10-Q 1 b44717ige10vq.txt INTERLEUKIN GENETICS, INC. UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the quarterly period ended: September 30, 2002 Commission File Number: 0-23413 INTERLEUKIN GENETICS, INC. (Exact name of registrant as specified in its Charter) DELAWARE 94-3123681 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 135 BEAVER STREET WALTHAM, MA 02452 (Address of principal executive offices) (Zip Code) (781) 398-0700 Registrant's Telephone Number, including area code Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES (X) NO ( ) Title of Each Class Outstanding at November 4, 2002 ------------------- ----------------------------- Common stock, $.001 Par value 23,115,354 INTERLEUKIN GENETICS, INC. FORM 10-Q INDEX PART I. FINANCIAL INFORMATION Item 1. Condensed Consolidated Balance Sheets at September 30, 2002 and December 31, 2001.............................. 1 Condensed Consolidated Statements of Operations for the Three and nine months ended September 30, 2002 and September 30, 2001.................................................... 2 Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2002 and September 30, 2001........... 3 Notes to Condensed Consolidated Financial Statements.................. 4 Item 2. Management's Discussion and Analysis of Financial Condition And Results of Operations............................................. 10 Item 3. Quantitative and Qualitative Disclosure About Market Risk............. 28 Item 4. Controls and Procedures............................................... 28 PART II. OTHER INFORMATION Item 1. Legal Proceedings.................................................. 29 Item 2. Changes in Securities and Use of Proceeds.......................... 29 Item 3. Default Upon Senior Securities..................................... 29 Item 4. Submission of Matters to a Vote of Security Holders................ 29 Item 5. Other Information.................................................. 29 Item 6. Exhibits and Reports on Form 8-K................................... 29 2 INTERLEUKIN GENETICS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS --------------------------------------------------------------------------------
ASSETS As of --------------------------------------- September 30, 2002 December 31, 2001 ------------------ ----------------- Current assets: Cash and cash equivalents $ 507,697 $ 3,922,736 Accounts receivable, net of allowance for doubtful accounts of $13,000 and $14,000 at September 30, 2002 and December 31, 2001, respectively 6,257 75,982 Prepaid expenses and other current assets 92,825 103,436 ----------- ----------- Total current assets 606,779 4,102,154 FIXED ASSETS, NET 335,273 178,904 OTHER ASSETS 92,225 112,068 ----------- ----------- TOTAL ASSETS $ 1,034,277 $ 4,393,126 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) CURRENT LIABILITIES: Accounts payable $ 259,674 $ 181,554 Accrued expenses 563,451 477,368 Deferred revenue and prepaid revenue 242,679 142,349 Bridge Loan , net of discount 224,833 -- Current portion of capital lease obligations 30,577 30,216 ----------- ----------- Total current liabilities 1,321,214 831,487 CAPITAL LEASE OBLIGATIONS, LESS CURRENT PORTION 21,798 11,091 ----------- ----------- Total liabilities 1,343,012 842,578 ----------- ----------- STOCKHOLDERS' EQUITY (DEFICIT): Preferred stock, no par value - 5,000,000 shares authorized; none issued or outstanding -- -- Common stock, $0.001 par value - 50,000,000 shares authorized; 21,463,723 and 21,452,326 shares issued and 21,439,096 and 21,427,699 outstanding at September 30, 2002 and December 31, 2001, respectively 21,464 21,452 Treasury stock - 24,627 shares at cost (250,119) (250,119) Additional paid-in capital 39,659,640 39,292,936 Accumulated deficit (39,739,720) (35,513,721) ----------- ------------ Total stockholders' equity (deficit): (308,735) 3,550,548 ----------- ------------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) $ 1,034,277 $ 4,393,126 =========== ============
The accompanying notes are an integral part of these condensed consolidated financial statements 1 INTERLEUKIN GENETICS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS --------------------------------------------------------------------------------
FOR THE THREE MONTHS ENDED SEPTEMBER 30 FOR THE NINE MONTHS ENDED SEPTEMBER 30, --------------------------------------- --------------------------------------- 2002 2001 2002 2001 ------------ ------------ ----------- ----------- REVENUE $ 79,677 $ 24,978 $ 102,229 $ 183,923 COST OF REVENUE 106 8,443 441 43,387 ------------ ------------ ----------- ----------- GROSS PROFIT 79,571 16,535 101,788 140,536 ------------ ------------ ----------- ----------- OPERATING EXPENSES: Research and development 716,964 634,719 2,504,132 2,050,665 Selling, general and administrative 652,637 565,110 1,764,343 1,741,231 ------------ ------------ ----------- ----------- Total operating expenses 1,369,601 1,199,829 4,268,475 3,791,896 ------------ ------------ ----------- ----------- LOSS FROM OPERATIONS (1,290,030) (1,183,294) (4,166,687) (3,651,360) ------------ ------------ ----------- ----------- OTHER INCOME (EXPENSE): Interest income 2,520 49,661 22,276 237,252 Interest expense (15,983) (2,396) (22,251) (8,165) Amortization of note discount (60,034) -- (60,034) -- Other income, net -- 149 697 202 ------------- ------------ ----------- ----------- Total other income (expense): (73,497) 47,414 (59,312) 229,289 ------------ ------------ ----------- ----------- NET LOSS $ (1,363,527) $ (1,135,880) $(4,225,999) $(3,422,071) ============ ============ =========== =========== BASIC AND DILUTED NET LOSS PER SHARE $ (0.06) $ (0.05) $ (0.20) $ (0.16) ============ ============ =========== =========== Weighted average common shares OUTSTANDING 21,436,231 21,424,105 21,431,558 20,922,361 ============ ============ =========== ===========
The accompanying notes are an integral part of these condensed consolidated financial statements 2 INTERLEUKIN GENETICS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS --------------------------------------------------------------------------------
FOR THE NINE MONTHS ENDED SEPTEMBER 30, --------------------------------------- 2002 2001 ------------- ------------- CASH FLOWS FROM OPERATING ACTIVITIES Net loss $ (4,225,999) $ (3,422,071) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 125,390 32,772 Change in value of stock options issued as compensation for services rendered (848) 165,331 Unrealized loss on marketable securities -- (13,244) Changes in assets and liabilities: Accounts receivable, net 69,726 32,878 Prepaid expenses and other current assets 10,611 64,749 Accounts payable 78,120 (105,881) Accrued expenses 86,083 142,206 Prepaid and deferred revenue 100,330 (120,859) ------------ ------------ Net cash used in operating activities (3,756,587) (3,224,119) ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES Purchases of fixed assets (179,487) (43,769) Decrease (increase) in other assets 19,842 (97,954) Proceeds from maturity of investments -- 2,999,040 ------------ ------------ Net cash (used in) provided by investing activities (159,645) 2,857,317 ------------ ------------ CASH FLOW FROM FINANCING ACTIVITIES Net proceeds from issuance of bridge loan 525,000 -- Net proceeds from sales of common stock, net 7,363 2,911,006 Proceeds from exercises of warrants and stock options -- 482,406 Payments of capitalized lease obligations (31,170) (46,844) ------------ ------------ Net cash provided by financing activities 501,193 3,346,568 ------------ ------------ Net (decrease) increase in cash and equivalents (3,415,039) 2,979,766 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 3,922,736 2,391,561 ------------ ----------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 507,697 $ 5,371,327 ============ =========== Supplemental disclosures of cash flow information: Cash paid for interest $ 7,599 $ 8,165 ============ =========== Cash paid for income taxes $ -- $ -- ============ =========== SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIES: Acquisition of fixed assets under capital leases $ 42,238 $ -- ============ ===========
The accompanying notes are an integral part of these condensed consolidated financial statements 3 NOTE 1 - PRESENTATION OF INTERIM INFORMATION Interleukin Genetics, Inc., a Delaware corporation is a functional genomics company focused on personalized medicine. We believe that by identifying individuals at risk for certain diseases and combining this knowledge with specific therapeutic interventions, better healthcare decisions can be made, reducing costs and greatly improving patient health outcomes. We have a growing portfolio of patents covering the genetics of a number of common diseases and conditions. We have prepared the accompanying unaudited condensed consolidated financial statements in accordance with generally accepted accounting principles for interim financial reporting and with Securities Exchange Commission rules and regulations for Form 10-Q. It is recommended that these interim condensed consolidated financial statements be read in conjunction with the consolidated financial statements and the notes in our Annual Report on Form 10-K for the year ended December 31, 2001. The interim condensed consolidated financial statements are unaudited; however, in the opinion of our management, include all adjustments, consisting only of normal recurring adjustments, necessary to make the interim financial information not misleading. All significant intercompany transactions and accounts have been eliminated in consolidation. Results for interim periods are not necessarily indicative of those to be expected for the full year. Since our inception, we have incurred accumulated deficits of approximately $39.7 million, including a net loss of approximately $4.2 million during the nine months ended September 30, 2002. For the nine months ended September 30, 2002, we have incurred negative cash flows from operating activities of approximately $3.8 million. We anticipate that our current cash resources, including cash received from the recent sale of term promissory notes (See Note 7: "Term Promissory Notes", beginning on page 7, for more details) and an interim financing arrangement with Pyxis Innovations, Inc. ("Pyxis")(See Note 8 "Interim Financing from Pyxis Innovations, Inc."), are adequate to fund operations approximately through December 2002 if Pyxis does not elect to purchase the third $500,000 promissory note contemplated in the financing arrangement or January 2003 if they do elect to purchase the third $500,000 promissory note. As a result, there is significant doubt about our ability to continue as a going concern. Our future capital requirements are anticipated to be substantial, and we do not have commitments for additional capital at this time. Our capital requirements are expected to arise from continued research and development efforts, the protection of our intellectual property rights (including preparing and filing of patent applications), repayment of the principal and interest on our 15% term promissory notes due August 2003 and December 2003, the commercial launch of additional genetic tests, as well as operational, administrative, legal and accounting expenses. We are currently pursuing various sources of capital and strategic partnerships in order to raise the capital necessary to continue operations past the end of January 2003. WE CAN GIVE NO ASSURANCE THAT WE WILL BE ABLE TO RAISE ANY ADDITIONAL CAPITAL, OR IF WE DO RAISE ADDITIONAL CAPITAL, THAT IT WILL BE ON TERMS ACCEPTABLE TO OUR STOCKHOLDERS OR US. IF ADDITIONAL AMOUNTS CANNOT BE RAISED, WE WOULD SUFFER MATERIAL ADVERSE CONSEQUENCES TO OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS AND WOULD LIKELY BE REQUIRED TO SEEK OTHER ALTERNATIVES UP TO AND INCLUDING PROTECTION UNDER THE UNITED STATES BANKRUPTCY LAWS. 4 NOTE 2 - RESEARCH ARRANGEMENTS We have had a collaborative relationship with Sheffield University since 1994. In July 1999, we entered into an arrangement with Sheffield whereby we acquired the right to develop and commercialize Sheffield's past and future discoveries. Pursuant to this Research and Technology Transfer Agreement, Sheffield agreed to forego its rights to future royalties and granted us commercialization rights to future discoveries in exchange for 275,000 shares of our common stock. This common stock had a market value of $653,000 at the time of issuance and was recorded as a research and development expense in the period of issuance. This agreement also requires us to issue options on July 1st of each year to Sheffield to purchase our common stock. Each option issued is exercisable at the then current market price for a number of shares determined as follows: (i) 25,000 shares if this agreement is in effect and (ii) 10,000 shares for each patent application related to Sheffield's discoveries that we filed during the preceding 12 months. This agreement has a term of five years and may be canceled by us if the principal collaborator at Sheffield, Dr. Gordon Duff, leaves Sheffield or by either party upon six months' notice. Under the terms of this agreement we have issued options to acquire 35,000 shares of our common stock in both 2001 and 2002. In total we have issued options to acquire 105,000 shares of our common stock. These options were fully vested upon issuance and expire five years from the dates of issuance. We also entered into a Research Support Agreement with Sheffield in July 1999 that requires us to pay the costs of all genetic research being conducted on our behalf at Sheffield. Sheffield conducts this research according to an Annual Research Plan that is determined by a Steering Committee made up equally of members from Sheffield and us. This agreement automatically renews in one-year increments, but may be canceled by us if Dr. Duff leaves Sheffield or by either party upon six months' notice. In the event Sheffield terminated the agreement, it is doubtful we could discover or commercialize new products without incurring greater expense and increased utilization of our resources. We have made payments of approximately $161,000 to Sheffield for the nine months ended September 30, 2002 and an aggregate amount of $699,000 to Sheffield under the terms of this agreement through September 30, 2002. In September 1999, we entered into a five-year Consulting Agreement with Dr. Gordon Duff, Sheffield's key collaborator. In accordance with the Consulting Agreement, Dr. Duff received 200,000 shares of our common stock for relinquishing interests in previous research agreements, the value of which was $475,000 and was recorded as research and development expense in the period of issuance. Under this agreement Dr. Duff will also receive a royalty equal to one percent of the first $4 million of net sales under the PST technology and two percent of net sales above $4 million. In July 2000, in consideration of future services, Dr. Duff received an option to purchase 25,000 shares of our common stock at the then current market price. In both July 2001 and July 2002, Dr. Duff received an additional option to purchase 25,000 shares our common stock at the market price as of that date in consideration of his ongoing consulting for us. These options were fully vested upon issuance and expire five years from the date of issuance. Dr. Duff also received cash payments of approximately $71,000 for the nine months ended September 30, 2002 for services rendered under the terms of this consulting agreement. 5 In December 2001, we entered into a research collaboration agreement with Kaiser Permanente's Center for Health Research ("Kaiser"), to study genetic risk factors for chronic diseases that are affected by inflammation. This agreement requires us to fund clinical trials completed at Kaiser per specific research study plans. The first study plan that we are funding is a study to assess the genetic risk that diabetic patients have of developing cardiovascular disease. We expect to announce additional studies with Kaiser. It is hoped that knowledge resulting from this work will enable us to develop new diagnostic tools that physicians and health care organizations can use to assess their patients' genetic risk for many diseases. In March 2002, we entered into a research collaboration agreement with UnitedHealth Group's research arm, the Center for Healthcare Policy and Evaluation, to study how commonly inherited gene variants affect the response of patients with certain inflammatory diseases to specific drugs. Knowledge resulting from this work will help us develop pharmacogenetic tests that physicians and managed care organizations can use to assist in the selection of the optimal drug for an individual patient. NOTE 3 - REVENUE RECOGNITION Revenue from genetic susceptibility tests is recognized when the tests have been completed and the results reported to the doctors, provided that collection of the related receivable is probable. To the extent test kits have been purchased but not yet submitted for test results, revenue recognition is deferred. Amounts received prior to meeting the above revenue recognition criteria are presented as deferred revenue in the accompanying balance sheets. Contract revenues are recognized ratably as services are provided. In accordance with Staff Accounting Bulletin No. 101, up front non-refundable license fees are deferred and recognized ratably over the license term. NOTE 4 - USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reported periods. Actual results could differ from those estimates. NOTE 5 - BASIC AND DILUTED NET LOSS PER COMMON SHARE Statement of Financial Accounting Standards (SFAS) No. 128 (SFAS 128), "Earnings per Share," outlines methods for computing and presenting earnings per share. SFAS 128 requires a calculation of basic and diluted earnings per share for all periods presented. We reported losses for the three and nine month periods ended September 30, 2002 and 2001 and accordingly, outstanding options and warrants have been excluded from the calculation of the diluted weighted average shares outstanding as they are antidilutive in loss periods. The calculation of diluted net loss per share excludes 2,775,302 and 2,629,279 stock options outstanding at September 30, 2002 and September 30, 2001, respectively and 1,569,407 and 1,345,952 warrants to purchase common stock outstanding at September 30, 2002 and September 30, 2001 respectively. 6 NOTE 6 - STOCKHOLDERS' EQUITY In January 2001, we sold in a private placement 1.2 million shares of common stock for $2.50 per share. The purchasers of the common stock also received warrants to purchase up to 600,000 shares of common stock exercisable at $3.00 per share. We generated net proceeds of approximately $2.9 million from this transaction. Under the terms of this private placement we were required to adjust downward the price per share paid in the offering, by issuing additional shares to match any lower price per share paid in subsequent offerings prior to May 23, 2003. On October 22, 2002, this agreement was amended. (See Note 8) In December 2000, we sold in a private placement 542,373 shares of common stock for $3.69 per share. The purchasers of the common stock also received warrants to purchase up to 135,593 shares of common stock exercisable at $4.83 per share. We generated net proceeds of approximately $2.0 million from this transaction. Under the terms of this private placement we were required to adjust downward the price per share paid in the offering, by issuing additional shares, to match any lower price per share paid in subsequent offerings prior to February 9, 2003. Following the January 2001 private placement described above, we issued an additional 257,627 shares of common stock to the purchasers in the December 2000 private placement, and new warrants to purchase 264,407 shares of Common Stock exercisable at a price of $3.13 per share to replace the previously issued warrants to purchase 135,593 shares of Common Stock at a price of $4.83 per share. On October 22, 2002, this agreement was amended. (See Note 8) On October 9, 2002 we received a letter from NASDAQ stating that we do not meet the criteria for the continued listing of our common stock on the NASDAQ SmallCap Market. The letter stated that our common stock is not in compliance with the $1 minimum bid price, that our stockholders' equity does not meet the $2.5 million minimum requirement, and that the NASDAQ Staff rejected our plan to regain compliance with those listing criteria. We have requested a hearing before the NASDAQ Listing Qualifications Panel to appeal the ruling by the NASDAQ Staff and have been notified that our hearing will be held on November 14, 2002. During the appeals process, which we expect may take up to 45 days, our common stock will continue to trade on the NASDAQ SmallCap Market. In the event that the Panel does not grant continued listing, our common stock will be immediately delisted from the Nasdaq SmallCap market and we expect it will trade on the OTC Bulletin Board (OTCBB). There can be no assurance that the Panel will grant our request for continued listing. NOTE 7 - TERM PROMISSORY NOTES On August 9, 2002 we received approximately $475,000 in net proceeds from the sale of term promissory notes with an original aggregate principal amount of $525,000. These notes mature in August 2003 and accrue interest at a rate of 15%. The outstanding principal amount and all accrued interest are to be paid upon maturity. We can prepay the principal and accrued interest at any time without penalty. The purchasers of the promissory notes received warrants to purchase one share of our common stock at a purchase price of $2.50 for every dollar invested in the promissory notes. In total warrants to purchase 525,000 shares of our common stock were issued. These warrants expire in ten years. 7 NOTE 8 - INTERIM FINANCING FROM PYXIS INNOVATIONS, INC. On October 23, 2002, subsequent to the end of the fiscal quarter, we entered into an interim financing agreement with Pyxis Innovations, Inc. to provide debt financing of up to $1.5 million. The financing is to be in the form of three $500,000 promissory notes, the first of which was closed on October 23, 2002. Subject to the satisfaction of certain condition, we expect to issue the second note on November 15, 2002. The third note will only be issued at the option of Pyxis on December 16, 2002. These notes will mature on December 31, 2003 and accrue interest at a rate of 15%. The outstanding principal amount and all accrued interest are to be paid upon maturity. We can prepay the principal and accrued interest at any time without penalty. These notes are secured by all of our intellectual property except intellectual property relating to periodontal disease and sepsis. On October 22, 2002, as a condition for the interim financing with Pyxis noted above, we entered into separate agreements with the purchasers in the December 2000 and January 2001 private placements to temporarily waive certain provisions of these private placement agreements. Specifically, the purchasers temporarily waived their right, through March 31, 2003, to receive cash payments of up to $100,000 per month if our common stock is delisted from the Nasdaq SmallCap Market. Also waived through March 31, 2003 is the purchasers' right to receive additional shares of our common stock for no additional consideration if we issue shares of our common stock at a price below $2.50 per share (for the purchaser in the December 2000 private placement this waiver is permanent, its right will expire February 9, 2003). Under these agreements the purchasers have also agreed to cancel warrants to purchase an aggregate of 864,407 shares of common stock. In exchange, we are required to issue an aggregate of 1,676,258 shares of our common stock to the purchasers for no additional cash consideration. If we receive an equity investment of at least $3,000,000 from Pyxis prior to March 31, 2003 the temporary waivers of rights by the purchasers will become permanent. If we do not receive such an equity investment by that date, the temporary waivers will terminate and we will be required to issue warrants to purchase an aggregate of 864,407 shares of our common stock exercisable at $1.70 per share, subject to any shareholder approvals required by the NASDAQ SmallCap Market or any other market or exchange on which our common stock is then traded or quoted. Of these warrants, the exercise price of warrants to purchase 600,000 shares of common stock will be subject to adjustment downward to equal 125% of the price per share at which we sell any shares of our common stock (or securities convertible into common stock) prior to May 23, 2003. NOTE 9 - SEGMENT INFORMATION We follow the provisions of SFAS No. 131 (SFAS 131), "Disclosures about Segments of an Enterprise and Related Information." SFAS 131 establishes standards for reporting information about operating segments in annual and interim financial statements, requiring that public business enterprises report financial and descriptive information about reportable segments based on a management approach. SFAS 131 also establishes standards for related disclosures about products and services, geographic areas and major customers. In applying the requirements of this statement, we continue to have one reportable segment, which is the development of genetic susceptibility tests and therapeutic targets for common diseases. 8 During 2000, we closed our foreign operations. Therefore, we no longer have any assets outside of the United States. For the nine-month periods ended September 30, 2002 and 2001 all assets were located, and all revenue was primarily generated in the United States. NOTE 10 - RECENT ACCOUNTING PRONOUNCEMENTS In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB 13, and Technical Corrections", which is effective for fiscal years beginning after May 15, 2002. Upon adoption of SFAS No. 145, companies will be required to apply the criteria in APB Opinion No. 30, "Reporting the Results Operations - Reporting the Effects of Disposal of a Segment of a Business and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" in determining the classification of gains/losses resulting from the extinguishment of debt shall be classified under the criteria in APB Opinion No. 30. We do not expect Adoption of SFAS No. 145 to have a material impact on our financial statements. In July 2002, FASB issued SFAS No. 146 "Accounting for Costs Associated with Exit or Disposal Activities", which becomes effective January 2003. SFAS No. 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of commitment. We do not expect Adoption of SFAS No. 146 to have a material impact on our financial statements. 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD LOOKING STATEMENTS THIS QUARTERLY REPORT ON FORM 10-Q CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT AND SECTION 21E OF THE SECURITIES EXCHANGE ACT. STATEMENTS CONTAINED IN THIS REPORT THAT ARE NOT STATEMENTS OF HISTORICAL FACT MAY BE DEEMED TO BE FORWARD-LOOKING STATEMENTS. WORDS OR PHRASES SUCH AS "WILL LIKELY RESULT", "WILL ENABLE", "EXPECT", "WILL CONTINUE", "ANTICIPATE", "ESTIMATE", "INTEND", "PLAN", "PROJECT", "OUTLOOK", OR SIMILAR EXPRESSIONS ARE INTENDED TO IDENTIFY FORWARD-LOOKING STATEMENTS. FORWARD-LOOKING STATEMENTS ADDRESS OR MAY ADDRESS THE FOLLOWING SUBJECTS: - THE SUFFICIENCY OF OUR CURRENT CASH RESOURCES AND FINANCING ARRANGEMENTS TO FUND OPERATIONS THROUGH JANUARY 2003; - OUR EXPECTATION THAT WE WILL ISSUE AND SELL ALL THREE $500,000 PROMISSORY NOTES CONTEMPLATED IN OUR INTERIM FINANCING AGREEMENT WITH PYXIS INNOVATIONS, INC.; - OUR ABILITY TO RAISE ADDITIONAL CAPITAL TO FUND OPERATIONS PAST DECEMBER 2002; - ANY EXPECTATION THAT WE MIGHT NEGOTIATE A STRATEGIC PARTNERSHIP, JOINT VENTURE OR RECEIVE EQUITY FINANCING FROM PYXIS INNOVATIONS, INC.; - OUR CONTINUED LISTING ON THE NASDAQ SMALLCAP MARKET; - OUR EXPECTATION OF THE BENEFITS THAT WILL RESULT FROM ONGOING RESEARCH PROGRAMS THAT OUTSIDE PARTIES ARE CONDUCTING ON OUR BEHALF; - OUR EXPECTATION OF THE BENEFITS THAT WILL RESULT FROM THE ONGOING RESEARCH WE ARE FUNDING AT SHEFFIELD UNIVERSITY; - ANY EXPECTATION WE MAY HAVE REGARDING THE SUCCESS OF DEVELOPING PRODUCTS, THE TIMING OF RELEASING PRODUCTS FOR SALE OR THE SUCCESS OF THESE PRODUCTS WHEN THEY ARE RELEASED; - OUR EXPECTATION THAT TOTAL RESEARCH AND DEVELOPMENT COSTS, INCLUDING CLINICAL COSTS, WILL BE BETWEEN APPROXIMATELY $3.2 AND $3.4 MILLION FOR THE YEAR ENDED DECEMBER 31, 2002; AND - OUR EXPECTATION THAT WE WILL CONTINUE TO EXPERIENCE LOSSES UNTIL OUR GENETIC TESTING REVENUES GROW SUBSTANTIALLY FROM CURRENT LEVELS. ACTUAL RESULTS MAY VARY MATERIALLY FROM THOSE EXPRESSED IN FORWARD-LOOKING STATEMENTS. FACTORS THAT COULD CAUSE ACTUAL RESULTS TO DIFFER FROM EXPECTATIONS INCLUDE BUT ARE NOT LIMITED TO: OUR ABILITY TO OBTAIN ADEQUATE CAPITAL, OUR ABILITY TO SELL ALL OF THE PROMISSORY NOTES CONTEMPLATED IN OUR INTERIM FINANCING AGREEMENT, RISKS RELATED TO MARKET ACCEPTANCE OF GENETIC RISK ASSESSMENT TESTS IN GENERAL AND OUR PRODUCTS IN PARTICULAR, RISK RELATED TO TECHNOLOGY AND PRODUCT OBSOLESCENCE, DELAYS IN DEVELOPMENT OF PRODUCTS, DEPENDENCE ON THIRD PARTIES, COMPETITIVE RISKS AND THOSE RISKS SET FORTH WITHIN THE SECTION BELOW TITLED "CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS". WE CANNOT BE CERTAIN THAT OUR RESULTS WILL NOT BE ADVERSELY AFFECTED BY ONE OR MORE OF THOSE FACTORS OR BY OTHER FACTORS NOT CURRENTLY ANTICIPATED. ALL INFORMATION SET FORTH IN THIS FORM 10-Q IS AS OF THE DATE OF THIS FORM 10-Q. UNLESS REQUIRED BY LAW WE ACCEPT NO RESPONSIBILITY TO UPDATE THIS INFORMATION. 10 GENERAL OVERVIEW We develop and sell genetic susceptibility tests, tests that identify which individuals will respond to specific drug therapies and medical research tools. We focus our efforts on discovering genetic factors that predict the susceptibility of individuals to various diseases or determine which individuals will respond to a specific drug therapy or to specific nutritional products. We market PST(R) in the United States and Europe. PST is our only genetic test currently on the market and predicts the risk of periodontal disease. Products currently under development include tests that predict the risk of osteoporosis, coronary artery disease and complications from diabetes and a test that predicts which drug treatment will be most effective for patients with advanced Rheumatoid Arthritis. Every living organism has a unique "genome," a master blueprint of all the cellular structures and activities necessary to build and support life. A genome is a map of the organism's DNA, which is in part comprised of segments called "genes." Genes contain the specific sequences of information responsible for particular physiological traits and processes. Each gene contains a sequence of nucleotides, which provide precise genetic instructions to create, or "express" a protein. Proteins are the primary building blocks of an organism's physiological characteristics. A typical human cell contains thousands of different proteins essential to its structure, growth and function. If even one gene or single nucleotide is abnormal, it can severely alter the cell's function and result in a disease condition. Throughout the past decade, researchers have focused on discovering genes and sequencing the human genome to determine the order of nucleotides in a specific gene, permitting identification of the gene and the protein it produces using a variety of techniques. For example, scientists have used cDNA libraries, which contain copies of DNA with only the expressed portion of the gene, in conjunction with computer software to identify locations of genes within the genome. Recent advances have allowed these technologies to operate in a high-throughput manner, causing the discovery of genes to become much more efficient and allowing researchers to focus on the functional aspects of genes. Understanding the functional aspects of genes permits the researchers to correlate those genes to medically relevant conditions. The efforts to discover and understand these functional aspects of the genes in the human genome are commonly referred to as "functional genomics." Identifying genes that may predispose a person to a particular disease may allow researchers to develop diagnostic tests for the disease permitting early diagnosis and more successful treatment. We believe that combining genetic susceptibility tests with specific therapeutic strategies results in improved clinical outcomes and more cost-effective disease management. We also develop and license our medical research tools to pharmaceutical and biotech companies. For instance, BioFusion(R) is our proprietary computer modeling system that simulates complex diseases and allows researchers to identify useful information from the rapidly increasing genetic information databases that companies and academic centers worldwide generate. We distribute PST through third party distributors. Kimball Genetics markets PST in the United States and Hain Diagnostika/ADA GmbH distributes PST in all countries outside of North America and Japan. Hain has extensive experience in commercializing genetic tests in several fields, as well as a specific 11 commitment to marketing products directly to dentists. Sales of PST have generated minimal revenues to date, and we do not know if or when PST will achieve commercial acceptance. 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. We are not certain whether we will be successful in developing and bringing to market our current or future tests based on the genetic discoveries made by our collaborators and us. Our ability to successfully commercialize genetic susceptibility tests depends partly 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 may be influenced by the scope and reimbursement for such tests by third-party payers. If both third-party payers 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. Research in the field of disease predisposing genes and genetic markers is intense and highly competitive. We have many competitors in the United States and abroad that have considerably greater financial, technical, marketing, and other resources available. If we do not discover disease predisposing genes or genetic markers and develop susceptibility tests and launch such services or products before our competitors, then revenues may be reduced or eliminated. RESULTS OF OPERATIONS COMPARISON OF THREE MONTHS ENDED SEPTEMBER 30, 2002 TO THREE MONTHS ENDED SEPTEMBER 30, 2001 Revenue for the three months ended September 30, 2002 was $79,677 compared to $24,978 for the three months ended September 30, 2001, an increase of 219%. The increase was entirely due to the amortized revenue associated with an option fee that was received from Pyxis Innovations, Inc. during the period. Excluding this fee, revenue decreased 67% in comparison to the same period last year. In the three months ended September 30, 2002, we recorded revenue from 381 PST tests compared to 577 tests in the same period in 2001. Cost of revenue was $106 for the three months ended September 30, 2002 compared to $8,443 for the same period in 2001. Gross profit margin was 99% in the three months ended September 30, 2002 compared to 66% for the same period in 2001. The decrease in test revenue was the result of the decrease in the number of PST tests processed and the replacement of our prior PST distributor, Straumann Company, with our current distributor, Kimball Genetics, as our primary distributor within the United States. We receive less revenue per test from Kimball than we did from Straumann but we do not need to pay a processing fee back to them. This change in distributors has reduced our revenue but improved our gross margin percentage. The gross profit per test to us is approximately the same for Kimball as it was for Straumann. For the three months ended September 30, 2002, we had research and development expenses of $716,964 as compared to $634,719 for the same quarter of 2001, an increase of 13%. The increase was primarily the result of 12 increases in personnel costs associated with the staffing of our new research laboratory and the cost of supplying the laboratory. We are currently conducting several research and clinical projects both in-house and through collaborative partners. The most significant projects are the following: CARDIOVASCULAR DISEASE: We are working with Kaiser Permanente's Center for Health Research to investigate the value of testing for genetic differences among people who have type 2 diabetes to determine their relative risk of developing cardiovascular disease. It is hoped that this program will enable us to develop new diagnostic tools for assessing diabetic patients' genetic risk for heart disease. Enrollment on this study is complete and the analysis is underway. If we are successful we expect to have a test predictive of cardiovascular complications from diabetes on the market in 2003. RHEUMATOID ARTHRITIS: In collaboration with United Health Group, we are conducting a study to determine whether analysis of genotype will be useful to predict responses to anti-cytokine therapy for individuals with rheumatoid arthritis. Different anti-cytokine therapies act very differently on a patient's biology. Two of the three anti-cytokine therapies used to treat rheumatoid arthritis are anti TNFa drugs; the other acts upon the IL-1 gene. We believe that depending upon the specific genetics of individual patients, we might be able to predict which class of drugs would be most effective. In collaboration with the University of Sheffield School of Health and Related Research (ScHARR), we are conducting a study to determine if it is cost effective to analyze patient genotypes prior to the use of Kineret in the treatment of Rheumatoid Arthritis. The preliminary results of this study were announced at the American College of Rheumatoid meeting on October 26, 2002. The results of the economic modeling indicate that use of a pharmacogenetic test prior to prescribing Kineret could potentially be cost-effective, producing higher response rates and potential cost savings. ALZHEIMER'S DISEASE: We are working with the University of Arkansas for Medical Sciences to study the genetic causes of inflammation in relation to Alzheimer's Disease. This study will focus on how IL-1 genetic variations alter inflammation in the brain leading to Alzheimer's Disease. This information, together with other genetic data, might be used to develop new drug targets and help in the development of therapeutics for individuals with genetic differences in their inflammatory mechanisms. SHEFFIELD STUDIES: We are funding research at Sheffield University in support of several research projects including the following: A study to determine the haplotypes, or sets of genetic variations that are inherited together, that exist within the IL-1 cluster; A study to discover novel drug targets for inflammatory diseases by discovering genes involved in the responses of cells after they have been activated by IL-1; the development of a system that measures the net IL-1 biologic activity of blood or any tissue fluid and the discovery of the genetic variations that control patient to patient differences in inflammatory mechanisms. We believe that the completion of these studies will greatly enhance our understanding of the IL-1 gene cluster and the relationship of this gene cluster to inflammatory responses and disease risk. 13 FUNCTIONAL GENETICS RESEARCH: We are currently conducting the following studies at our research center in Waltham, Massachusetts: - Identify functional SNPs: A project to determine which of the SNPs, within the IL-1 gene cluster, leads to an alteration in the expression of the IL-1 genes. - Create IL-1 genotype and haplotype specific cell models that can be used for studying drug responses. It is hoped that these models will be critical to the analyses of drug or nutriceutical product response for use in future partnerships and collaborative projects in support of the development of new drugs or nutriceuticals. - Investigate IL-1 genotype and haplotype influences on the expression of inflammatory response genes derived from normal and disease tissues. OSTEOPOROSIS: We anticipate conducting one or more clinical studies that we hope will confirm our initial findings of association between polymorphisms in the IL-1 and TNFa and a woman's risk for vertebral fracture. Any further studies will depend upon our ability to raise additional funds. We expect total research and development costs, including clinical costs, to be between approximately $3.2 and $3.4 million for the calendar year 2002. Actual costs may vary from this estimate as a result of our ability to raise additional new capital, changes in technology, the success of current and future research projects, the success or failure of our current or future strategic alliances and collaborations and the identification of new business opportunities. We have not made an attempt to finalize an estimate of our research and development expenses beyond 2002 due to the factors listed above. Selling, general and administrative expenses were $652,637 during the three months ended September 30, 2002 compared to $565,110 during the same quarter last year, an increase of 15%. The increase was primarily the result of an increase in legal expenses related to our efforts to obtain additional financing. This was partially offset by reduction in administrative, sales and marketing expense related to the sale and distribution of PST and a decrease in travel expense. Interest income for the three months ended September 30, 2002 was $2,520 compared to $49,661 for the same period in 2001. This decrease is due primarily to the lower average cash and cash equivalent balances in 2002 in comparison to the same period in 2001. Interest expense of $15,983 was incurred during the quarter ended September 30, 2002, compared to $2,396 in the same period in 2001. The increase is primarily due to interest expense related to the bridge financing entered into in August 2002. Other expense of $60,034 is related to the amortization of the value of the warrants associated with that bridge financing. This expense is being amortized over the life of the loan. COMPARISON OF NINE MONTHS ENDED SEPTEMBER 30, 2002 TO NINE MONTHS ENDED SEPTEMBER 30, 2001 Revenue for the nine months ended September 30, 2002 was $102,229 compared to $183,923 for the nine months ended September 30, 2001, a decrease of 44%. In the nine months ended September 30, 2002, we recorded revenue from 1,374 PST 14 tests compared to 3,035 tests in the same period in 2001. Cost of revenue was $441 for the nine months ended September 30, 2002 compared to $43,387 for the same period in 2001. Gross profit margin was 99% in the nine months ended September 30, 2002 compared to 76% for the same period in 2001. The decrease in revenue was the result of (i) the inclusion in last year's revenue totals of $101,520 for the processing of 1,128 tests in association with a single clinical trial that was conducted by Washington Delta Dental, (ii) a decrease in the number of PST tests processed, exclusive of the clinical trial mentioned above, and (iii) the replacement of our prior PST distributor, Straumann Company, with our current distributor, Kimball Genetics, as our primary distributor within the United States. We receive less revenue per test from Kimball than we had from Straumann but we do not need to pay a processing fee back to them. This change in distributors has reduced our revenue but improved our gross margin percentage. The gross profit per test to us is approximately the same for Kimball as it was for Straumann. This decrease was partially offset by the amortized revenue associated with the receipt of an option fee from Pyxis Innovations, Inc. that was received during the period. For the nine months ended September 30, 2002, we had research and development expenses of $2,504,132 as compared to $2,050,665 for the same period of 2001, an increase of 22%. The increase was primarily the result of increases in personnel costs associated with an increased number of ongoing clinical projects and with staffing of our new research laboratory and the cost of supplying the laboratory. Selling, general and administrative expenses were $1,764,343 during the nine months ended September 30, 2002 compared to $1,741,231 during the same period last year, an increase of 1%. Increases in legal expenses, rent and expenses related to our business development effort were almost completely offset by decreases in travel, consulting and reductions in administrative, sales and marketing expense related to the sale and distribution of PST. Interest income for the nine months ended September 30, 2002 was $22,276 compared to $237,252 for the same period in 2001. This decrease is due primarily to the lower average cash and cash equivalent balances in 2002 in comparison to the same period in 2001. Interest expense of $22,251 was incurred during the nine months ended September 30, 2002, compared to $8,165 in the same period in 2001. This increase was primarily due to interest expense associated with the bridge financing that was closed in August 2002. We had other expense of $59,337 during the nine months ended September 30, 2002. This was primarily the amortization of the expense related to issuing warrants associated with that August 2002 financing. LIQUIDITY AND CAPITAL RESOURCES To date, we have funded our operations primarily through public and private sales of equity and private sales of debt. During 2001, we raised net proceeds of approximately $2.9 million, from a private placement of common stock and approximately $480,000 from the exercise of stock options and warrants. On August 9, 2002, we received approximately $475,000, net proceeds, from the sale of term promissory notes with an aggregate original principal amount of $525,000. These notes mature in one year and pay interest at a rate of 15%. 15 The principal and all interest are to be paid upon maturity. We can prepay the principal and accrued interest without penalty. The promissory notes purchasers received warrants to purchase one share of stock for a purchase price of $2.50 for every dollar invested in the promissory notes. In total warrants to purchase 525,000 shares of stock were issued. These warrants expire in ten years. On September 3, 2002 we received an option fee from Pyxis Innovations, Inc. in conjunction with a letter of intent that was signed with that company. The option fee allows Pyxis to exclusively negotiate a joint venture or license agreement with us in the area of nutritional genomics over a period of 105 days. The revenue from this option agreement is being recognized over the life of the option period. On October 23, 2002, subsequent to the end of the fiscal quarter, we entered into an interim financing agreement with Pyxis for debt financing of up to $1.5 million. The financing is to be in the form of three $500,000 promissory notes, the first of which was issued on October 23, 2002. We expect the second note to be issued on November 15, 2002. The third note will be issued, at the option of Pyxis, on December 16, 2002. These notes will mature on December 31, 2003 and accrue interest at a rate of 15%. The outstanding principal amount and all accrued interest are to be paid upon maturity. We can prepay the principal and accrued interest at any time without penalty. These notes are secured by all of our intellectual property except intellectual property relating to periodontal disease and sepsis. Since inception, we have incurred accumulated deficits of approximately $39.7 million, including losses of approximately $4.2 million during the nine months ended September 30, 2002. Net cash used in operating activities was $3.8 million during the nine months ended September 30, 2002 and $3.2 million during the same period last year. We anticipate that we will continue to experience losses until our genetic testing revenues grow substantially from current levels. In addition, if we are successful in reaching agreements with strategic partners, milestone payments, if any, from these strategic partners would help fund our research and development efforts. We cannot give any assurances that we will be able to increase our revenues, either from genetic tests or licensing revenue, or that we will be able to reach strategic partnering agreements. We will be required to repay $603,750 in principal and interest on our 15% term promissory notes during August 2003 and approximately $590,000 in principal and interest on our first $500,000 promissory note issued to Pyxis during December 2003. In December 2003, we will also be required to repay an aggregate of approximately $1,160,000 if the second and third notes contemplated in our interim financing arrangement are issued. The letter stated that our common stock is not in compliance with the $1 minimum bid price, that our stockholders' equity does not meet the $2.5 million minimum requirement, and that the NASDAQ Staff rejected our plan to regain compliance with those listing criteria. We have requested a hearing before the NASDAQ Listing Qualifications Panel to appeal the ruling by the NASDAQ Staff and have been notified that our hearing will be held on November 14, 2002. During the appeals process, which we expect may take up to 45 days, our common stock will continue to trade on the NASDAQ SmallCap Market. In the event that the Panel does not grant continued listing, our common stock will be immediately delisted from the Nasdaq SmallCap market and we expect it will 16 trade on the OTC Bulletin Board (OTCBB). There can be no assurance that the Panel will grant our request for continued listing. Our obligation at September 30, 2002 for capitalized lease obligations totaled approximately $52,000, of which $22,000 is classified as long-term and $30,000 is classified as current. We currently do not have any commitments for material capital expenditures. As of September 30, 2002 we had cash and cash equivalents totaling $508,000 compared to $3.9 million as of December 31, 2001. We anticipate that existing cash and cash equivalents, including funds received from the recent sale of promissory notes (described above) are adequate to fund operations approximately through December 2002 if Pyxis does not elect to purchase the third $500,000 promissory note contemplated in the financing arrangement or January 2003 if they do elect to purchase the third $500,000 promissory note. As a result, there is significant doubt about our ability to continue as a going concern. Our future capital requirements are anticipated to be substantial, and we do not have commitments for additional capital at this time. Capital requirements are expected to arise from the commercial launch of additional genetic tests, continued research and development efforts, the protection of intellectual property rights (including preparing and filing of patent applications), and repayment of the principal and interest on our 15% term promissory notes due in August 2003 and December 2003, as well as operational, administrative, legal and accounting expenses. We are currently pursuing sources of capital and strategic partnerships in order to raise the capital necessary to continue operations past January 2003. WE CAN GIVE NO ASSURANCE THAT WE WILL BE ABLE TO RAISE ANY ADDITIONAL CAPITAL, OR IF WE DO RAISE ADDITIONAL CAPITAL, THAT IT WILL BE ON TERMS ACCEPTABLE TO OUR STOCKHOLDERS OR US. IF ADDITIONAL AMOUNTS CANNOT BE RAISED, WE WOULD SUFFER MATERIAL ADVERSE CONSEQUENCES TO OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS AND WOULD LIKELY BE REQUIRED TO SEEK OTHER ALTERNATIVES UP TO AND INCLUDING PROTECTION UNDER THE UNITED STATES BANKRUPTCY LAWS. CRITICAL ACCOUNTING POLICIES Our significant accounting policies are described in Note 2 to the consolidated financial statements included in this report. We believe our most critical accounting policies are in the areas of revenue recognition, cost estimations of certain ongoing research contracts and our decision to expense all patent related costs as incurred. Revenue recognition: Revenue from genetic susceptibility tests is recognized when the tests have been completed and the results reported to the doctors. To the extent test kits have been purchased but not yet submitted for test results, we defer recognition of revenue. This amount is presented on our balance sheet as deferred revenue. Contract revenues are recognized ratably as services are provided based on a fixed contract price or on negotiated hourly rates. Fees for the sale or licensing of product rights are recorded as deferred revenue upon receipt and recognized as revenue on the straight-line basis over the period that the related products or services are delivered or obligations as defined in the agreement are performed. Cost estimates: 17 Much of our research and development is done on contract by outside parties. It is not unusual that at the end of an accounting period we need to estimate both the total cost of these projects and the percent of that project which was completed as of the accounting date. We then need to adjust those estimates when final invoices are received. To date, these adjustments have not been material to our financial statements, and we believe that the estimates that we made as of September 30, 2002 are reflective of the actual expenses incurred as of that date. However, readers should be cautioned that the possibility exists that certain research projects might cost more than we have estimated and that these higher costs will be reflected in future periods. Patent expenses: We have made the decision to expense patent expenses as incurred due to the possibility that we will never be able to derive any benefits from our patents. We have exclusive rights in nine issued U.S. patents and have twenty pending U.S. patents applications. We have also been granted a number of corresponding foreign patents and we have a number of foreign counterparts of our U.S. patents and patent applications pending. Since inception we have expensed over to $2.2 million in the effort to obtain patent protection for our intellectual property including approximately $310,000 during the nine months ended September 2002. If we had decided to record the costs of developing patent protection as an intangible asset on the balance sheet it would have had a material effect on the presentation of our financial statements. In future periods we may decide to change this presentation as the realizability of return on this investment becomes more certain. Research and Development expenses: We expense research and development expenses as incurred. Research and Development expenses include all expenses related to clinical trials, laboratory research and outside research completed on our behalf. It also includes all payroll, benefit, supply and travel expenses of those employees whose activities are in support of the efforts described above. CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS IF WE FAIL TO OBTAIN ADDITIONAL CAPITAL, OR OBTAIN IT ON UNFAVORABLE TERMS, THEN WE MAY HAVE TO END OUR RESEARCH AND DEVELOPMENT PROGRAMS AND OTHER OPERATIONS We anticipate that our current financial resources are adequate to maintain our current and planned operations through November 2002. We anticipate that our current financial resources together with the proceeds from the sale of notes to Pyxis Innovations, Inc. will be adequate to maintain our current and planned operations through December 2002 (if Pyxis does not elect to purchase the third $500,000 note) or January 2003 (if Pyxis does elect to purchase the third $500,000 note). If we cannot raise additional capital prior to any of these dates, we will be unable to fund our business operations and will be required to seek other strategic alternatives and may be required to declare bankruptcy. Any future issuances of equity securities by the Company may require stockholder approval for an increase in authorized shares. If the 18 Company is unable to obtain such approval, it will be required to seek other strategic alternatives and may be required to declare bankruptcy. Our future capital needs depend on many factors. We will need capital for the commercial launch of additional genetic tests, continued research and development efforts, obtaining and protecting patents and administrative expenses. Additional financing may not be available when needed, or, if available, it may not be available on favorable terms. If we cannot obtain additional funding on acceptable terms when needed, we may have to discontinue operations, or, at a minimum, curtail one or more of our research and development programs. WE MAY BE DELISTED FROM NASDAQ RESULTING IN A LIMITED PUBLIC MARKET FOR OUR COMMON STOCK AND VOLATILITY IN OUR STOCK PRICE Our common stock is currently listed on the Nasdaq SmallCap Market and the Boston Stock Exchange. On April 2, 2002 we received a notice from Nasdaq stating that we were not in compliance with their continued listing requirements because our common stock bid price had fallen below Nasdaq's $1.00 minimum bid price requirement. The Rule states that if our stock price is below the minimum bid price requirement for 30 consecutive trading days, we would have 180 days to regain compliance with this requirement or face delisting. The 180-day grace period expired September 30, 2002. To meet the bid price requirement, the bid price of our common stock had to close at or above $1.00 per share for more than ten consecutive trading days prior to September 30, 2002. From April 1, 2002 through September 30, 2002, our closing bid price ranged from $0.50 to $1.02, but did not close above $1 for more than two consecutive days. In addition, we received a notice from Nasdaq that as of June 30, 2002 we did not satisfy the Nasdaq rule that we have stockholders' equity of at least $2.5 million. We presented a plan for achieving compliance to Nasdaq on September 13, 2002. Nasdaq did not approve of our plan and announced its decision to delist our common stock anyway. We have requested a hearing regarding this decision and have been notified that the hearing will be held on November 14, 2002. While we expect the Listing Qualifications Panel to take up to 45 days to issue its decision, it could do so at any time following the hearing and if they reject our appeal our common stock will be immediately delisted from the Nasdaq SmallCap Market. If they accept our appeal and grant us additional time to regain compliance with the listing criteria, among other things we will need to increase stockholder's equity by a total of approximately $5 million in order to satisfy the stockholders' equity requirements through December 31, 2002. Accordingly, whether or not our appeal is successful we may not be able to maintain our continued listing on the Nasdaq or the Boston Stock Exchange. If we are unable to maintain our Nasdaq Smallcap market quotation, our common stock would likely begin to trade on the NASD's OTC Bulletin Board and become a "penny stock", as long as it trades below $5.00 per share. Broker-dealer practices in connection with transactions in penny stocks are regulated by penny stock rules adopted by the SEC. The penny stock rules require a broker-dealer, prior to a transaction in a penny stock not otherwise exempt from the rules, to deliver a standardized risk disclosure statement prepared by the SEC that provides information about penny stocks and the nature and level of risks in the penny stock market. The broker-dealer also must provide the customer with current bid and offer quotations for the penny stock, the compensation of the broker-dealer and its salesperson in the transaction, as well as the monthly account statements showing the market value of each penny stock held 19 in the customer's account. In addition, the penny stock rules require that, prior to a transaction in a penny stock not otherwise exempt from such rules, the broker-dealer must make a special written determination that the penny stock is a suitable investment for the purchaser and receive the purchaser's written agreement to the transaction. Selling our common stock will also be more difficult because of reduced trading volume and transaction size. Transactions could also be delayed, and security analysts' and news media's coverage, if any, of us will be reduced. These factors may result in lower prices and larger spreads in the bid and ask prices for our shares. The delisting of our shares would also greatly impair our ability to raise additional necessary capital through equity or debt financing. Historically, our common stock has experienced low trading volumes. The market price of our common stock has been highly volatile, and it may continue to be highly volatile, as has been the case with the securities of other public biotechnology companies. Factors such as announcements by us or by our competitors concerning technological innovations, new commercial products or procedures, proposed government regulations and developments or disputes relating to patents or proprietary rights are likely to affect the market price of our common stock. Changes in the market price of our common stock may bear no relation to our actual operational or financial results. IF OUR COMMON STOCK IS DELISTED FROM NASDAQ, WE MAY NEED TO PAY PENALTIES OF $100,000 PER MONTH. Pursuant to the terms of our December 2000 and January 2001 financings, if our common stock is delisted from Nasdaq, we must pay $100,000 per month to the investors in those financings continuing indefinitely. We recently entered into agreements with each of these investors in which the investors agreed to waive their rights to any such payments until April 1, 2003. If we receive at least $3 million of equity financing from Pyxis Innovations, Inc. or its affiliates prior to April 1, 2003 these provisions will be permanently waived. These payments, if they become required, would make it more difficult for us to raise additional funds and to operate our business. WE HAVE A HISTORY OF OPERATING LOSSES AND EXPECT THESE LOSSES TO CONTINUE IN THE FUTURE We have experienced significant operating losses since our inception and expect these losses to continue for the foreseeable future. We incurred losses from operations of $6.2 million in 1999, $5.2 million in 2000 and $4.8 million in 2001. As of September 30, 2002, our accumulated deficit was $39.7 million. Our losses result primarily from research and development and selling, general and administrative expenses. We have not generated significant revenues from product sales, and we do not know if we will ever generate significant revenues from product sales. We will need to generate significant revenues to continue our research and development programs and achieve profitability. We cannot predict when, if ever, we will achieve profitability. THE MARKET FOR GENETIC SUSCEPTIBILITY TESTS IS UNPROVEN The market for genetic susceptibility tests is at an early stage of development and may not continue to grow. The general scientific community, including us, has only a limited understanding of the role of genes in predicting disease. When we identify a gene or genetic marker that may predict 20 disease, we conduct clinical trials to confirm the initial scientific discovery and to establish the scientific discovery's clinical utility in the marketplace. The results of these clinical trials could limit or delay our ability to bring the test to market, reduce the test's acceptance by our customers or cause us to cancel the program, any of which limit or delay sales and cause additional losses. The only genetic susceptibility test we currently market is PST, and it has produced only minimal revenues to date. The marketplace may never accept our products, and we may never be able to sell our products at a profit. We may not complete development of or commercialize our other genetic susceptibility tests. The success of our 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 by third-party payors, such as insurance companies and the government. We can achieve broad market acceptance only with substantial education about the benefits and limitations of genetic susceptibility tests. Our tests may not gain market acceptance on a timely basis, if at all. If patients, dentists and physicians do not accept our tests, or take a longer time to accept them than we anticipate, then it will reduce our sales, resulting in additional losses. WE RELY HEAVILY ON THIRD PARTIES TO PERFORM SALES, MARKETING AND DISTRIBUTION FUNCTIONS ON OUR BEHALF, WHICH COULD LIMIT OUR EFFORTS TO SUCCESSFULLY MARKET PRODUCTS We have limited experience and capabilities with respect to distributing, marketing and selling genetic susceptibility tests. We have relied and plan to continue to rely significantly on sales, marketing and distribution arrangements with third parties, over which we have limited influence. If these third parties do not successfully market our products, it will reduce our sales and increase our losses. If we are unable to negotiate acceptable marketing and distribution agreements with future third parties, or if in the future we elect to perform sales, marketing and distribution functions ourselves, we will incur significant costs and face a number of additional risks, including the need to recruit experienced marketing and sales personnel. WE RELY HEAVILY ON THIRD PARTIES TO PERFORM RESEARCH AND DEVELOPMENT ON OUR BEHALF, WHICH COULD LIMIT OUR EFFORTS TO SUCCESSFULLY DEVELOP PRODUCTS We have limited research and development capabilities. In July 1999, we entered into a new contractual arrangement with the University of Sheffield, replacing the research and development agreement that had been in place since 1996. Under our arrangement with Sheffield, we will undertake the business development and commercialization of discoveries resulting from Sheffield's research. The agreement is non-cancelable for those discoveries on which Sheffield and we have reached a specific business development agreement, but otherwise either party can end the arrangement upon six months' notice. This agreement with Sheffield has a five-year term with an automatic yearly renewal. As part of this arrangement, we issued an aggregate of 475,000 shares of our common stock to Sheffield and its researchers in exchange for patent rights and other interests held by Sheffield and its researchers under our previous project agreements. Our agreement with Sheffield requires us to fund agreed upon research and development activities at the University of Sheffield on our behalf based upon annual budgets. We also entered into a five-year consulting agreement with Sheffield's key collaborator, Dr. Gordon Duff. 21 Reliance on third-party research and development entails risks we would not be subject to if we performed this function ourselves. These risks include reliance on the third party for regulatory compliance and quality assurance, the possibility of breach of agreements by third parties because of factors beyond our control and the possibility of terminations or nonrenewals of agreements by third parties, based on their own business priorities, at times that are costly or inconvenient for us. We may in the future elect to perform all research and development ourselves, which will require us to raise substantial additional funds and recruit additional qualified personnel. IF WE ARE UNSUCCESSFUL IN ESTABLISHING ADDITIONAL STRATEGIC ALLIANCES, OUR ABILITY TO DEVELOP AND MARKET PRODUCTS AND SERVICES WILL BE DAMAGED Entering into strategic alliances for the development and commercialization of products and services based on our discoveries is an important element of our business strategy. We anticipate entering into additional collaborative arrangements with Sheffield and other parties in the future. We face significant competition in seeking appropriate collaborators. In addition, these alliance arrangements are complex to negotiate and time-consuming to document. If we fail to maintain existing alliances or establish additional strategic alliances or other alternative arrangements, then our ability to develop and market products and services will be damaged. In addition, the terms of any future strategic alliances may be unfavorable to us or these strategic alliances may be unsuccessful. IF WE FAIL TO OBTAIN AN ADEQUATE LEVEL OF REIMBURSEMENT FOR OUR PRODUCTS OR SERVICES BY THIRD-PARTY PAYORS, THEN OUR PRODUCTS AND SERVICES WILL NOT BE COMMERCIALLY VIABLE The availability and levels of reimbursement by governmental and other third-party payors affect the market for any healthcare service. These third-party payors continually attempt to contain or reduce the costs of healthcare by challenging the prices charged for medical products and services. Our ability to successfully commercialize our existing genetic susceptibility test and others that we may develop depends on obtaining adequate reimbursement from third-party payors. The extent of third-party payor reimbursement will likely heavily influence physicians' and dentists' decisions to recommend genetic susceptibility tests, as well as patients' elections to pursue testing. If reimbursement is unavailable or limited in scope or amount, then we cannot sell our products and services profitably. In particular, third-party payors tend to deny reimbursement for services which they determine to be investigational in nature or which are not considered "reasonable and necessary" for diagnosis or treatment. To date, few third-party payors have agreed to reimburse patients for genetic susceptibility tests, and we do not know if third-party payors will, in the future, provide full reimbursement coverage for these genetic tests. If third-party payors do not provide adequate reimbursement coverage, then individuals may choose to directly pay for the test. If both third-party payors and individuals are unwilling to pay for the tests, then the number of tests we can sell will be significantly decreased, resulting in reduced revenues and additional losses. IF WE FAIL TO OBTAIN PATENT PROTECTION FOR OUR PRODUCTS AND PRESERVE OUR TRADE SECRETS, THEN COMPETITORS MAY DEVELOP COMPETING PRODUCTS AND SERVICES, WHICH WILL DECREASE OUR SALES AND MARKET SHARE 22 Our success will partly depend on our ability to obtain patent protection, 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 upon the proprietary rights of third parties. We own exclusive rights in nine issued U.S. patents and have 20 U.S. patent applications pending. We have also been granted a number of corresponding foreign patents and have a number of foreign counterparts of our U.S patents and patent applications pending. Our patent positions, and those of other pharmaceutical and biotechnology companies, are generally uncertain and involve complex legal, scientific and factual questions. Our ability to develop and commercialize products and services depends on our ability to: - Obtain patents; - Obtain licenses to the proprietary rights of others; - Prevent others from infringing on our proprietary rights; and - Protect trade secrets. Our pending patent applications may not result in issued patents or any issued patents may never afford meaningful protection for our technology or products. Further, others may develop competing products which avoid legally infringing upon, or conflicting with, our patents. In addition, competitors may challenge any patents issued to us, and these patents may subsequently be narrowed, invalidated or circumvented. We also rely on trade secrets and proprietary know-how that we seek to protect, in part, by confidentiality agreements. The third parties we contract with may breach these agreements, and we might not have adequate remedies for any breach. Additionally, our competitors may discover or independently develop our trade secrets. THIRD PARTIES MAY OWN OR CONTROL PATENTS OR PATENT APPLICATIONS AND REQUIRE US TO SEEK LICENSES, WHICH COULD INCREASE OUR COSTS OR PREVENT US FROM DEVELOPING OR MARKETING OUR PRODUCTS OR SERVICES We may not have rights under patents or patent applications which are related to our current or proposed products. Third parties may own or control these patents and patent applications in the United States and abroad. Therefore, in some cases, to develop or sell any proposed products or services, with patent rights controlled by third parties, our collaborators or we may seek, or may be required to seek, licenses under third-party patents and patent applications. If this occurs, we will pay license fees or royalties or both to the licensor. If licenses are not available to us on acceptable terms, we or our collaborators may be prohibited from developing or selling our products or services. If third parties believe our products or services infringe upon their patents, they could bring legal proceedings against us seeking damages or seeking to enjoin us from testing, manufacturing or marketing our products or services. Any litigation could result in substantial expenses to us and significant diversion of attention by our technical and management personnel. Even if we prevail, the time, cost and diversion of resources of patent litigation would 23 likely damage our business. If the other parties in any patent litigation brought against us are successful, in addition to any liability for damages, we may have to cease the infringing activity or obtain a license. TECHNOLOGICAL CHANGES MAY CAUSE OUR PRODUCTS AND SERVICES TO BE OBSOLETE Our competitors may develop susceptibility tests that are more effective than our technologies or that make our technologies obsolete. Innovations in the treatment of the diseases in which we have products or product candidates could make our products obsolete. These innovations could prevent us from selling, and significantly reduce or eliminate the markets for, our products. WE HAVE COMPLETED FINANCIAL TRANSACTIONS THAT MAY REQUIRE US TO ISSUE MORE SHARES TO EXISTING SHAREHOLDERS WHICH WILL DILUTE THE VALUE OF THE STOCK In December 2000 and January 2001 we sold a total of 2 million shares of our common stock in private placements for $2.50 per share and issued warrants to purchase 600,000 shares of common stock exercisable at $3.00 per share and 264,407 shares of common stock exercisable at $3.13. Under the terms of these private placements we are required to adjust downward the price per share in the offering, by issuing additional shares, to match any offering price paid in subsequent offerings during a 24-month period following completion of the private placements. In connection with the investors' waiver of certain rights, we recently issued a total of 1,676,258 additional shares to these same investors, resulting in an effective purchase price to the investors of $1.36 per share and the investors surrendered their warrants for cancellation. If we do not receive equity investment of at least $3 million from Pyxis Innovations, Inc. or its affiliates prior to April 1, 2003, we are required, subject to the receipt of any required stockholder approvals, to issue to the investors new warrants to purchase an aggregate of 864,407 shares of common stock exercisable at $1.70 per share. Of these warrants, the exercise price of warrants to purchase 600,000 shares of common stock will be subject to adjustment downward to equal 125% of the price per share at which we sell any shares of our common stock (or securities convertible into common stock) prior to May 23, 2003. The price of our common stock has been volatile and has recently been trading below $1.00 per share. This low share price will make it very difficult to raise additional capital at a price matching the adjusted effective purchase price of the private placements. The remainder of the 24-month period has been waived by the December 2000 investor while the 24-month period for the January 2001 investor expires in May 2003. Therefore, it is likely that we will need to issue additional shares to the investors in the January 2001 offerings, if we are to raise additional capital. This might significantly dilute the value of the outstanding common stock. WE MAY BE PROHIBITED FROM FULLY USING OUR NET OPERATING LOSS CARRYFORWARDS, WHICH COULD AFFECT OUR FINANCIAL PERFORMANCE As a result of the losses incurred since inception, we have not recorded a federal income tax provision and have recorded a valuation allowance against all future tax benefits. As of December 31, 2001, we had net operating loss carryforwards of approximately $27.9 million for federal and state income tax purposes, expiring in varying amounts through the year 2021. We also had a research tax credit of approximately $397,000 at December 31, 2001, that expires in varying amounts through the year 2021. Our ability to use these net operating loss and credit carryforwards is subject to restrictions contained in the Internal Revenue Code which provide for limitations on our utilization 24 of our net operating loss and credit carryforwards following a greater than 50% ownership change during the prescribed testing period. We experienced a change in ownership interest in June 1999. As a result, approximately $15.6 million of our net operating loss carryforwards are limited in utilization to approximately $825,000 annually. The annual limitation may result in the expiration of the carryforwards prior to utilization. In addition, in order to realize the future tax benefits of our net operating loss and tax credit carryforwards, we must generate taxable income, of which there is no assurance. WE ARE SUBJECT TO INTENSE COMPETITION FROM OTHER COMPANIES, WHICH MAY DAMAGE OUR BUSINESS Our industry is highly competitive. Our competitors in the United States and abroad are numerous and include 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 competitors have considerably greater financial resources, research and development staffs, facilities, technical personnel, marketing and other resources than we do. Furthermore, many of these competitors are more experienced than we are in discovering, commercializing and marketing products. These greater resources may allow our competitors to discover important genes or genetic markers before we do. If we, in conjunction with the University of Sheffield, do not discover disease predisposing genes and commercialize these discoveries before our competitors, then our ability to generate sales and revenues will be reduced or eliminated, and could make our products obsolete. We expect competition to intensify in our industry as technical advances are made and become more widely known. WE ARE SUBJECT TO GOVERNMENT REGULATION WHICH MAY SIGNIFICANTLY INCREASE OUR COSTS AND DELAY INTRODUCTION OF FUTURE PRODUCTS The sale, performance or analysis of our genetic tests do not currently require FDA or other federal regulatory authority approval. Changes in existing regulations could require advance regulatory approval of genetic susceptibility tests, resulting in a substantial curtailment or even prohibition of our activities without regulatory approval. If our genetic tests ever require regulatory approval, on either a state or federal level, then the costs of introduction will increase and marketing and sales of products may be significantly delayed. WE MAY BE SUBJECT TO PRODUCT LIABILITY CLAIMS THAT ARE COSTLY TO DEFEND AND THAT COULD LIMIT OUR ABILITY TO USE SOME TECHNOLOGIES IN THE FUTURE The design, development, manufacture and use of our genetic susceptibility tests involve an inherent risk of product liability claims and associated adverse publicity. Producers of medical products face substantial liability for damages in the event of product failure or allegations that the product caused harm. We currently maintain product liability insurance, but it is expensive and difficult to obtain, may not be available in the future on economically acceptable terms and may not be adequate to fully protect us against all claims. We may become subject to product liability claims that, even if they are without merit, could result in significant legal defense costs. We could be held liable for damages in excess of the limits of our insurance coverage, and any claim or resulting product recall could create significant adverse publicity. 25 ETHICAL, LEGAL AND SOCIAL ISSUES RELATED TO GENETIC TESTING MAY REDUCE DEMAND FOR OUR PRODUCTS Genetic testing has raised issues regarding the appropriate utilization and the confidentiality of information provided by genetic testing. Genetic tests for assessing a person's likelihood of developing a chronic disease have focused public attention on the need to protect the privacy of genetic assessment medical information. For example, concerns have been expressed that insurance carriers and employers may use these tests to discriminate on the basis of genetic information, resulting in barriers to the acceptance of genetic tests by consumers. This could lead to governmental authorities prohibiting genetic testing or calling for limits on or regulating the use of genetic testing, particularly for diseases for which there is no known cure. Any of these scenarios would decrease demand for our products and result in substantial losses. OUR DEPENDENCE ON KEY EXECUTIVES AND SCIENTISTS COULD ADVERSELY IMPACT THE DEVELOPMENT AND MANAGEMENT OF OUR BUSINESS Our success substantially depends on the ability, experience and performance of our senior management and other key personnel. If we lose one or more of the members of our senior management or other key employees, it could damage our development programs and our business. In addition, our success depends on our ability to continue to hire, train, retain and motivate skilled managerial and scientific personnel. The pool of personnel with the skill that we require is limited. Competition to hire from this limited pool is intense. We compete with numerous pharmaceutical and health care companies, as well as universities and nonprofit research organizations in the highly competitive Boston, Massachusetts business area. Loss of the services of Dr. Philip R. Reilly, our Chairman and CEO, Dr. Kenneth Kornman, our President, or Dr. Paul M. Martha, our Chief Medical Officer, could delay our research and development programs and damage our business. We have entered into employment agreements with three to five year terms with Drs. Reilly, Kornman and Martha. Any of these employees can terminate his employment upon 30 days notice. We do not maintain key man life insurance on any of our personnel. BECAUSE OUR PRINCIPAL SHAREHOLDERS, OFFICERS AND DIRECTORS CONTROL A LARGE PERCENTAGE OF OUR VOTING POWER, OTHER STOCKHOLDERS' VOTING POWER MAY BE LIMITED As of February 28, 2002, our directors, executive officers and certain of their affiliates beneficially owned approximately 18% 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 Certificate of Incorporation or By-Laws and the approval of certain mergers and other significant corporate transactions, including a sale of substantially all of our assets. These shareholders may make decisions that are adverse to other shareholders' or warrantholders' interests. This ownership concentration may also adversely affect the market price of our common stock. 26 WE DO NOT EXPECT TO PAY DIVIDENDS FOR THE FORESEEABLE FUTURE AND YOU SHOULD NOT EXPECT TO RECEIVE ANY FUNDS WITHOUT SELLING YOUR SHARES OF COMMON STOCK, WHICH YOU MAY ONLY BE ABLE TO DO AT A LOSS We have never declared or paid any cash dividends on our capital stock. We currently intend to retain any earnings for use in the operation and expansion of our business and do not anticipate paying any cash dividends on our common stock in the foreseeable future. Therefore, you should not expect to receive any funds without selling your shares, which you may only be able to do at a loss. IF WE DEFAULT ON OUR OBLIGATIONS UNDER PROMISSORY NOTES ISSUED TO PYXIS INNOVATIONS, INC. WE MAY BE REQUIRED TO REPAY TO PYXIS THE FULL PRINCIPAL AMOUNT OF THE NOTES, TOGETHER WITH INTEREST, AND WE MAY INCUR ADDITIONAL FINANCIAL OBLIGATIONS TO PYXIS. Under the terms of the promissory note that we issued to Pyxis Innovations, Inc. in October 2002 and those that we may issue to Pyxis in the future, Pyxis may declare the full principal amount of the note, together with all accrued but unpaid interest on the note and other amounts that we owe to Pyxis on the date of acceleration, to be immediately due and payable in cash upon the occurrence of an event of default. As of November 1, 2002, there was $500,000 in principal amount outstanding under the note, which is due on December 31, 2003. Interest on the note accrues at 15% annually and is payable on December 31, 2003. Any one of the following events will constitute an event of default under the note: - our default in the timely payment to Pyxis of the principal amount of, or interest on, the notes; - our default in the timely repayment of indebtedness (including our 15% term promissory notes due August 2003), or failure to perform any obligation, to any other party; - any representation or warranty that we made to Pyxis proves to have been incorrect when we made it under the note or the agreements under which the note was issued; - our failure to observe or perform any covenant or agreement under, or our breach of, the note or the agreements pursuant to which the note was issued - any bankruptcy, insolvency or reorganization proceedings involving us or any of our subsidiaries; or - any change of control. OUR FORMER USE OF ARTHUR ANDERSEN LLP AS OUR INDEPENDENT AUDITORS MAY POSE RISK TO US AND WILL LIMIT YOUR ABILITY TO SEEK POTENTIAL RECOVERIES FROM THEM RELATED TO THEIR WORK. On June 15, 2002, Arthur Andersen LLP, our former independent auditor, was convicted on a federal obstruction of justice charge. Some investors, including institutional investors, may choose not to invest in or hold securities of a company whose financial statements were audited by Arthur 27 Andersen, which may serve to, among other things, depress the price of our common stock. In July and August 2002, our board of directors decided to no longer engage Arthur Andersen and engaged Grant Thornton LLP to serve as our independent auditors. SEC rules require us to present our audited financial statements in various SEC filings, along with Arthur Andersen's consent to our inclusion of its audit report in those filings. The SEC recently has provided regulatory relief designed to allow companies that file reports with the SEC to dispense with the requirement to file a consent of Arthur Andersen in certain circumstances. Notwithstanding the SEC's regulatory relief, the inability of Arthur Andersen to provide its consent or to provide assurance services to us could negatively affect our ability to, among other things, access the public capital markets. Any delay or inability to access the public markets as a result of this situation could have a material adverse impact on our business. Also, an investor's ability to seek potential recoveries from Arthur Andersen related to any claims that an investor may assert as a result of the work performed by Arthur Andersen will be limited significantly in the absence of a consent and may be further limited by the diminished amount of assets of Arthur Andersen that are or may in the future be available for claims. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK As of September 30, 2002 the only financial instruments we carried were cash and cash equivalents. We believe the market risk arising from holding these financial instruments is not material. Some of our sales occur outside the United States and are transacted in foreign currencies. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. At this time we do not believe this risk is material and we do not currently use derivative financial instruments to manage foreign currency fluctuation risk. However, if foreign sales increase and the risk of foreign currency exchange rate fluctuation increases, we may in the future consider utilizing derivative instruments to mitigate these risks. ITEM 4. CONTROLS AND PROCEDURES EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES Our principal executive officer and principal financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-14(c) and 15d-14(c)) on November 6, 2002 have concluded that, based on such evaluation, our disclosure controls and procedures were adequate and effective to ensure that material information relating to us, including our consolidated subsidiaries, was made known to them by others within those entities, particularly during the period in which this Quarterly Report on Form 10-Q was being prepared. CHANGES IN INTERNAL CONTROLS There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation, nor were there any significant deficiencies or material 28 weaknesses in our internal controls. Accordingly, no corrective actions were required or undertaken. PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company is not a party to, nor is its property the subject of, any pending legal proceeding. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS On August 9, 2002 we issued term promissory notes with an original aggregate principal amount of $525,000 to purchasers including members of our Board of Directors and our Chief Executive Officer. These notes mature in August 2003 and accrue interest at a rate of 15%. The purchasers of the promissory notes also received warrants to purchase one share of our common stock at an exercise price of $2.50 for every dollar invested in the promissory notes. In total, warrants to purchase 525,000 shares of our common stock were issued. These warrants expire in ten years. This offering was exempt from registration under the Securities Act of 1933, as amended pursuant to Section 4(2) thereof and Rule 506 of Regulation D promulgated thereunder. In connection with the offering, we also entered into a Registration Rights Agreement, dated as of August 9, 2002, with the purchasers. Pursuant to the Registration Rights Agreement, we agreed to file a registration statement with the Securities and Exchange Commission prior to August 9, 2003 covering the resale by the purchasers of the shares of our common stock issuable to the purchasers upon the exercise of the warrants. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None ITEM 5. OTHER INFORMATION None c) Not applicable d) Not applicable ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K On July 3, 2002 the Company filed a report on Form 8-K to disclose the dismissal of Arthur Andersen LLP as the Company's independent public accountants. 29 On August 5, 2002 the Company filed a report on Form 8-K to disclose the engagement of Grant Thornton LLP as the Company's independent public accountants for the year ending December 31, 2002. On August 5, 2002 the Company filed a report on Form 8-K to disclose an announcement of the securing of interim financing to support operations into October 2002. On September 3, 2002 the Company filed a report on Form 8-K to disclose the announcement of the signing of a letter of intent with Pyxis Innovations, Inc. EXHIBITS: Exhibit 10.1: Form of Note and Warrant Subscription Agreement, by and between the Registrant and each Investor. Exhibit 10.2: Form of Promissory Note, dated as of August 9, 2002, issued to each Investor. Exhibit 10.3: Form of Common Stock Purchase Warrant, dated as of August 9, 2002, issued to each Investor. Exhibit 10.4: Registration Rights Agreement, dated as of August 9, 2002, by and among the Registrant and the Investors. 30 SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. INTERLEUKIN GENETICS, INC. Date: November 6, 2002 By: /s/ Philip R. Reilly --------------------------------- Philip R. Reilly Chairman of the Board and Chief Executive Officer (Principal Executive Officer) By: /s/ Fenel M. Eloi --------------------------------- Fenel M. Eloi Chief Financial Officer, Secretary & Treasurer (Principal Financial and Accounting Officer) 31 CERTIFICATIONS PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 CERTIFICATION ------------- I, Philip R. Reilly, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Interleukin Genetics, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal 32 controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 6, 2002 /s/ PHILIP R. REILLY PHILIP R. REILLY CHIEF EXECUTIVE OFFICER CERTIFICATION ------------- I, Fenel M. Eloi, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Interleukin Genetics, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): 33 a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 6, 2002 /s/ FENEL M. ELOI FENEL M. ELOI CHIEF FINANCIAL OFFICER 34