shareholders," "Indemnification of Officers and Directors," "Description of the Securities," and "Shares Eligible For Future Sale" have been reviewed by such counsel, and insofar as they refer to statements of law, descriptions of statutes, licenses, rules or regulations or legal conclusions, are correct in all material respects. In addition, such counsel shall state that such counsel has participated in conferences with officials and other representatives of the Company, the Underwriters, Underwriter's Counsel and the independent certified public accountants of the Company, at which such conferences the contents of the Registration Statement and Prospectus and related matters were discussed, and although they have not certified the accuracy or completeness of the statements contained in the Registration Statement or the Prospectus, nothing has come to the attention of such counsel which leads them to believe that, at the time the Registration Statement became effective and at all times subsequent thereto up to and on the Closing Date and on any later date on which Option Shares are to be purchased, the Registration Statement and any amendment or supplement, when such documents became effective or were filed with the Commission (other than the financial 14 15 statements including the notes thereto and supporting schedules and other financial and statistical information derived therefrom, as to which such counsel need express no comment) contained any untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading, or at the Closing Date or any later date on which the Option Shares are to be purchased, as the case may be, the Prospectus and any amendment or supplement thereto (other than the financial statements including the notes thereto and other financial and statistical information derived therefrom, as to which such counsel need express no comment) contained any untrue statement of a material fact or omitted to state a material fact necessary to make the statements therein, in the light of the circumstances under which they were made, not misleading. Such opinion shall also cover such other matters incident to the transactions contemplated hereby and the offering Prospectus as you or counsel to the Underwriter shall reasonably request. In rendering such opinion, to the extent deemed reasonable by them, such counsel may rely upon certificates of any officer of the Company or public officials as to matters of fact of which the maker of such certificate has knowledge. (ii) a certificate, signed by the Chief Executive Officer and the Chief Financial Officer of the Company dated the Closing Date, to the effect that with regard to the Company, each of the conditions set forth in Section 5(d) have been satisfied. (iii) a letter, addressed to the Underwriter and in form and substance satisfactory to the Underwriter in all respects (including the nonmaterial nature of the changes or decreases, if any, referred to in clause (D) below), from, Singer Lewak Greenbaum & Goldstein LLP dated, respectively, as of the effective date of the Registration Statement and as of the Closing Date, as the case may be: (A) Confirming that they are independent public accountants with respect to the Company and its consolidated subsidiaries, if any, within the meaning of the Act and the applicable published Rules and Regulations. (B) Stating that, in their opinion, the financial statements, related notes and schedules of the Company and its consolidated subsidiaries, if any, included in the Registration Statement examined by them comply as to form in all material respects with the applicable accounting requirements of the Act and the published Rules and Regulations thereunder. (C) Stating that, with respect to the period from December 31, 1996, to a specified date (the specified date") not earlier than five (5) business days prior to the date of such letter, they have read the minutes of meetings of the shareholders and board of directors (and various committees thereof) of the Company and its consolidated subsidiaries, if any, for the period from December 31, 1996 through the specified date, and made inquiries of officers of the Company and its consolidated subsidiaries, if any, responsible for financial and accounting matters and, especially as to whether there was any decrease in sales, income before extraordinary items or net income as compared with the corresponding period in the preceding year; or any change in the capital stock of the Company or any change in the longterm debt or any increase in the short-term bank borrowings or any decrease in net current assets or net assets of the Company or of any of its consolidated subsidiaries, if any, and further stating that while such procedures and inquiries do not constitute an examination made in accordance with generally accepted auditing standards, nothing came to their attention which caused them to believe that during the period from December 31, 1996, through the specified date there were any decreases as compared with the corresponding period in the preceding year in sales, income before extraordinary items or net income; or any change in the capital stock of the Company or consolidated subsidiary, if any, or any change in the long term debt or any increase in the short-term bank borrowings (other than any increase in short-term bank borrowings in the ordinary course of business) of the Company or any consolidated subsidiary, if any, or any decrease in the net current assets or net assets of the Company or any consolidated subsidiary, if any; and (D) Stating that they have carried out certain specified procedures (specifically set forth in such letter or letters) as specified by the Underwriter (after consultations with Singer Lewak Greenbaum & Goldstein LLP relating to such procedures), not constituting an audit, with respect to certain tables, statistics and other financial data in the Prospectus specified by the Underwriter and such financial data not included in the Prospectus but from which information in the Prospectus is derived, and which have been obtained from the general accounting records of the Company or consolidated subsidiaries, if any, or from such accounting records by analysis or computation, and having compared such financial data with the accounting records of the Company or the consolidated subsidiaries, if any, stating that they have found such financial data to agree with the accounting records of the Company. 15 16 (c) All corporate proceedings and other legal matters relating to this Agreement, the Prospectus and other related matters shall be satisfactory to or approved by counsel to the Underwriter and you shall have received from Jeffers, Wilson, Shaff & Falk, LLP a signed opinion dated as of each closing date, with respect to the incorporation of the Company, the validity of the Securities, the form of the Prospectus, (other than the financial statements together with related notes and other financial and statistical data contained in the Prospectus or omitted therefrom, as to which such counsel need express no opinion), the execution of this Agreement and other related matters as you may reasonably require. (d) At each closing date, (i) the representations and warranties of the Company contained in this Agreement shall be true and correct in all material respects with the same effect as if made on and as of such closing date; (ii) the Prospectus and any amendments or supplements thereto shall contain all statements which are required to be stated therein in accordance with the Act and the Rules and Regulations and in all material respects conform to the requirements thereof, and neither the Prospectus nor any amendment or supplement thereto shall contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary, in light of the circumstances under which they were made, in order to make the statements therein not misleading; (iii) there shall have been since the respective dates as of which information is given no material adverse change in the business, properties or condition (financial or otherwise), results of operations, capital stock, longterm debt or general affairs of the Company from that set forth in the Prospectus, except changes which the Prospectus indicates might occur after the effective date of the Prospectus, and the Company shall not have incurred any material liabilities or material obligations, direct or contingent, or entered into any material transaction, contract or agreement not in the ordinary course of business other than as referred to in the Prospectus and which would be required to be set forth in the Prospectus; and (iv) except as set forth in the Prospectus, no action, suit or proceeding at law or in equity shall be pending or threatened against the Company which would be required to be set forth in the Prospectus, and no proceedings shall be pending or threatened against the Company or any subsidiary before or by any commission, board or administrative agency in the United States or elsewhere, wherein an unfavorable decision, ruling or finding would materially and adversely affect the business, property, condition (financial or otherwise), results of operations or general affairs of the Company. (e) On the Initial Closing Date, the Company shall have executed and delivered to the Underwriter, (i) the Underwriters' Warrant substantially in the form filed as an Exhibit to the Registration Statement in final form and substance satisfactory to the Underwriter, and (ii) the Underwriters' Warrants in such denominations and to such designees as shall have been provided to the Company. (f) On or before the Initial Closing Date, the Securities shall have been duly approved for listing on an exchange or on NASDAQ, Small Cap Market or National Market. (g) On or before the Initial Closing Date, there shall have been delivered to the Underwriter all of the Lock-up Agreements required to be delivered pursuant to Section 3(a)(xxv) and 4(h), in form and substance satisfactory to the Underwriter and Underwriter's counsel. If any condition to the Underwriters' obligations hereunder to be fulfilled prior to or at the Initial Closing Date or the relevant Option Closing Date, as the case may be, is not so fulfilled, the Underwriter may terminate this Agreement or, if the Underwriter so elects, it may waive any such conditions which have not been fulfilled or extend the time for their fulfillment. 6. Conditions of the Company's Obligations. The obligation of the Company to sell and deliver the Securities is subject to the following: (a) The provisions regarding the effective date, as described in Section 10. (b) At the Initial Closing Date, no stop order suspending the effectiveness of the Prospectus shall have been issued under the Act or any proceedings therefor initiated or threatened by the Commission or by any state securities department. (c) Tender of payment by the Underwriters in accord with Section 2 hereof. 16 17 7. Indemnification. (a) The Company agrees to indemnify and hold harmless each Underwriter and its employees and each person, if any, who controls you within the meaning of the Act, against any losses, claims, damages or liabilities, joint or several (which shall, for any purposes of this Agreement, include, but not be limited to, all costs of defense and investigation and all attorneys' fees), to which each Underwriter or such controlling person may become subject, under the Act or otherwise, insofar as such losses, claims, damages or liabilities (or actions in respect thereof) arise out of or are based upon any untrue statement or alleged untrue statement of any material fact contained in the Prospectus, or any amendment or supplement thereto, or arise out of or are based upon the omission or alleged omission made in the Prospectus, or such amendment or supplement to state a material fact required to be stated therein or necessary to make the statements therein not misleading, which is in reliance upon and in conformity with written information furnished by the Company to you specifically for use in the preparation thereof, and provided further that the indemnity agreement contained in this subsection (a) shall not inure to the benefit of you with respect to any person asserting any such loss, claim, damage or liability who has purchased the Securities which are the subject thereof if you or any participants failed to send or give a copy of the Prospectus to such person at or prior to the written confirmation of the sale of such Securities to such person and except that, with respect to any untrue statement or omission or any alleged untrue statement or omission, made in any Pre-Effective Prospectus, the indemnity agreement contained in this subsection (a) shall not inure to the benefit of any Underwriter (or to any person controlling any such underwriter) from whom the person asserting any such loss, claim, damage or liability purchased the securities concerned to the extent that such untrue statement or omission, or alleged untrue statement or omission, has been corrected in a later Pre-Effective Prospectus or in the Final Prospectus unless the Underwriter circulated a later Pre-Effective Prospectus or the Final Prospectus to such person. (b) Each Underwriter will indemnify and hold harmless the Company, each of its directors, each of its officers, each person, if any, who controls the Company within the meaning of the Act against any losses, claims, damages or liabilities, joint or several (which shall, for all purposes of this Agreement, include, but not be limited to, all costs of defense and investigation and all attorneys' fees) to which the Company or any such director, officer or controlling person may become subject under the Act or otherwise, insofar as such losses, claims, damages or liabilities (or actions in respect thereof) arise out of or are based upon any untrue statement or alleged untrue statement of any material fact contained in the Prospectus, or any amendment or supplement thereto, or arise out of or are based upon the omission or the alleged omission to state therein a material fact required to be stated therein or necessary to make the statements therein not misleading, in each case to the extent, but only to the extent, that such untrue statement or alleged untrue statement or omission was made in the Prospectus, or such amendment or supplement, in reliance upon and in conformity with written information furnished to the Company by you specifically for use in the preparation thereof. This indemnity will be in addition to any liability which any Underwriter may otherwise have. (c) Promptly after receipt by an indemnified party under this Section of notice of the commencement of any action, such indemnified party will, if a claim in respect thereof is to be made against the indemnifying party under this Section, notify the indemnifying party of the commencement thereof, but the omission so to notify the indemnifying party will not relieve it from any liability which it may have to any indemnified party otherwise than under this Section. In case any such action is brought against any indemnified party, and it notifies the indemnifying party of the commencement thereof, the indemnifying party will be entitled to participate in, and, to the extent that it may wish, jointly with any other indemnifying party, similarly notified, to assume the defense thereof, subject to the provisions herein stated, with counsel satisfactory to such indemnified party, and after notice from the indemnifying party to such indemnified party of its election so to assume the defense thereof, the indemnifying party will not be liable to such indemnified party under this Section for any legal or other expenses subsequently incurred by such indemnified party in connection with the defense thereof other than reasonable costs of investigation. The indemnified party shall have the right to employ separate counsel in any such action and to participate in the defense thereof, but the fees and expenses of such counsel shall not be at the expense of the indemnifying party if the indemnifying party has assumed the defense of the action with counsel reasonably satisfactory to the indemnified party; provided that, if the indemnified party is you or a person who controls you, the fees and expenses of such 17 18 counsel shall be at the expense of the indemnifying party if (i) the employment of such counsel has been specifically authorized in writing by the indemnifying party or (ii) the named parties to any such action (including any impleaded parties) include both you or such controlling person and the indemnifying party and you or such controlling person shall have been advised by such counsel that there is a conflict of interest which would prevent counsel for the indemnifying party from representing the indemnifying party and you or such controlling person (in which case the indemnifying party shall not have the right to assume the defense of such action on behalf of you or such controlling person, it being understood, however, that the indemnifying party shall not, in connection with any one such action or separate but substantially similar or related actions in the same jurisdiction or which are consolidated into the same jurisdiction arising out of the same general allegations or circumstances, be liable for the reasonable fees and expenses of more than one separate firm of attorneys for you and all such controlling persons, which firm shall be designated in writing by you). No settlement of any action against an indemnified party shall be made without the consent of the indemnified party, which shall not be unreasonably withheld in light of all factors of importance to such indemnified party. 8. Contribution. In order to provide for just and equitable contribution tinder the Act in any case in which (i) the indemnifying party makes a claim for indemnification pursuant to Section 7 hereof but it is judicially determined (by the entry of a final judgment or decree by a court of competent jurisdiction and the expiration of time to appeal or the denial of the last right of appeal) that such indemnification may not be enforced in such case notwithstanding the fact that the express provisions of Section 7 provide for indemnification in such case, or (ii) contribution under the Act may be required on the part of the Underwriters, then the Company and the Underwriters in the aggregate shall contribute to the aggregate losses, claims, damages, or liabilities to which they may be subject (which shall, for all purposes of this Agreement, include, but not be limited to, all costs of defense and investigation and all attorneys' fees) in either such case (after contribution from others) in such proportions that the Underwriters are responsible in the aggregate for that portion of such losses, claims, damages or liabilities determined by multiplying the total amount of such losses, claims, damages or liabilities times the difference between the public offering price and the commission to the Underwriters and dividing the product thereof by the public offering price, and the Company, if applicable, shall be responsible for that portion of such losses, claims, damages or liabilities times the commission to the Underwriters and dividing the product thereof by the public offering price; provided, however, that the Underwriters shall not be required to so contribute any amount in excess of the underwriting discount applicable to the Securities purchased by the Underwriters hereunder if such allocation is not permitted by applicable law, then the relative fault of the Company and the Underwriters in connection with the statements or omissions which resulted in such damages and other relevant equitable considerations shall also be considered. No person guilty of a fraudulent misrepresentation (within the meaning of Section 12(2) of the Act) shall be entitled to contribution from any person who is not guilty of such fraudulent misrepresentation. The foregoing contribution agreement shall in no way affect the contribution liabilities of any person having liability under Section 12 of the Act other than the Company and the Underwriter. As used in this paragraph, the term "Underwriters" includes any person who controls the Underwriters within the meaning of Section 15 of the Act. If the full amount of the contribution specified in this paragraph is not permitted by law, then any Underwriter and each person who controls any Underwriter shall be entitled to contribution from the Company, to the full extent permitted by law. 9. Effective Date. This Agreement shall become effective at 10:00 a.m. New York time on the next full business day following the effective date of the Registration Statement, or at such other time after the effective date of the Prospectus as you in your discretion shall first commence the public offering of any of the Securities covered thereby, provided, however, that at all times the provisions of Sections 7, 8, 9 and 11 shall be effective. 10. Termination. (a) This Agreement, may be terminated at any time prior to the Closing Date by you if in your judgment it is impracticable to offer for sale or to enforce contracts made by you for the sale of the Securities agreed to be sold hereunder by reason of (i) the Company as a whole having sustained a material loss, whether or not insured, by reason of fire, earthquake, flood, accident or other calamity, or from any labor dispute or court or government action, order or decree, (ii) trading in securities of the Company having been suspended by a state securities administrator or by the Commission, (iii) material governmental restrictions having been imposed on trading in 18 19 securities generally (not in force and effect on the date hereof) or trading on the New York Stock Exchange, American Stock Exchange, or in the over-the-counter market shall have been suspended, (iv) a banking moratorium having been declared by federal or New York State authorities, (v) an outbreak or escalation of hostilities or other national or international calamity having occurred, (vi) the passage by the Congress of the United States or by any state legislative body, of any act or measure, or the adoption of any orders, rules or regulations by any governmental body or any authoritative accounting institute or board, or any governmental executive, which is believed likely by you to have a material impact on the business, financial condition or financial statements of the Company; or (vii) any material adverse change having occurred, since the respective dates as of which information is given in the Prospectus, in the condition, financial or otherwise, of the Company as a whole, whether or not arising in the ordinary course of business, (viii) Paul J. White, Kenneth S. Kornman and Michael G. Newman cease to be employed by the Company in their present capacity; (ix) the Securities are not listed the American Stock Exchange or any other exchange or on NASDAQ. (b) If you elect to prevent this Agreement from becoming effective or to terminate this Agreement as provided in this Section 10 or in Section 9, the Company shall be promptly notified by you, by telephone or telegram, confirmed by letter. 11. Representations, Warrants and Agreements to Survive Delivery. The respective indemnities, agreements, representations, warranties and other statements of the Company (or its officers) and the Underwriters set forth in or made pursuant to this Agreement will remain in full force and effect, regardless of any investigation made by or on behalf of the Underwriters, the Company, or any of their officers or directors and will survive delivery of and payment for the Securities. 12. Notices. All communications hereunder will be in writing and, except as otherwise expressly provided herein, if sent to you, will be mailed, delivered or telephoned and confirmed to you at, Nutmeg Securities, Ltd., 495 Post Road East, Westport, CT 06880 Attn: Daniel T. Guilfoile, Director, Investment Banking Division; to the Company at 4400 MacArthur Boulevard, Suite 980, Newport Beach, CA 92660. 13. Parties in Interest. This Agreement is made solely for the benefit of the Underwriter(s), and the Company, and their respective controlling persons, directors and officers, and their respective successors, assigns, executors and administrators. No other person shall acquire or have any right under or by virtue of this Agreement. 14. Headings. The Section headings in this Agreement have been inserted as a matter of convenience of reference and are not a part of this Agreement. 15. Applicable Law. This Agreement shall be governed by and construed in accordance with the laws of the State of Connecticut, without giving effect to conflict of law principles. 16. Counterparts. This Agreement may be executed in any number of counterparts, each of which together shall constitute one and the same instrument. 19 20 If the foregoing correctly sets forth the understanding between the Company and you, as Representative of the several underwriters, please so indicate in the space provided below for such purpose, whereupon this letter and your acceptance shall constitute a binding agreement between us. Very truly yours, Medical Science Systems,Inc. By: ------------------------ Paul J. White, President Accepted as of the date first above written: Nutmeg Securities, Ltd. As Representative of the several Underwriters By: -------------------------------------- (Authorized Officer) (Vice) President Director, Investment Banking Division 20 21 EXHIBIT A SCHEDULE I UNDERWRITERS
Shares of Underwriters Common Stock - ------------ ------------ Nutmeg Securities, Ltd. Millennium Financial Group, Inc. --------- TOTAL 2,500,000 =========
21 EX-1.2 3 FORM OF AGREEMENT AMONG UNDERWRITERS 1 EXHIBIT 1.2 MEDICAL SCIENCE SYSTEMS, INC. 2,500,000 SHARES OF COMMON STOCK AGREEMENT AMONG UNDERWRITERS , 19 Nutmeg Securities, Ltd. 495 Post Road East Westport, Ct 06880 as Representative GENTLEMEN: We wish to confirm as follows the agreement among you, the undersigned and the other members of the Underwriting Group named in Schedule I to the Underwriting Agreement, as it is to be executed (all such parties being herein called the "Underwriters"), with respect to the purchase by the Underwriters severally from Medical Science Systems, Inc. ("Company") of 2,500,000 shares of Common Stock ("Securities") set forth in Schedule I to the Underwriting Agreement. The number of Securities to be purchased by each Underwriter from the Company shall be determined in accordance with Section 2 of the Underwriting Agreement. It is understood that changes may be made in those who are to be Underwriters and in the respective numbers of Securities to be purchased by them, but that the Underwriting Agreement will not be changed without our consent, except as provided herein, and in the Underwriting Agreement. The obligations of the Underwriters to purchase the number of Securities set opposite their respective names in Schedule I to the Underwriting Agreement, are herein called their "underwriting obligations." The number of Securities set opposite our name in said Schedule I, are herein called "our Securities." For purposes of this Agreement the following definitions shall be applicable: (a) "Manager's Concession" shall be the compensation to you for acting as Manager as provided in Paragraph 1 of not less than percent ( %) of the underwriting discount. The Manager's Concession shall include the right to a portion of the warrants to be issued pursuant to the Underwriting Agreement and, the right to the nonaccountable expenses to be paid pursuant to the Underwriting Agreement. (b) "Underwriting Group Concession" shall mean compensation to members of the Underwriting Group for assuming the underwriting risk and shall be not less than percent ( %) of the underwriting discount. (c) "Dealer's Concession" shall mean compensation to Dealers, who are members of the Selling Group and shall, as to Dealers who have executed an agreement with you, be not less than percent ( %) of the underwriting discount. (d) "Dealer's Reallowance Concession" shall mean the compensation allowed Dealers by Underwriters other than you and shall be one-half (1/2) of the Dealer's Concession. (e) It is contemplated that the underwriting discount will be ten percent (10%) of the offering price. You, in your absolute discretion, shall determine, within the foregoing limitations, the precise allocation of the underwriting discount and shall notify us of the same at least twenty-four (24) hours prior to the execution of the Underwriting Agreement. 1. Authority and Compensation of Representative. We hereby authorize you, as our Representative and on our behalf, (a) to enter into an agreement with the Company substantially in the form attached hereto as Exhibit A ("Underwriting Agreement"), but with such changes therein as in your judgment are not materially adverse to the Underwriters, (b) to exercise all the authority and discretion vested in the Underwriters and in you by the provisions 1 2 of the Underwriting Agreement, and (c) to take all such action as you, in your discretion, may deem necessary or advisable in order to carry out the provisions of the Underwriting Agreement and this Agreement and the sale and distribution of the Securities, provided, however, that the time within which the Registration Statement is required to become effective pursuant to the Underwriting Agreement will not be extended more than forty-eight (48) hours without the approval of a majority in interest of the Underwriters (including you). We authorize you, in executing the Underwriting Agreement on our behalf, to set forth in Schedule I of the Underwriting Agreement as our commitment to purchase the number of Securities (which shall not be substantially in excess of the number of Securities included in your invitation to participate unless we have agreed otherwise) included in a wire, telex, or similar means of communication transmitted by you to us at least twenty-four (24) hours prior to the commencement of the offering as our finalized underwriting participation. As our share of the compensation for your services hereunder, we will pay you, and we authorize you to charge to our account, a sum equal to the Manager's Concession. 2. Public Offering. A public offering of the Securities is to be made, as herein provided, as soon after the Registration Statement relating thereto shall become effective as in your judgment is advisable. The Securities shall be initially offered to the public at the public offering price of $ per share. You will advise us by telegraph or telephone when the Securities shall be released for offering. We authorize you as Representative of the Underwriters, after the initial public offering, to vary the public offering price, in your sole discretion, by reason of changes in general market conditions or otherwise. The public offering price of the Securities at any time in effect is herein called the "Offering Price." We hereby agree to deliver all preliminary and final Prospectuses as required for compliance with the provisions of Rule 15c2-8 under the Securities Exchange Act of 1934 and Section 5(b) of the Securities Act of 1933. You have heretofore delivered to us such preliminary Prospectuses as have been requested by us, receipt of which is hereby acknowledged, and will deliver such final Prospectuses as will be requested by us. 3. Offering to Dealers and Group Sales. We authorize you to reserve for offering and sale, and on our behalf to sell, to institutions or other retail purchasers (such sales being herein called "Group Sales") and to dealers selected by you (such dealers being herein called the "Dealers") all or any part of our Securities as you may determine. Such sales of Securities, if any, shall be made (i) in the case of Group Sales, at the Offering Price, and (ii) in the case of sales to Dealers, at -the Offering Price less the Dealer's Concession. Any Group Sales shall be as nearly as practicable in proportion to the underwriting obligations of the respective Underwriters. Any sales to Dealers made for our account shall be as nearly as practicable in the ratio that the Securities reserved for our account for offering to Dealers bears to the aggregate of all Securities of all Underwriters, including you, so reserved. On any Group Sales or sales to Dealers made by you on our behalf, we shall be entitled to receive only the Underwriter's Concession. You agree to notify us not less than twenty-four (24) hours prior to the commencement of the public offering as to the number of Securities, if any, which we may retain for direct sale. Prior to the termination of this Agreement, you may reserve for offering and sale, as herein before provided, any Securities remaining unsold theretofore retained by us and we may, with your consent, retain any Securities remaining unsold theretofore reserved by you. Sales to Dealers shall be made under a Selected Dealers Agreement, attached hereto as Exhibit B and by this reference incorporated herein. We authorize you to determine the form and manner of any communications with Dealers, and to make such changes in the Selected Dealers Agreement, as you may deem appropriate. In the event that there shall be any such agreements with Dealers, you are authorized to act as managers thereunder, and we agree, in such event, to be governed by the terms and conditions of such agreements. Each Underwriter agrees that it will not offer any of the Securities for sale at a price below the Offering Price or allow any concession therefrom, except as herein otherwise provided. We, as to our Securities, may enter into agreements with Dealers, but any Dealer's Reallowance Concession shall not exceed half of the Dealer's Concession. It is understood that any person to whom an offer may be made, as herein before provided, shall be a member of the National Association of Securities Dealers, Inc. ("NASD") or dealers or institutions with their principal place of 2 3 business located outside of the United States, its territories or possessions, and who are not eligible for membership under Section 1 of the Bylaws of the NASD who agree to make no sales within the United States, its territories or possessions, or to persons who are nationals thereof, or residents therein, and, in making sales, to comply with the NASD's Rules of Fair Practice. We authorize you to determine the form and manner of any public advertisement of the Securities. Nothing contained in this Agreement shall be deemed to restrict our right, subject to the provisions of this Section 3, to offer our Securities prior to the effective date of the Registration Statement, provided, however, that any such offer shall be made in compliance with any applicable requirements of the Securities Act of 1933 and the Securities Exchange Act of 1934 and the rules and regulations of the Securities and Exchange Commission thereunder and of any applicable state securities laws. 4. Repurchases in the Open Market. Any Securities sold by us (otherwise than through you) which, prior to the termination of this Agreement, or such earlier date as you may determine, shall be contracted for or purchased in the open market by you on behalf of any Underwriter or Underwriters, shall be repurchased by us on demand at a price equal to the cost of such purchase plus commissions and taxes, if any, on redelivery. Any Securities delivered on such repurchase need not be the identical Securities originally sold by us. In lieu of delivery of such Securities to us, you may (i) sell such Securities in any manner for our account and charge us with the amount of any loss or expense, or credit us with the amount of any profit, less any expense, resulting from such sale, or (ii) charge our account with an amount not in excess of the concession to Dealers on such Securities. 5. Delivery and Payment. We agree to deliver to you, at or before 9:00 A.M., New York, New York Time, on the Initial Closing Date referred to in the Underwriting Agreement, at your office, a certified or bank cashier's check payable to your order for the offering price of the Securities less Dealer's Concession of the Securities which we retained for direct sale by us, the proceeds of which check shall be delivered to you, in the manner provided in the Underwriting Agreement, to or for the account of the Company against delivery of certificates for such Securities to you for our account. You are authorized to accept such delivery and to give receipts therefor. You may advance funds for Securities which have been sold or reserved for sale to retail purchasers or Dealers for our account. If we fail (whether or not such failure shall constitute a default hereunder) to deliver to you, or you fail to receive, our check and/or payment for sales made by you for our account for the Securities which we have agreed to purchase, you, individually and not as Representative of the Underwriters, are authorized (but shall not be obligated) to make payment, in the manner provided in the Underwriting Agreement, to or for the account of the Company for such Securities for our account, but any such payment by you shall not relieve us of any of our obligations under the Underwriting Agreement or under this Agreement and we agree to repay you on demand the amount so advanced for our account. We also agree on demand to take up and pay for or to deliver to you funds sufficient to pay for at cost any Securities of the Company purchased by you for our account pursuant to the provisions of Section 9 hereof, and to deliver to you on demand any Securities sold by you for our account, pursuant to any provision of this Agreement. We authorize you to deliver our Securities, and any other Securities purchased by you for our account pursuant to the provisions of Section 9 hereof, against sales made by you for our account pursuant to any provision of this Agreement. Upon receipt by you of payment for the Securities sold by us and/or through you for our account, you will remit to us promptly an amount equal to the Underwriter's Concession on such Securities. You agree to cause to be delivered to us, as soon as practicable after the Closing Date referred to in the Underwriting Agreement, such part of our Securities purchased on such Closing Date as shall not have been sold or reserved for sale by you for our account. In case any Securities reserved for sale in Group Sales or to Dealers shall not be purchased and paid for in due course as contemplated hereby, we agree to accept delivery when tendered by you of any Securities so reserved for our account and not so purchased and pay you the offering price less the Dealer's and Underwriter's Concessions. 3 4 6. Authority to Borrow. We authorize you to advance your funds for our account (charging current interest rates) and to arrange loans for our account for the purpose of carrying out this Agreement, and in connection therewith to execute and deliver any notes or other instruments, and to hold, or pledge as security therefor, all or any part of our Securities of the Company purchased hereunder for our account. Any lending bank is hereby authorized to accept your instructions as Representative in all matters relating to such loans. Any part of our Securities held by you, may be delivered to us for carrying purposes, and if so delivered, will be redelivered to you upon demand. 7. Allocation of Expense and Liability. We authorize you to charge our account with, and we agree to pay (a) all transfer taxes on sales made by you for our account, except as herein otherwise provided, and (b) our proportionate share (based on our underwriting obligations) of all expenses in excess of those reimbursed by the Company incurred by you in connection with the purchase, carrying and distribution, or proposed purchase and distribution, of the Securities and all other expenses arising under the terms of the Underwriting Agreement or this Agreement. Your determination of all such expenses and your allocation thereof shall be final and conclusive. Funds for our account at any time in your hands as our Representative may be held in your general funds without accountability for interest. As soon as practicable after the termination of this Agreement, the net credit or debit balance in our account, after proper charge and credit for all interim payments and receipts, shall be paid to or paid by us, provided, however, that you, in your discretion, may reserve from distribution an amount to cover possible additional expenses chargeable to the several Underwriters. 8. Liability for Future Claims. Neither any statement by you, as Representative of the Underwriters, of any credit or debit balance in our account nor any reservation from distribution to cover possible additional expenses relating to the Securities shall constitute any representation by you as to the existence or nonexistence of possible unforeseen expenses or liabilities of or charges against the several Underwriters. Notwithstanding the distribution of any net credit balance to us or the termination of this Agreement, or both, we shall be and remain liable for, and will pay on demand, (a) our proportionate share (based on our underwriting obligations) of all expenses and liabilities which may be incurred by, or for the accounts of the Underwriters, including any liability which may be incurred by the Underwriters or any of them, and (b) any transfer taxes paid after such settlement on account of any sale or transfer for our account. 9. Stabilization. We authorize you, until the termination of this Agreement, (a) to make purchases and sales of the Securities, in the open market or otherwise, for long or short account, and on such terms, and at such prices as you in your discretion may deem desirable, (b) in arranging for sales of Securities, to overallot, and (c) either before or after the termination of this Agreement, to cover any short position incurred pursuant to this Section 9; subject, however, to the applicable rules and regulations of the Securities and Exchange Commission under the Securities Exchange Act of 1934. All such purchases, sales and overallotments shall be made for the accounts of the several Underwriters as nearly as practicable in proportion to their respective underwriting obligations; provided, however, that our net position resulting from such purchases and sales and overallotments shall not at any time exceed, either for long or short account, fifteen percent (15%) of the number of Securities agreed to be purchased by us. If you engage in any stabilizing transactions as representative of the underwriters, you shall promptly notify us of that fact and in like manner you agree to promptly notify and file with us any stabilizing transaction in accordance with the requirements of Rule 17a-2(d) under the Securities Exchange Act of 1934. We agree to advise you from time to time, upon request, until the settlement of accounts hereunder, of the number of Securities at the time retained by us unsold, and we will upon request sell to you, for the accounts of one or more of the several Underwriters, such number of our unsold Securities as you may designate, at the Offering Price less such amount, not in excess of the concession to Dealers, as you may determine. 10. Open Market Transactions. We agree that, except with your consent and except as herein provided upon advice from you, we will not make purchases or sales on the open market or otherwise, or attempt to induce others to make purchases or sales, either before or after the purchase of the Securities, and prior to the completion (as defined in Regulation M of the Securities Exchange Act of 1934) of our participation in the distribution, we will otherwise 4 5 comply with Regulation M. Nothing in this Section 10 contained shall prohibit us from acting as broker or agent in the execution of unsolicited orders of customers for the purchase or sale of any securities of the Company. 11. Blue Sky. Prior to the initial offering by the Underwriters, you will inform us as to the states under the respective securities or Blue Sky laws of which it is believed that the Securities have been qualified or are exempt for sale, but you do not assume any responsibility or obligation as to the accuracy of such information or as to the right of any Underwriter or Dealer to sell the Securities in any jurisdiction. We will not sell any Securities in any other state or jurisdiction and we will not sell Securities in any state or jurisdiction unless we are qualified or licensed to sell securities in such state or jurisdiction. We authorize you, if you deem it inadvisable in arranging sales of Securities for our account hereunder, to sell any of our Securities to any particular Dealer, or other buyer, because of the securities or Blue Sky laws of any jurisdiction, to sell our Securities to one or more other Underwriters at the Offering Price less, in the case of a sale to any Dealer, such amount, not in excess of the concession to Dealers thereon, as you may determine. The transfer tax on any such sales among Underwriters shall be treated as an expense and charged to the respective accounts of the several Underwriters, in proportion to their respective underwriting obligations. 12. Default by Underwriters. Default by one or more Underwriters, in respect to their obligations under the Underwriting Agreement shall not release us from any of our obligations. In case of such default by one or more Underwriters, you are authorized to increase, pro rata, with the other nondefaulting Underwriters, the number of defaulted Securities which we shall be obligated to purchase from the Company, provided, however, that the aggregate amount of all such increases for all Underwriters shall not exceed ten percent (10%) of such Securities, and, if the aggregate number of the Securities not taken up by such defaulting Underwriters exceeds such ten percent (10%), you are further authorized, but shall not be obligated, to arrange for the purchase by other persons, who may include yourselves, of all or a portion of the Securities not taken up by such Underwriters. In the event any such increases or arrangements are made, the respective numbers of Securities to be purchased by the nondefaulting Underwriters and by any such other person or persons shall be taken as the basis for the underwriting obligations under this Agreement, but this shall not in any way affect the liability of any defaulting Underwriters to the other Underwriters for damages resulting from such default. In the event of default by one or more Underwriters in respect of their obligations under this Agreement to take up and pay for any Securities purchased by your for their respective accounts, pursuant to Section 9 hereof, or to deliver any such Securities sold or overallotted by you for their respective accounts pursuant to any provisions of this Agreement, and to the extent that arrangements shall not have been made by you for other persons to assume the obligations of such defaulting Underwriter or Underwriters, each nondefaulting Underwriter shall assume its proportionate share of the aforesaid obligations of each such defaulting Underwriter without relieving any such Underwriter of its liability therefor. 13. Termination of Agreement. Unless earlier terminated by you, the provisions of Sections 2, 3, 4, 6, 9 and 10 of this Agreement shall, except as otherwise provided therein, terminate thirty (30) full business days after the effective date of the Registration Statement herein referred to, but may be extended by you for an additional period or periods not exceeding thirty (30) full business days in the aggregate. Except as otherwise provided, you may terminate this Agreement, or any provisions hereof, at any time by written or telegraphic notice to us. 14. General Position of the Representative. In taking action under this Agreement, you shall act only as agent of the several Underwriters. Your authority as Representative of the several Underwriters shall include the taking of such action as you may deem advisable in respect of all matters pertaining to any and all offers and sales of the Securities, including the right to make any modifications which you consider necessary or desirable in the arrangements with Dealers or others. You shall be under no liability for or in respect of the value of the Securities or the validity or the form thereof, the Registration Statement, the Prospectus, the Underwriting Agreement, or other instruments executed by the Company or others of any agreement on its or their part; nor shall you, as such Representative or otherwise, be liable under any of the provisions hereof, or for any matters connected herewith, except for want of good faith, and except for any liability arising under the Securities Act of 1933; and no obligation not expressly assumed by you as such Representative herein shall be implied from this Agreement. In representing the Underwriters hereunder, you shall act as the representative of each of them respectively. Nothing herein contained shall constitute the several Underwriters partners with you or with each other, or render any Underwriter 5 6 liable for the commitments of any other Underwriter, except as otherwise provided in Section 12 hereof. The commitments and liabilities of each of the several Underwriters are several in accordance with their respective underwriting obligations and are not joint. 15. Acknowledgment of Registration Statement, etc. We hereby confirm that we have examined the Registration Statement (including all amendments thereto) relating to the Securities as heretofore filed with the Securities and Exchange Commission, that we are familiar with the amendment(s) to the Registration Statement and the final form of Prospectus proposed to be filed, that we are willing to accept the responsibilities of an underwriter thereunder, and that we are willing to proceed as therein contemplated. We further confirm that the statements made under the heading "Underwriting" in such proposed final form of Prospectus are correct and we authorize you so to advise the Company on our behalf. We understand that the aforementioned documents are subject to further change and that we will be supplied with copies of any amendment or amendments to the Registration Statement and of any amended Prospectus promptly, if and when received by you, but the making of such changes and amendments shall not release us or affect our obligations hereunder or under the Underwriting Agreement. 16. Indemnification. Each Underwriter, including you, agrees to indemnify and hold harmless each other Underwriter and each person who controls any other Underwriter within the meaning of Section 15 of the Securities Act of 1933, as amended, to the extent of their several commitments under the Underwriting Agreement and upon the terms that such Underwriter agrees to indemnify and hold harmless the Company as set forth in Section 7 of the Underwriting Agreement. The Agreement contained in this Section 16 shall survive any termination of this Agreement Among Underwriters. 17. Capital Requirements. We confirm that our ratio of aggregate indebtedness to net capital is such that we may, in accordance with and pursuant to Rule 15c3-1, promulgated by the Securities and Exchange Commission under the Securities Exchange Act of 1934, agree to purchase the number of Securities we may be obligated to purchase under any provision of the Underwriting Agreement or this Agreement. 18. Miscellaneous. We have transmitted herewith a completed Underwriters' Questionnaire on the form thereof supplied by you. Any notice hereunder from you to us or from us to you shall be deemed to have been duly give if sent by registered mail, telegram, teletype, telex, telecopier, graphic scan, or other written form of telecommunication to us at our address as set forth in the Underwriting Agreement, or to you at the address set forth on the first page of this Agreement. You hereby confirm that you are registered as a broker-dealer with the United States Securities and Exchange Commission and that you are a member of the NASD and we confirm that we are either a member of the NASD or a foreign broker-dealer not eligible for membership under Section I of the Bylaws of the NASD, who agrees to make no sales within the United States, its territories or possessions, or to persons who are nationals thereof or residents therein, and, in making sales, to comply with the requirements of the NASD's Interpretation with Respect to Free Riding and Withholding, and with Sections 2730, 2740 and 2420 to the extent applicable to foreign nonmember brokers or dealers, and Section 2750 of the NASD's Rules of Fair Practice. We will comply with all applicable federal laws, the laws of the states or other jurisdictions concerned and the Rules and Regulations of the NASD, including, but not limited to, Section 2740 of the Rules of Fair Practice. This instrument may be signed by the Underwriters in various counterparts which together shall constitute one and the same agreement among all the Underwriters and shall become effective as between us at such time as you shall have confirmed same by returning an executed copy to us, and thereafter, as to us and the other Underwriters, upon execution by them of counterparts which are confirmed by you. In no event, however, shall we have any liability under this Agreement if the Underwriting Agreement is not executed. 6 7 Please confirm that the foregoing correctly states the understanding between us by signing and returning to us a counterpart hereof. Very truly yours, By --------------------------------- Attorney-in-Fact for the several Underwriters named in Schedule I to the Underwriting Agreement Confirmed as of the date first above written. NUTMEG SECURITIES,LTD. As Representative By: ---------------------------------------- President or Director Investment Banking 7 EX-1.3 4 FORM OF SELECTED DEALERS AGREEMENT 1 EXHIBIT 1.3 EXHIBIT B A REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE SECURITIES AND EXCHANGE COMMISSION BUT HAS NOT YET BECOME EFFECTIVE. NO OFFER TO BUY THE SECURITIES CAN BE ACCEPTED AND NO PART OF THE PURCHASE PRICE CAN BE RECEIVED UNTIL THE REGISTRATION STATEMENT HAS BECOME EFFECTIVE, AND ANY SUCH OFFER MAY BE WITHDRAWN OR REVOKED, WITHOUT OBLIGATION OR COMMITMENT OF ANY KIND, AT ANY TIME PRIOR TO NOTICE OF ITS ACCEPTANCE GIVEN AFTER THE EFFECTIVE DATE. YOUR EXECUTION HEREOF WELL INVOLVE NO OBLIGATION OR COMMITMENT OF ANY KIND UNTIL THE REGISTRATION STATEMENT HAS BECOME EFFECTIVE. MEDICAL SCIENCE SYSTEMS, INC. SELECTED DEALERS AGREEMENT , 19 Dear Sirs: 1. Nutmeg Securities, Ltd., named as the Underwriter ("Underwriter") in the enclosed preliminary Prospectus, proposes to offer on a firm commitment basis, subject to the terms and conditions and execution of the Underwriting Agreement, 2,500,000 Shares of Common Stock at $ per share ("Securities") of the above Company. The Securities are more particularly described in the enclosed preliminary Prospectus, additional copies of which will be supplied in reasonable quantities upon request. Copies of the definitive Prospectus will be supplied after the effective date of the Registration Statement. 2. The Underwriter is soliciting offers to buy, upon the terms and conditions hereof, a part of the Securities from Selected Dealers, including you who are to act as principal and who are (i) registered with the Securities and Exchange Commission ("Commission") as broker-dealers under the Securities Exchange Act of 1934, as amended ("1934 Act"), and members in good standing with the National Association of Securities Dealers, Inc. ("NASD"), or (ii) dealers or institutions with their principal place of business located outside the United States, its territories and possessions who are not eligible for membership in the NASD and who agree to make no sales within the United States, its territories or possessions or to persons who are nationals thereof or residents therein and, in making sales, to comply with the NASD's Interpretation with Respect to Free Riding and Withholding and with Sections 2730, 2740, 2420, to the extent applicable to foreign nonmember brokers or dealers, and Section 2750 of the NASD's Rules of Fair Practice. The Securities are to be offered at a public price of $ per share of Common Stock. Selected Dealers will be allowed a concession of not less than $ per share, except as provided below. You will be notified of the precise amount of such concession prior to the effective date of the Registration Statement. You may reallow not in excess of $ per share to dealers who meet the requirements set forth in this Section 2. This offer is solicited subject to the issuance and delivery of the Securities and their acceptance by the Underwriter, to the approval of legal matters by counsel and to the terms and conditions as herein set forth. 3. Your offer to purchase may be revoked in whole or in part without obligation or commitment of any kind by you and any time prior to acceptance and no offer may be accepted by us and no sale can be made until after the registration statement covering the Securities has become effective with the Commission. Subject to the foregoing, upon execution by you of the Offer to Purchase below and the return of same to us, you shall be deemed to have offered to purchase the number of Securities set forth in your offer on the basis set forth in paragraph 2 above. 1 2 Any oral notice by us of acceptance of your offer shall be immediately followed by written or telegraphic confirmation preceded or accompanied by a copy of the Prospectus. If a contractual commitment arises hereunder, all the terms of this Selected Dealers Agreement shall be applicable. We may also make available to you an allotment to purchase Securities, but such allotment shall be subject to modification or termination upon notice from us any time prior to an exchange of confirmations reflecting completed transactions. All references hereafter in this Agreement to the purchase and sale of Securities assume and are applicable only if contractual commitments to purchase are completed in accordance with the foregoing. 4. You agree that in reoffering said Securities, if your offer is accepted after the effective date, you will make a bona fide public distribution of same. You will advise us upon request of Securities purchased by you remaining unsold and we shall have the right to repurchase such Securities upon demand at the public offering price without paying the concession with respect to any Securities so repurchased. Any of the Securities purchased by you pursuant to this Agreement are to be subject to the terms hereof. Securities shall not be offered or sold by you below the public offering price before the termination of this Agreement. 5. Payment for Securities which you purchase hereunder shall be made by you on or before three (3) business days after the date of each confirmation by certified or bank cashier's check payable to the Underwriter. Certificates for the Securities shall be delivered as soon as practicable after delivery instructions are received by the Underwriter. 6. A registration statement covering the offering has been filed with the Securities and Exchange Commission in respect to the Securities. You will be promptly advised when the registration statement becomes effective. Each Selected Dealer in selling Securities pursuant hereto agrees (which agreement shall also be for the benefit of the Company) that it will comply with the applicable requirements of the Securities Act of 1933 and of the Securities Exchange Act of 1934 and any applicable rules and regulations issued under said Acts. No person is authorized by the Company or by the Underwriter to give any information or to make any representations other than those contained in the Prospectus in connection with the sale of the Securities. Nothing contained herein shall render the Selected Dealers a member of the Underwriting Group or partners with the Underwriter or with one another. 7. You will be informed by us as to the states in which we have been advised by counsel the Securities have been qualified for sale or are exempt under the respective securities or blue sky laws of such states, but we have not assumed and will not assume any obligation or responsibility as to the right of any Selected Dealer to sell Securities in any state. You agree not to sell Securities in any other state or jurisdiction and to not sell Securities in any state or jurisdiction unless you are qualified or licensed to sell securities in such state or jurisdiction. 8. The Underwriter shall have full authority to take such action as it may deem advisable in respect of all matters pertaining to the offering or arising thereunder. The Underwriter shall not be under any liability to you, except such as may be incurred under the Securities Act of 1933 and the rules and regulations thereunder, except for lack of good faith and except for obligations assumed by us in this Agreement, and no obligation on our part shall be implied or inferred herefrom. 9. Selected Dealers will be governed by the conditions herein set forth until this Agreement is terminated. This Agreement will terminate when the offering is completed. Nothing herein contained shall be deemed a commitment on our part to sell you any Securities; such contractual commitment can only be made in accordance with the provisions of paragraph 3 hereof. 10. You represent that you are a member in good standing of the NASD and registered as a broker-dealer with the Commission, or that you are a foreign broker-dealer not eligible for membership under Section 1 of the Bylaws of the NASD who agrees to make no sales within the United States, its territories or possessions or to persons who are nationals thereof or residents therein and, in making sales, to comply with the NASD's interpretation with Respect to Free Riding and Withholding and with Sections 2730, 2740, 2420 to the extent applicable to foreign nonmember brokers and dealers, and Section 2750 of the NASD's Rules of Fair Practice. Your attention is called to and you agree to comply with the following: (a) Article III, Section 1 of the Rules of Fair Practice of the NASD and the interpretations of said Section promulgated by the Board of Governors of the NASD including Section 24 and the 2 3 interpretation with respect to "Free-Riding and Withholding;" (b) Section 10(b) of the 1934 Act and Regulation M and Rule 10b-10 of the general rules and regulations promulgated under the 1934 Act; and (c) Rule 15c2-8 of the general rules and regulations promulgated under the 1934 Act requiring the distribution of a preliminary Prospectus to all persons reasonably expected to be purchasers of the Securities from you at least 48 hours prior to the time you expect to mail confirmations. You, as a member of the NASD, by signing this Agreement, acknowledge that you are familiar with the cited laws and rules and agree that you will not directly and/or indirectly violate any provisions of applicable law in connection with your participation in the distribution of the Securities. 11. In addition to compliance with the provisions of paragraph 10 hereof, you will not, until advised by us in writing or by wire that the entire offering has been distributed and closed, bid for or purchase Securities in the open market or otherwise make a market in the Securities or otherwise attempt to induce others to purchase the Securities in the open market. Nothing contained in this paragraph 11 shall, however, preclude you from acting as agent in the execution of unsolicited orders of customers in transactions effectuated for them through a market maker. 12. You understand that the Underwriter may in connection with the offering engage in stabilizing transactions. If the Underwriter contracts for or purchases in the open market in connection with such stabilization any Securities sold to you hereunder and not effectively placed by you, the Underwriter may charge you the Selected Dealer's concession originally allowed you on the Securities so purchased and you agree to pay such amount to us on demand. 13. By submitting an Offer to Purchase you confirm that you may, in accordance with Rule 15c3-1 adopted under the 1934 Act, agree to purchase the number of Securities you may become obligated to purchase under the provisions of this Agreement. 14. All communications from you should be directed to us at 495 Post Road East, Westport, CT 06880 Attn: Daniel T. Guilfoile, Director Investment Banking Division (203-226-1857) and fax (203-226-5343). All communications from us to you shall be directed to the address to which this letter is mailed. Very truly yours, Nutmeg Securities, Ltd. By: -------------------------------- (Authorized Officer) 3 4 OFFER TO PURCHASE The undersigned does hereby offer to purchase (subject to the right to revoke as set forth in paragraph 3) ___________________* Securities in accordance with the terms and conditions set forth above. We hereby acknowledge receipt of the Prospectus referred to in the first paragraph thereof relating to such Securities. We further state that in purchasing such Securities we have relied upon such Prospectus and upon no other statement whatsoever, written or oral. - ------------------------------------ By: --------------------------------- (Authorized Officer) - --------------- * If a number appears here which does not correspond with what you wish to offer to purchase, you may change the number by crossing out the number, inserting a different number and initializing the change. 4 EX-4.2 5 FORM OF UNDERWRITERS' WARRANT 1 EXHIBIT 4.2 THIS WARRANT AND THE SECURITIES ISSUABLE UPON EXERCISE OF THIS WARRANT HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933 (THE "ACT") OR ANY STATE SECURITIES LAWS AND MAY NOT BE OFFERED, SOLD, TRANSFERRED, PLEDGED OR HYPOTHECATED IN THE ABSENCE OF ANY EFFECTIVE REGISTRATION STATEMENT AS TO SUCH SECURITIES FILED UNDER THE ACT, OR AN EXEMPTION FROM REGISTRATION, AND COMPLIANCE WITH APPLICABLE STATE SECURITIES LAWS. THE ISSUER MAY REQUIRE AN OPINION OF COUNSEL SATISFACTORY TO THE ISSUER HEREOF THAT SUCH REGISTRATION IS NOT REQUIRED AND THAT SUCH LAWS ARE COMPLIED WITH. VOID AFTER 3:30 P.M., EASTERN TIME, ON , 2002. MEDICAL SCIENCE SYSTEMS, INC. UNDERWRITERS' WARRANT TO PURCHASE SHARES OF COMMON STOCK This is to Certify That, FOR VALUE RECEIVED, ____________________________ (the "Holder") is entitled to purchase, subject to the provisions of this warrant (the "Warrant"), from Medical Science Systems, Inc. (the "Company"), a Texas corporation, at any time on or after , 1998, and not later than 3:30 p.m., Eastern Time, on 2002, shares of Common Stock of the Company ("Securities") exercisable at a purchase price for the shares of Common Stock which is 165% of the public offering price of the Common Stock ($ ). The number of Securities to be received upon the exercise of this Warrant and the price to be paid for the Securities may be adjusted from time to time as hereinafter set forth. The purchase price of a share of Common Stock in effect at any time and as adjusted from time to time is hereinafter sometimes referred to as the "Exercise Price." This Warrant is or may be one of a series of Warrants identical in form issued by the Company to purchase an aggregate of 250,000 shares of Common Stock. The shares of Common Stock, as adjusted from time to time underlying the Warrants are hereinafter sometimes referred to as "Warrant Shares". The Common Stock issuable upon the exercise hereof are in all respects identical to the Common Stock being purchased by the Underwriter for resale to the public pursuant to the terms and conditions of the Underwriting Agreement. (a) Exercise of Warrant. Subject to the provisions of Section (g) hereof, this Warrant may be exercised in whole or in part at anytime or from time to time on or after , 1998, but not later than 3:30 p.m., Eastern Time on , 2002, or if , 2002, is a day on which banking institutions are authorized by law to close, then on the next succeeding day which shall not be such a day, by presentation and surrender hereof to the Company or at the office of its stock transfer agent, if any, with the Purchase Form annexed hereto duly executed and accompanied by payment of the Exercise Price for the number of shares specified in such Form, together with all federal and state taxes applicable upon such exercise. The Company agrees to provide notice to the Holder that any tender offer is being made for the Company's shares of Common Stock no later than the day the Company becomes aware that any tender offer is being made for the Company's shares of Common Stock. If this Warrant should be exercised in part only, the Company shall, upon surrender of this Warrant for cancellation, execute and deliver a new Warrant evidencing the right of the Holder to purchase the balance of the shares purchasable hereunder along with any additional Underwriters' Warrants not exercised. Upon receipt by the Company of this Warrant at the office of the Company or at the office of the Company's stock transfer agent, in proper form for exercise and accompanied by the total Exercise Price, the Holder shall be deemed to be the holder of record of the shares of Common Stock issuable upon such exercise, notwithstanding that the stock transfer books of the Company shall then be closed or that certificates representing such shares of Common Stock shall not then be actually delivered to the Holder. (b) Reservation of Securities. The Company hereby agrees that at all times there shall be reserved for issuance and/or delivery upon exercise of this Warrant such number of shares of its Common Stock as shall be required for issuance or delivery upon exercise of this Warrant. The Company covenants and agrees that, upon exercise of the 1 2 Warrants and payment of the Exercise Price therefor, all shares of Common Stock and other securities issuable upon such exercise shall be duly and validly issued, fully paid, non-assessable and not subject to the preemptive rights of any stockholder. As long as the Warrants shall be outstanding, the Company shall use its best efforts to cause all shares of Common Stock issuable upon the exercise of the Warrants to be listed (subject to official notice of issuance) on all securities exchanges on which the Common Stock issued to the public in connection herewith may then be listed and/or quoted on NASDAQ. (c) Fractional Shares. No fractional shares or scrip representing fractional shares shall be issued upon the exercise of this Warrant. With respect to any fraction of a share called for upon any exercise hereof, the Company shall pay to the Holder an amount in cash equal to such fraction multiplied by the current market value of such fractional share, determined as follows: (1) If the Common Stock is listed on a national securities exchange or admitted to unlisted trading privileges on such exchange, the current value shall be the last reported sale price of the Common Stock on such exchange on the last business day prior to the date of exercise of this Warrant or if no such sale is made on such day, the average of the closing bid and asked prices for such day on such exchange; or (2) If the Common Stock is not so listed or admitted to unlisted trading privileges, the current value shall be the mean of the last reported bid and asked prices reported by the National Association of Securities Dealers Automated Quotation System (or, if not so quoted on NASDAQ, by the National Quotation Bureau, Inc.) on the last business day prior to the date of the exercise of this Warrant; or (3) If the Common Stock is not so listed or admitted to unlisted trading privileges and bid and asked prices are not so reported, the current value shall be an amount, not less than book value, determined in such reasonable manner as may be prescribed by the Board of Directors of the Company, such determination to be final and binding on the Holder. (d) Exchange, Assignment or Loss of Warrant. This Warrant is exchangeable, without expense, at the option of the Holder, upon presentation and surrender hereof to the Company or at the office of its stock transfer agent, if any, for other Warrants of different denominations entitling the Holder thereof to purchase (under the same terms and conditions as provided by this Warrant) in the aggregate the same number of shares of Common Stock purchasable hereunder. This Warrant may not be sold, transferred, assigned, or hypothecated until after one year from the effective date of the registration statement except that it may be (i) assigned in whole or in part to the officers of the "Underwriter", and (ii) transferred to any successor to the business of the "Underwriter." Any such assignment shall be made by surrender of this Warrant to the Company, or at the office of its stock transfer agent, if any, with the Assignment Form annexed hereto duly executed and with funds sufficient to pay any transfer tax; whereupon the Company shall, without charge, execute and deliver a new Warrant in the name of the assignee named in-such instrument of assignment, and this Warrant shall promptly be canceled. This Warrant may be divided or combined with other Warrants which carry the same rights upon presentation hereof at the office of the Company or at the office of its stock transfer agent, if any, together with a written notice specifying the names and denominations in which new Warrants are to be issued and signed by the Holder hereof. The term "Warrant" as used herein includes any Warrants issued in substitution for or replacement of this Warrant, or into which this Warrant may be divided or exchanged. Upon receipt by the Company of evidence satisfactory to it of the loss, theft, destruction or mutilation of this Warrant, and (in the case of loss, theft or destruction) of reasonably satisfactory indemnification, and upon surrender and cancellation of this Warrant, if mutilated, the Company will execute and deliver a new Warrant of like tenor and date. Any such new Warrant executed and delivered shall constitute an additional contractual obligation on the part of the Company, whether or not this Warrant so lost, stolen, destroyed, or mutilated shall be at any time enforceable by anyone. (e) Rights of the Holder. The Holder shall not, by virtue hereof, be entitled to any rights of a shareholder in the Company, either at law or equity, and the rights of the Holder are limited to those expressed in the Warrant and are not enforceable against the Company except to the extent set forth herein. 2 3 (f) Notices to Warrant Holders. So long as this Warrant shall be outstanding and unexercised (i) if the Company shall make any stock distribution upon the Common Stock, or (ii) if the Company shall offer to the holders of Common Stock for subscription or purchase by them any shares of stock of any class or any other rights, or (iii) if any capital reorganization of the Company, reclassification of the capital stock of the Company, consolidation or merger of the Company with or into another corporation, sale, lease or transfer of all or substantially all of the property and assets of the Company to another corporation, or voluntary or involuntary dissolution, liquidation or winding up of the Company shall be effected, then, in any such case, the Company shall cause to be delivered to the Holder, at least ten (10) days prior to the date specified in (x) or (y) below, as the case may be, a notice containing a brief description of the proposed action and stating the date on which (x) a record is to be taken for the purpose of such dividend, distribution or rights, or (y) such reclassification, reorganization, consolidation, merger, conveyance, lease, dissolution, liquidation or winding up is to take place and the date, if any, is to be fixed, as of which the holders of Common Stock of record shall be entitled to exchange their shares of Common Stock for equivalent securities or other property deliverable upon such reclassification, reorganization, consolidation, merger, conveyance, dissolution, liquidation or winding up. (g) Adjustment of Exercise Price and Number of Shares of Common Stock Deliverable. (A)(i) Except as hereinafter provided, in the event the Company shall, at any time or from time to time after the date hereof, issue any shares of Common Stock as a stock dividend to the holders of Common Stock, or subdivide or combine the outstanding shares of Common Stock into a greater or lesser number of shares (any such issuance, subdivision or combination being herein called a "Change of Shares"), then, and thereafter upon each further Change of Shares, the Exercise Price for the Warrants (whether or not the same shall be issued and outstanding) in effect immediately prior to such Change of Shares shall be changed to a price (including any applicable fraction of a cent to the nearest cent) determined by dividing (i) the sum of (a) the total number of shares of Common Stock outstanding immediately prior to such Change of Shares, multiplied by the Exercise Price in effect immediately prior to such Change of Shares, and (b) the consideration, if any, received by the Company upon such issuance, subdivision or combination by (ii) the total number of shares of Common Stock outstanding immediately after such Change of Shares; provided, however, that in no event shall the Exercise Price be adjusted pursuant to this computation to an amount in excess of the Exercise Price in effect immediately prior to such computation, except in the case of a combination of outstanding shares of Common Stock. For the purposes of any adjustment to be made in accordance with this Section (g) the following provisions shall be applicable: (I) Shares of Common Stock issuable by way of dividend or other distribution on any capital stock of the Company shall be deemed to have been issued immediately after the opening of business on the day following the record date for the determination of shareholders entitled to receive such dividend or other distribution and shall be deemed to have been issued without consideration. (II) The number of shares of Common Stock at any one time outstanding shall not be deemed to include the number of shares issuable (subject to readjustment upon the actual issuance thereof) upon the exercise of options, rights or warrants and upon the conversion or exchange of convertible or exchangeable securities. (ii) Upon each adjustment of the Exercise Price pursuant to this Section (g), the number of shares of Common Stock purchasable upon the exercise of each Warrant shall be the number derived by multiplying the number of shares of Common Stock purchasable immediately prior to such adjustment by the Exercise Price in effect prior to such adjustment and dividing the product so obtained by the applicable adjusted Exercise Price. (B) In case of any reclassification or change of outstanding shares of Common Stock issuable upon exercise of the Warrants (other than a change in par value, or from par value to no par value, or from no par value to par value or as a result of a subdivision or combination), or in case of any consolidation or merger of the Company with or into another corporation other than a merger with a "Subsidiary" (which shall mean any corporation or corporations, as the 3 4 case may be, of which capital stock having ordinary power to elect a majority of the Board of Directors of such corporation (regardless of whether or not at the time capital stock of any other class or classes of such corporation shall have or may have voting power by reason of the happening of any contingency) is at the time directly or indirectly owned by the Company or by one or more Subsidiaries) or by the Company and one or more Subsidiaries in which merger the Company is the continuing corporation and which does not result in any reclassification or change of the then outstanding shares of Common Stock or other capital stock issuable upon exercise of the Warrants (other than a change in par value, or from par value to no par value, or from no par value to par value or as a result of subdivision or combination) or in case of any sale or conveyance to another corporation of the property of the Company as an entirety or substantially as an entirety, then, as a condition of such reclassification, change, consolidation, merger, sale or conveyance, the Company, or such successor or purchasing corporation, as the case may be, shall make lawful and adequate provision whereby the Holder of each Warrant then outstanding shall have the right thereafter to receive on exercise of such Warrant the kind and amount of securities and property receivable upon such reclassification, change, consolidation, merger, sale or conveyance by a holder of the number of securities issuable upon exercise of such Warrant immediately prior to such reclassification, change, consolidation, merger, sale or conveyance and shall forthwith file at the principal office of the Company a statement signed by its President or a Vice President and by its Treasurer or an Assistant Treasurer or its Secretary or an Assistant Secretary evidencing such provision. Such provisions shall include provision for adjustments which shall be as nearly equivalent as may be practicable to the adjustments provided for in Section (g)(A). The above provisions of this Section (g)(B) shall similarly apply to successive reclassifications and changes of shares of Common Stock and to successive consolidations, mergers, sales or conveyances. (C) Irrespective of any adjustments or changes in the Exercise Price or the number of shares of Common Stock purchasable upon exercise of the Warrants, the Warrant Certificates theretofore and thereafter issued shall, unless the Company shall exercise its option to issue new Warrant Certificates pursuant hereto, continue to express the Exercise Price per share and the number of shares purchasable thereunder as the Exercise Price per share and the number of shares purchasable thereunder as expressed in the Warrant Certificates when the same were originally issued. (D) After each adjustment of the Exercise Price pursuant to this Section (g), the Company will promptly prepare a certificate signed by the Chairman or President, and by the Treasurer or an Assistant Treasurer or the Secretary or an Assistant Secretary, of the Company setting forth: (i) the Exercise Price as so adjusted, (ii) the number of shares of Common Stock purchasable upon exercise of each Warrant, after such adjustment, and (iii) a brief statement of the facts accounting for such adjustment. The Company will promptly file such certificate in the Company's minute books and cause a brief summary thereof to be sent by ordinary first class mail to each Holder at his last address as it shall appear on the registry books of the Company. No failure to mail such notice nor any defect therein or in the mailing thereof shall affect the validity thereof except as to the holder to whom the Company failed to mail such notice, or except as to the holder whose notice was defective. The affidavit of an officer or the Secretary or an Assistant Secretary of the Company that such notice has been mailed shall, in the absence of fraud, be prima facie evidence of the facts stated therein. (E) No adjustment of the Exercise Price shall be made as a result of or in connection with the issuance or sale of shares of Common Stock if the amount of said adjustment shall be less than $.10, provided, however, that in such case, any adjustment that would otherwise be required then to be made shall be carried forward and shall be made at the time of and together with the next subsequent adjustment that shall amount, together with any adjustment so carried forward, to at least $.10. In addition, Holders shall not be entitled to cash dividends paid by the Company prior to the exercise of any Warrant or Warrants held by them. (F) In the event that the Company shall at any time prior to the exercise of all Warrants declare a dividend consisting solely of shares of Common Stock or otherwise distribute to its stockholders any assets, property, rights, evidences of indebtedness, the Holders of the unexercised Warrants shall thereafter be entitled, in addition to the shares of Common Stock or other securities and property receivable upon the exercise thereof, to receive, upon the exercise of such Warrants, the same property, assets, rights, evidences of indebtedness, that they would have been 4 5 entitled to receive at the time of such dividend or distribution as if the Warrants had been exercised immediately prior to such dividend or distribution. At the time of any such dividend or distribution, the Company shall make appropriate reserves to ensure the timely performance of the provisions of this Section (g). (h) Piggyback Registration. If, at any time commencing one year from the date hereof and expiring six (6) years thereafter, the Company proposes to register any of its securities under the Securities Act of 1933, as amended (the "Act") (other than in connection with a merger or pursuant to Form S-8, S-4 or other comparable registration statement) it will give written notice by registered mail, at least thirty (30) days prior to the filing of each such registration statement, to the Underwriter and to all other Holders of the Warrants and/or the Warrant Stock of its intention to do so. If the Underwriter or other Holders of the Warrants and/or Warrant Stock notify the Company within twenty (20) days after receipt of any such notice of its or their desire to include any such securities in such proposed registration statement, the Company shall afford each of the Underwriters and such Holders of the Warrants and/or Warrant Stock the opportunity to have any such Warrant Stock registered under such registration statement. Notwithstanding the provisions of this Section, the Company shall have the right at any time after it shall have given written notice pursuant to this Section (irrespective of whether a written request for inclusion of any such securities shall have been made) to elect not to file any such proposed registration statement, or to withdraw the same after the filing but prior to the effective date thereof. (i) Demand Registration. (1) At any time commencing one year from the date hereof and expiring four (4) years thereafter, the Holders of the Underwriters' Warrants and/or Warrant Shares representing a "Majority" (as hereinafter defined) of such securities (assuming the exercise of all of the Underwriters' Warrants) shall have the right (which right is in addition to the registration rights under Section (i) hereof), exercisable by written notice to the Company, to have the Company prepare and file with the Securities and Exchange Commission (the "Commission"), on one occasion, a registration statement and such other documents, including a prospectus, as may be necessary in the opinion of both counsel for the Company and counsel for the Underwriter and Holders, in order to comply with the provisions of the Act, so as to permit a public offering and sale of their respective Warrant Shares for nine (9) consecutive months by such Holders and any other holders of the Underwriters' Warrants and/or Warrant Shares who notify the Company within ten (10) days after receiving notice from the Company of such request. (2) The Company covenants and agrees to give written notice of any registration request under this Section (i) by any Holder or Holders to all other registered Holders of the Underwriters' Warrants and the Warrant Shares within ten (10) days from the date of the receipt of any such registration request. (3) In addition to the registration rights under this Section (i) at any time commencing one year after the date hereof and expiring four (4) years thereafter, the Holders of Underwriters' Warrants and/or Warrant Shares shall have the right, exercisable by written request to the Company, to have the Company prepare and file, on one occasion, with the Commission a registration statement so as to permit a public offering and sale for nine (9) consecutive months by such Holders of its Warrant Shares; provided, however, that the provisions of Section (i)(2) hereof shall not apply to any such registration request and registration and all costs incident thereto shall be at the expense of the Holder or Holders making such request. (4) The Company shall include such Underwriters' Warrants in the Registration Statement relating to this offering and shall keep such Registration Statement current at least until the expiration of such Underwriters' Warrants or shall bear all of the costs of a new registration statement in the event the Underwriters' Warrants are to be exercised. (j) Covenants of the Company With Respect to Registration. In connection with any registration under Section (h) or (i) hereof, the Company covenants and agrees as follows: 5 6 (i) The Company shall use its best efforts to file a registration statement within sixty (60) days of receipt of any demand therefor, shall use its best efforts to have any registration statement declared effective at the earliest possible time, and shall furnish each Holder desiring to sell Warrant Shares such number of prospectuses as shall reasonably be requested. (ii) The Company shall pay all costs (excluding fees and expenses of Holder(s)' counsel and any underwriting or selling commissions), fees and expenses in connection with all registration statements filed pursuant to Sections (h), (i) and (o) hereof including, without limitation, the Company's legal and accounting fees, printing expenses, blue sky fees and expenses. If the Company shall fail to comply with the provisions of Section (j)(i), the Company shall, in addition to any other equitable or other relief available to the Holder(s), extend the Exercise Period by such number of days as shall equal the delay caused by the Company's failure. (iii) The Company will take all necessary action which may be required in qualifying or registering the Warrant Shares included in a registration statement for offering and sale under the securities or blue sky laws of such states as reasonably are requested by the Holder(s), provided that the Company shall not be obligated to execute or file any general consent to service of process or to qualify as a foreign corporation to do business under the laws of any such jurisdiction. (iv) The Company shall indemnify the Holder(s) of the Warrant Shares to be sold pursuant to any registration statement and each person, if any, who controls such Holders within the meaning of Section 15 of the Act or Section 20(a) of the Securities Exchange Act of 1934, as amended ("Exchange Act"), from and against all loss, claim, damage, expense or liability (including all expenses reasonably incurred in investigating, preparing or defending against any claim whatsoever) to which any of them may become subject under the Act, the Exchange Act or otherwise, arising from such registration statement but only to the same extent and with the same effect as the provisions pursuant to which the Company has agreed to indemnify the Underwriter contained in Section 7 of the Underwriting Agreement. (v) The Holder(s) of the Warrant Shares to be sold pursuant to a registration statement, and their successors and assigns, shall severally, and not jointly, indemnify the Company, its officers and directors and each person, if any, who controls the Company within the meaning of Section 15 of the Act or Section 20(a) of the Exchange Act, against all loss, claim, damage or expense or liability (including all expenses reasonably incurred in investigating, preparing or defending against any claim whatsoever) to which they may become subject under the Act, the Exchange Act or otherwise, arising from information furnished by or on behalf of such Holders, or their successors or assigns, for specific inclusion in such registration statement to the same extent with the same effect as the provisions contained in Section 7 of the Underwriting Agreement pursuant to which the Underwriter has agreed to indemnify the Company. (vi) The Holder(s) shall exercise their Warrants prior to the initial filing of any registration statement or the effectiveness thereof. (vii) The Company shall not permit the inclusion of any securities other than the Warrant Shares to be included in any registration statement filed pursuant to Section (i) hereof, or permit any other registration statement to be or remain effective during the effectiveness of a registration statement filed pursuant to Section (i) hereof, other than a secondary offering of equity securities by the Company, without the prior written consent of the Holders of the Warrants and Warrant Shares representing a Majority (as herein defined) of such securities (assuming an exercise of all the Warrants). (viii) The Company shall furnish to each Holder participating in the offering and to each Underwriter, if any, a signed counterpart, addressed to such Holder or Underwriter, of (x) an opinion of counsel to the Company, dated the effective date of such registration statement (and, if such registration includes an underwritten public offering, an opinion dated the date of the closing under the underwriting agreement), and (y) a "cold comfort" letter dated the effective date of such registration statement (and, if such registration includes an underwritten public offering, a letter dated the date of the closing under the underwriting agreement) signed by the independent public accountants who have issued a report on the Company's financial statements included in such registration statement, 6 7 in each case covering substantially the same matters with respect to such registration statement (and the prospectus included therein) and, in the case of such accountants' letter, with respect to events subsequent to the date of such financial statements, as are customarily covered in opinions of issuer's counsel and in accountants' letters delivered to Underwriters in underwritten public offerings of securities. (ix) The Company shall as soon as practicable after the effective date of the registration statement, and in any event within 15 months thereafter, make "generally available to its security holders" (within the meaning of Rule 158 under the Act) an earnings statement (which need not be audited) complying with Section 11(a) of the Act and covering a period of at least 12 consecutive months beginning after the effective date of the registration statement. (x) The Company shall deliver promptly to each Holder participating in the offering requesting the correspondence and memoranda described below and to the managing underwriters, copies of all correspondence between the Commission and the Company, its counsel or auditors and all memoranda relating to discussions with the Commission or its staff with respect to the registration statement and permit each Holder and Underwriter to do such investigation, upon reasonable advance notice, with respect to information contained in or omitted from the registration statement as it deems reasonably necessary to comply with applicable securities laws or rules of the National Association of Securities Dealers, Inc. ("NASD"). Such investigation shall include access to books, records and properties and opportunities to discuss the business of the Company with its officers and independent auditors, all to such reasonable extent and at such reasonable times and as often as any such Holder or Underwriter shall reasonably request. (xi) The Company shall enter into an underwriting agreement with the managing underwriters, which may be the Underwriter. Such agreement shall be satisfactory in form and substance to the Company, and such managing underwriters, and shall contain such representations, warranties and covenants by the Company and such other terms as are customarily contained in agreements of that type used by the managing underwriter; provided however, that no Holder shall be required to make any representations, warranties or covenants or grant any indemnity to which it shall object in any such underwriting agreement. The Holders shall be parties to any underwriting agreement relating to an underwritten sale of their Warrant Securities and may, at their option, require that any or all the representations, warranties and covenants of the Company to or for the benefit of such Underwriters shall also be made to and for the benefit of such Holders. Such Holders shall not be required to make any representations or warranties to or agreements with the Company or the Underwriters except as they may relate to such Holders and their intended methods of distribution. (xii) For purposes of this Agreement, the term "Majority" in reference to the Holders of Warrants or Warrant Stock, shall mean in excess of fifty (50%) of the then outstanding Warrants or Warrant Shares that (i) are not held by the Company, an affiliate, officer, creditor, employee or agent thereof or any of their respective affiliates, members of their family, persons acting as nominees or in conjunction therewith or (ii) have not been resold to the public pursuant to a registration statement filed with the Commission under the Act. (k) The Company's obligation under Section 6) hereof shall be conditioned as to each such public offering, upon a timely receipt by the Company in writing of: (A) Information as to the terms of such public offering furnished by or on behalf of the Holders making a public distribution of their Warrant Shares; and (B) Such other information as the Company may reasonably require from such Holder, or any Underwriter for any of them, for inclusion in such registration statement or offering statement or post-effective amendment. (C) An agreement by the Holder to sell his Warrants and Warrant Shares on the basis provided in the Underwriting Agreement. (l) The Company's agreements with respect to the Warrant Shares in this Warrant will continue in effect regardless of the exercise or surrender of this Warrant. 7 8 (m) Any notices or certificates by the Company to the Holder and by the Holder to the Company shall be deemed delivered if in writing and delivered personally or sent by certified mail, to the Holder, addressed to him or sent to Nutmeg Securities, Ltd., 495 Post Road East, Westport, CT 06880, or, if the Holder has designated, by notice in writing to the Company, any other address, to such other address, and, if to the Company, addressed to it at 4400 MacArthur Boulevard, Suite 980, Newport Beach, CA 92660. The Company may change its address by written notice to Nutmeg Securities, Ltd. (n) Limited Transferability. This Warrant Certificate and the Warrant may not be sold, transferred, assigned or hypothecated for a one-year period after the effective date of the Registration Statement except to Underwriters of the Offering referred to in the Underwriting Agreement or to individuals who are either partners or officers of such an Underwriter or by operation of law. The Warrant may be divided or combined, upon request to the Company by the Holder, into a certificate or certificates evidencing the same aggregate number of Warrants. The Warrant may not be offered, sold, transferred, pledged or hypothecated in the absence of any effective registration statement as to such Warrant filed under the Act, or an exemption from the requirement of such registration, and compliance with the applicable state securities laws. The Company may require an opinion of counsel satisfactory to the Company that such registration is not required and that such laws are complied with. The Company may treat the registered holder of this Warrant as he or it appears on the Company's book at any time as the Holder for all purposes. The Company shall permit the Holder or his duly authorized attorney, upon written request during ordinary business hours, to inspect and copy or make extracts from its books showing the registered holders of Warrants. (o) Transfer to Comply With the Securities Act of 1933. The Company may cause the following legend, or one similar thereto, to be set forth on the Warrants and on each certificate representing Warrant Shares, or any other security issued or issuable upon exercise of this Warrant not theretofore distributed to the public or sold to Underwriters for distribution to the public pursuant to Sections (h) or (i) hereof; unless counsel satisfactory to the Company is of the opinion as to any such certificate that such legend, or one similar thereto, is unnecessary: "The warrants represented by this certificate may not be offered for sale, sold or otherwise transferred except pursuant to an opinion of counsel satisfactory to the Company is obtained stating that such offer or sale is in compliance with state and federal securities law." (p) Applicable Law. This Warrant shall be governed by, and construed in accordance with, the laws of the State of Connecticut , without giving effect to conflict of law principles. (q) This Warrant may not be extended except in a writing signed by each Holder and the Company. (r) The indemnification provisions of this Warrant shall survive until the earlier of (i) one (1) year from the date of exercise; or (ii) , 2002 (the date after which this Warrant may not be exercised). 8 9 Medical Science Systems, Inc. a Texas corporation Date: By: -------------------------- ----------------------------- Paul J. White, President S E A L Attest: - -------------------------------- Secretary 9 10 PURCHASE FORM Dated , 19 ---------------- --- The undersigned hereby irrevocably elects to exercise the Warrant to the extent of purchasing _______ shares of Common Stock and hereby makes payment of $________ in payment of the actual exercise price thereof. INSTRUCTIONS FOR REGISTRATION OF STOCK Name ___________________________________________________________________________ (please typewrite or print in block letters) Address ________________________________________________________________________ Signature ______________________________________________________________________ ASSIGNMENT FORM FOR VALUE RECEIVED, ____________________________________________________________ hereby sells, assigns and transfers unto Name ___________________________________________________________________________ (please typewrite or print in block letters) Address ________________________________________________________________________ the right to purchase Common Stock as represented by this Warrant to the extent of ____________ shares as to which such right is exercisable and does hereby irrevocably constitute and appoint, ___________________________, attorney, to transfer the same on the books of the Company with full power of substitution in the premises. Signature ______________________________________________________________________ Dated: _______________________, 19___ 10 EX-5.1 6 OPINION OF JEFFERS, WILSON, SHAFF & FALK, LLP 1 EXHIBIT 5.1 JEFFERS, WILSON, SHAFF & FALK, LLP ATTORNEYS AT LAW 18881 VON KARMAN AVENUE SUITE 1400 IRVINE, CALIFORNIA 92612 TELEPHONE: (714) 660-7700 FACSIMILE: (714) 660-7799 November 12, 1997 Medical Science Systems, Inc. 4400 MacArthur Boulevard, Suite 980 Newport Beach, California 92660-2031 Re: Registration Statement on Form SB-2 Gentlemen: We have acted as counsel to Medical Science Systems, Inc. (the "Company"), a Texas corporation, in connection with the Registration Statement on Form SB-2 (333-37441), filed with the Securities and Exchange Commission on October 8, 1997, as amended (the "Registration Statement"), covering 2,500,000 shares of the Company's no par value Common Stock (the "Shares"). In acting as counsel for the Company and arriving at the opinions as expressed below, we have examined and relied upon originals or copies, certified or otherwise identified to our satisfaction, of such records of the Company, agreements and other instruments, certificates of officers and representatives of the Company, certificates of public officials and other documents as we have deemed necessary or appropriate as a basis for the opinions expressed herein. In connection with our examination we have assumed the genuineness of all signatures, the authenticity of all documents tendered to us as originals, the legal capacity of natural persons and the conformity to original documents of all documents submitted to us as certified or photostated copies. Based on the foregoing, and subject to the qualifications and limitations set forth herein, it is our opinion that the Shares have been duly authorized and when issued, delivered and paid for, will be validly issued, fully paid and non-assessable. We express no opinion with respect to laws other than those of the State of California and federal laws of the United States of America, and we assume no responsibility as to the applicability thereof, or the effect thereon, of the laws of any other jurisdiction. We hereby consent to the filing of this opinion as Exhibit 5.1 to the Registration Statement and to its use as part of the Registration Statement. Very truly yours, /s/ JEFFERS, WILSON, SHAFF & FALK, LLP -------------------------------------- Jeffers, Wilson, Shaff & Falk, LLP EX-23.1 7 CONSENT OF SINGER LEWAK GREENBAUM & GOLDSTEIN LLP 1 EXHIBIT 23.1 CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS We have issued our report dated September 26, 1997, accompanying the financial statements of Medical Science Systems, Inc. contained in the Registration Statement and Prospectus. We consent to the use of the aforementioned report in the Registration Statement and Prospectus, and to the use of our name as it appears under the caption "Experts." SINGER LEWAK GREENBAUM & GOLDSTEIN LLP Los Angeles, California November 12, 1997 EX-99.1 8 CONSENT OF RONALD A. LA ROSA 1 EXHIBIT 99.1 RONALD L. LA ROSA 231 S. FRANCISCO PLACE ANAHEIM HILLS, CALIFORNIA 92807 November 7, 1997 Medical Science Systems, Inc. 4400 MacArthur Boulevard, Suite 980 Newport Beach, California 92660 Re: Consent to Being Named in Registration Statement ------------------------------------------------ Gentlemen: Pursuant to Rule 438 of the Securities Act of 1933, as amended, I hereby consent to my being named as a person who is to become a member of the Board of Directors of Medical Science Systems, Inc. (the "Company") in the Company's Registration Statement on Form SB-2. Sincerely, /s/ RONALD A. LA ROSA ---------------------------- Ronald A. La Rosa -----END PRIVACY-ENHANCED MESSAGE-----