10-Q 1 d10q.txt FORM 10-Q FOR PERIOD ENDING 06/30/01 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2001 OR [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 000-31615 ----------- DURECT CORPORATION (Exact name of registrant as specified in its charter) Delaware 94-3297098 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 10240 Bubb Road Cupertino, California 95014 (Address of principal executive offices, including zip code) (408) 777-1417 (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 [_] As of August 3, 2001, there were 48,003,522 shares of the registrant's Common Stock outstanding. ================================================================================ 1 INDEX
Page ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements....................................................................... 3 Condensed Consolidated Statements of Operations............................................ 3 For the three and six months ended June 30, 2001 and 2000 (unaudited) Condensed Consolidated Balance Sheets...................................................... 4 As of June 30, 2001(unaudited) and December 31, 2000 Condensed Consolidated Statements of Cash Flows............................................ 5 For the six months ended June 30, 2001 and 2000 (unaudited) Notes to Condensed Consolidated Financial Statements (unaudited)........................... 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations...... 11 Item 3. Quantitative and Qualitative Disclosures about Market Risk................................. 30 PART II. OTHER INFORMATION Item 1. Legal Proceedings.......................................................................... 31 Item 2. Changes in Securities and Use of Proceeds.................................................. 31 Item 3. Defaults Upon Senior Securities............................................................ 32 Item 4. Submission of Matters to a Vote of Security Holders........................................ 32 Item 5. Other Information.......................................................................... 32 Item 6. Exhibits and Reports on Form 8-K........................................................... 32 (a) Exhibits............................................................................... 32 (b) Reports on Form 8-K.................................................................... 32 Signatures................................................................................................. 33
2 PART I. FINANCIAL INFORMATION Item 1. Financial Statements. DURECT CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share amounts) (unaudited)
Three months ended Six months ended ------------------ ---------------- June 30, June 30, -------- -------- 2001 2000 2001 2000 ---- ---- ---- ---- Revenue, net.................................................... $ 1,687 $ 998 $ 3,086 $ 1,081 Cost of goods sold(1)........................................... 974 575 1,585 611 -------- ------- -------- ------- Gross profit.................................................... 713 423 1,501 470 -------- ------- -------- ------- Operating expenses: Research and development...................................... 5,315 2,983 9,409 5,242 Research and development to related party..................... 18 171 65 433 Selling, general and administrative........................... 2,157 1,003 4,035 1,973 Amortization of intangible assets............................. 461 233 735 302 Stock-based compensation(1)................................... 919 1,367 1,854 2,499 Acquired in-process research and development.................. 14,030 -- 14,030 -- -------- ------- -------- ------- Total operating expenses................................... 22,900 5,757 30,128 10,449 -------- ------- -------- ------- Loss from operations............................................ (22,187) (5,334) (28,627) (9,979) Other income (expense): Interest income............................................... 1,281 540 2,864 828 Interest expense.............................................. (84) (33) (145) (55) -------- ------- -------- ------- Net other income................................................ 1,197 507 2,719 773 -------- ------- -------- ------- Net loss................................................... (20,990) (4,827) (25,908) (9,206) Accretion of cumulative dividends on Series B convertible preferred stock.................................... -- 326 -- 653 -------- ------- -------- ------- Net loss attributable to common stockholders.................... $(20,990) $(5,153) $(25,908) $(9,859) ======== ======= ======== ======= Net loss per common share, basic and diluted.................... $ (0.45) $ (0.65) $ (0.57) $ (1.35) ======== ======= ======== ======= Shares used in computing basic and diluted net loss per share...................................................... 46,325 7,958 45,726 7,279 ======== ======= ======== ======= Pro forma net loss per share, basic and diluted(2).............. $ (0.14) $ (0.28) ======= ======= Shares used in computing pro forma net loss per share(2)................................................... 35,461 33,055 ======= ======= ___________ (1) Stock-based compensation related to the following: Cost of goods sold.............................................. $ 65 $ 21 $ 87 $ 21 Research and development........................................ 613 960 1,294 1,665 Selling, general and administrative............................. 306 407 560 834 -------- ------- -------- ------- $ 984 $ 1,388 $ 1,941 $ 2,520 ======== ======= ======== =======
(2) See note 1 for a description of the calculation of pro forma amounts. See accompanying notes. 3 DURECT CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands)
June 30, December 31, 2001 2000 ---- ---- (unaudited) ----------- Assets Current assets: Cash and cash equivalents................................................. $ 35,623 $ 46,702 Short-term investments.................................................... 33,092 57,730 Accounts receivable, net.................................................. 1,262 1,261 Inventories............................................................... 2,389 2,682 Prepaid expenses and other current assets................................. 2,143 938 -------- -------- Total current assets................................................... 74,509 109,313 Property and equipment, net................................................. 10,527 4,472 Intangible assets, net...................................................... 11,186 5,175 Long-term investments....................................................... 25,476 1,652 -------- -------- Total assets................................................................ $121,698 $120,612 ======== ======== Liabilities and stockholders' equity Current liabilities: Accounts payable.......................................................... $ 1,242 $ 658 Accrued liabilities....................................................... 1,865 923 Accrued construction in progress.......................................... 1,152 1,673 Accrued contract manufacturing............................................ -- 248 Accrued liabilities to related party...................................... 25 54 Contract research liability............................................... 663 290 Current portion of long-term debt......................................... 150 -- Equipment financing obligations, current portion.......................... 517 407 -------- -------- Total current liabilities................................................... 5,614 4,253 Long-term debt, less current portion........................................ 1,575 -- Equipment financing obligations, noncurrent portion......................... 823 1,105 Other noncurrent liabilities................................................ 100 -- Commitments and contingencies Stockholders' equity: Common stock.............................................................. 4 4 Additional paid-in capital................................................ 188,809 165,638 Notes receivable from stockholders........................................ (632) (652) Accumulated other comprehensive income.................................... 294 29 Deferred compensation..................................................... (4,046) (4,830) Deferred royalties and commercial rights.................................. (13,480) (13,480) Accumulated deficit....................................................... (57,363) (31,455) -------- -------- Stockholders' equity........................................................ 113,586 115,254 -------- -------- Total liabilities and stockholders' equity.................................. $121,698 $120,612 ======== ========
4 DURECT CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited)
Six months ended June 30, -------- 2001 2000 -------- ------- Cash flows from operating activities Net loss..................................................................................... $(25,908) $(9,206) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization.............................................................. 540 278 Noncash charges related to stock-based compensation........................................ 1,941 2,520 Amortization of certain intangible assets.................................................. 735 302 Acquired in-process research and development............................................... 14,030 Changes in assets and liabilities: Accounts receivable....................................................................... 673 (644) Inventories............................................................................... 592 (3,346) Prepaid expenses and other assets......................................................... (888) (640) Accounts payable ........................................................................ 308 (182) Accrued liabilities ..................................................................... (151) 607 Accrued liabilities to related party .................................................... (29) 2,269 Contract research liability ............................................................. 373 30 -------- ------- Total adjustments ..................................................................... 18,124 1,194 -------- ------- Net cash and cash equivalents used in operating activities ............................ (7,784) (8,012) -------- ------- Cash flows from investing activities Purchases of equipment ..................................................................... (3,860) (999) Purchases of investments ................................................................... (49,122) (2,634) Payment of transaction costs in the acquisition of SBS....................................... (450) -- Proceeds from maturities of investments .................................................... 50,202 11,690 Acquisition of intangible assets ........................................................... -- (4,635) -------- ------- Net cash and cash equivalents provided by (used in) investing activities .............. (3,230) 3,422 -------- ------- Cash flows from financing activities Net proceeds from equipment financing obligations .......................................... -- 976 Payments on equipment financing obligations ................................................ (203) (133) Payments on short-term debt.................................................................. (100) -- Net proceeds from notes receivable from stockholders ....................................... 20 (360) Net proceeds from issuances of common and preferred stock .................................. 218 25,423 -------- ------- Net cash and cash equivalents provided by (used in) financing activities ............... (65) 25,906 -------- ------- Net increase (decrease) in cash and cash equivalents ....................................... (11,079) 21,316 Cash and cash equivalents, beginning of the period ......................................... 46,702 3,863 -------- ------- Cash and cash equivalents, end of the period ............................................... $ 35,623 $25,179 ======== ======= Supplemental disclosure of cash flow information Cash paid during the period for interest ................................................... $ 112 $ 32 ======== ======= Issuance of stock, stock options and warrants for acquisition of SBS ....................... $ 22,716 $ -- ======== ======= Notes receivable from stockholders issued in connection with exercise of stock options ..... $ -- $ 591 ======== ======= Issuance of warrants to equipment lessor ................................................... $ -- $ 190 ======== ======= Issuance of warrants to ALZA Corporation ................................................... $ -- $ 4,576 ======== =======
See accompanying notes. 5 DURECT CORPORATION NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS June 30, 2001 Note 1. Summary of Significant Accounting Policies Nature of Operations and Basis of Presentation DURECT Corporation (the "Company") was incorporated in the state of Delaware on February 6, 1998. The Company is a pharmaceutical systems company developing therapies for chronic disorders that require continuous dosing. The Company's lead product is for the treatment of chronic pain. Additionally, the Company manufactures and sells osmotic pumps used in laboratory research and sells micro-catheters used in the treatment of ear disorders. The Company's wholly owned subsidiary, Southern BioSystems, Inc. ("SBS") manufacturers biodegradable polymers used in pharmaceutical products and conducts research and development of pharmaceutical products with third party pharmaceutical company partners. Basis of Presentation The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission and, therefore, do not include all the information and footnotes necessary for a complete presentation of the Company's results of operations, financial position, and cash flows in conformity with generally accepted accounting principles. The unaudited financial statements reflect all adjustments (consisting only of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the financial position at June 30, 2001, the operating results for the three and six months ended June 30, 2001 and 2000, and cash flows for the six months ended June 30, 2001 and 2000. The condensed consolidated balance sheet as of December 31, 2000 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. These financial statements and notes should be read in conjunction with the Company's audited financial statements and notes thereto, included in the Company's annual report on Form 10-K filed with the Securities and Exchange Commission. The results of operations for the interim periods presented are not necessarily indicative of results that may be expected for any other interim period or for the full fiscal year. Inventories Inventories are stated at the lower of cost or market, with cost determined on a first-in, first-out basis. Inventories consisted of the following (in thousands):
June 30, December 31, ------------ -------------- 2001 2000 ------ ------ (unaudited) Raw materials ................................................................... $ 291 $ 191 Work in process ................................................................. 118 1,278 Finished goods .................................................................. 1,980 1,213 ------ ------ Total inventories ............................................................ $2,389 $2,682 ====== ======
Revenue Recognition Revenue from the sale of products is recognized at the time product is shipped to customers, provided no continuing obligation exists. The Company maintains consigned inventory at customer locations for certain products. For these products, revenue is recognized at the time the Company is notified that the device has been used. The Company provides credit, in the normal course of business, to its customers. The Company also maintains an allowance for doubtful customer accounts and charges actual losses when incurred to this allowance. 6 Comprehensive Loss Statement of Financial Accounting Standards No.130, "Reporting Comprehensive Income" ("SFAS 130"), establishes standards for reporting comprehensive loss and its components in the financial statements. SFAS 130 requires unrealized gains and losses on the Company's available-for-sale securities to be included in other comprehensive income or loss. The Company's comprehensive losses for the three months ended June 30, 2001 and 2000, were $20,943,000 and $4,829,000, respectively, compared to its net losses of $20,990,000 and $4,827,000, respectively. The Company's comprehensive losses for the six months ended June 30, 2001 and 2000, were $25,643,000 and $9,228,000, respectively, compared to its net losses of $25,908,000 and $9,206,000, respectively. Reclassifications Certain prior period amounts have been reclassified to conform to the current period presentation. Such reclassifications did not change the previously reported net loss amounts. Net Loss Per Share Basic net loss per share and diluted net loss per share are computed in conformity with Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS 128") and Securities and Exchange Commission Staff Accounting Bulletin No. 98. Basic net loss per share is calculated by dividing net loss attributable to common stockholders by the weighted-average number of common shares outstanding, less the weighted average number of common shares subject to the Company's right of repurchase, which lapses ratably. Diluted net loss per share includes the impact of options and warrants to purchase common stock (using the treasury stock method), if dilutive. There is no difference between basic and diluted net loss per share as the Company incurred a net loss in each period presented. Pro forma basic and diluted net loss per share has been computed as described above and also gives effect, under SEC guidance, to the conversion of convertible preferred stock (using the if-converted method) from the original date of issuance. Upon conversion of the Series B preferred stock at the time of the Company's initial public offering, all accumulated dividends were forgiven and did not continue to accumulate. The net loss used in the pro forma basic and diluted net loss per share excludes the accumulated dividends. The following table presents the calculations of basic and diluted and pro forma basic and diluted net loss per share (in thousands, except per share amounts):
Three months ended Six months ended ------------------ ---------------- June 30, June 30, -------- -------- 2001 2000 2001 2000 ---- ---- ---- ---- Net loss ....................................................... $(20,990) $(4,827) $(25,908) $(9,206) Less: accumulated dividend on Series B preferred stock ....... -- (326) -- (653) -------- ------- -------- ------- Net loss available to common stockholders ...................... $(20,990) $(5,153) $(25,908) $(9,859) ======== ======= ======== ======= Basic and diluted weighted average shares: Weighted-average shares of common stock outstanding .......... 47,525 10,957 47,045 10,129 Less: weighted-average shares subject to repurchase .......... (1,200) (2,999) (1,319) (2,850) -------- ------- -------- ------- Weighted-average shares used in computing basic and diluted net loss per share ......................................... 46,325 7,958 45,726 7,279 ======== ======= ======== ======= Basic and diluted net loss per share ........................... $ (0.45) $ (0.65) $ (0.57) $ (1.35) ======== ======= ======== ======= Pro forma: Net loss ..................................................... $(4,827) $(9,206) ======= ======= Shares used above ............................................ 7,958 7,279 Pro forma adjustment to reflect weighted effect of assumed conversion of convertible preferred stock .................. 27,503 25,776 ------- ------- Shares used in computing pro forma basic and diluted net loss per share .................................................. 35,461 33,055 ======= ======= Pro forma net loss per share, basic and diluted ................. $ (0.14) $ (0.28) ======= =======
7 Recent Accounting Pronouncements In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS 133"), which we adopted on January 1, 2001. This statement establishes accounting and reporting standards requiring that every derivative instrument, including certain derivative instruments embedded in other contracts, be recorded in the balance sheet as either an asset or liability measured at its fair value. The statement also requires that changes in the derivative's fair value be recognized in earnings unless specific hedge accounting criteria are met. The adoption of SFAS 133 did not have a material effect on our operating results or financial position since we currently do not invest in derivative instruments or engage in hedging activities. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 141, Business Combinations ("SFAS 141"). SFAS 141 establishes new standards for accounting and reporting for business combinations and will require that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. Use of the pooling-of-interests method will be prohibited. We expect to adopt this statement during the first quarter of fiscal 2002 and we do not believe that SFAS 141 will have a material effect on our operating results or financial position. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets ("SFAS 142"), which supersedes APB Opinion No. 17, Intangible Assets. SFAS 142 establishes new standards for goodwill, including the elimination of goodwill amortization to be replaced with methods of periodically evaluating goodwill for impairment. We expect to adopt this statement during the first quarter of fiscal 2002, and we do not believe that SFAS 142 will have a material effect on our operating results or financial position. Note 2. Acquisition of Southern BioSystems, Inc. On April 30, 2001, the Company acquired SBS, a privately held Alabama corporation, that designs, develops, licenses and manufactures controlled- release products, and through its wholly-owned subsidiary, Birmingham Polymers, Inc., SBS also designs, develops and manufactures biodegradable polymers. Under the terms of the acquisition, the Company issued 1,355,235 shares of common stock, and agreed to issue up to 720,161 additional shares of common stock upon the exercise of outstanding SBS options and warrants, in exchange for all of SBS's outstanding equity interests, and assumed SBS's liabilities, including $1.7 million in debt. The total purchase price was $23.2 million. The transaction was accounted for as a purchase and is intended to qualify as a tax- free reorganization. At the time of the registration of these shares with the Securities and Exchange Commission, which is expected to be in the fourth quarter of 2001, the Company may be required to issue additional shares of common stock to former SBS shareholders, as well as reserve additional shares for issuance upon the exercise of outstanding SBS options and warrants, depending on the Company's stock price at that time. Up to 4,150,854 additional shares may be issued and reserved for issuance upon the exercise of outstanding SBS options and warrants. The maximum total number of shares issued and shares reserved for issuance upon the exercise of outstanding SBS options and warrants in connection with our acquisition of SBS will be determined by dividing $24.9 million by the greater of $4.00 or the average closing sale price of the Company's stock during a specified time period proceeding the registration of shares, subject to certain conditions. Further information regarding the SBS acquisition is included in the company's current Report on Form 8-K filed with the SEC on May 15, 2001. The Company recorded $918,000 of unearned compensation related to the intrinsic value of approximately 152,000 unvested employee options assumed in connection with the acquisition. This amount will be expensed to stock compensation ratably over the vesting period. Direct transaction costs related to the acquisition were approximately $450,000. 8 The acquisition has been accounted for as a purchase and accordingly, the accompanying financial statements include the results of operations of SBS subsequent to the acquisition date. The purchase price has been allocated to the tangible net assets acquired, the intangible assets acquired, and in-process research and development based on their estimated fair values as determined by an independent appraisal. The purchase price allocation is as follows (in thousands):
Net tangible assets acquired $ 1,472 Intangible assets acquired: Core technology 1,560 Developed technology 1,810 Assembled workforce 740 Acquired in-process research and development 14,030 Goodwill 2,636 Unearned compensation 918 ------- Total purchase price allocation $23,166 =======
Tangible net assets acquired include cash, accounts receivable, inventories and fixed assets. Liabilities assumed principally include accounts payable, accrued expenses, a line of credit, and an issued bond. For the remainder of 2001, the intangible assets acquired and goodwill are each being amortized on a straight-line basis over their estimated useful lives, which are 4 and 10 years, respectively. Beginning in 2002, goodwill and assembled workforce will not be amortized but reviewed for impairment (See Note 1: Recent Accounting Pronouncements). Acquired in-process research and development, which has not reached technological feasibility and therefore has no alternative future use, has been expensed during the three months ended June 30, 2001. SBS's research and development programs are in various stages of preclinical development. Currently, none of the products utilizing SBS's proprietary technology is in any stage of human clinical testing nor is approved for marketing in humans. A valuation of the purchased assets was undertaken to assist us in determining the fair value of each identifiable intangible asset and in allocating the purchase price among the acquired assets, including the portion of the purchase price attributed to in-process research and development projects. Standard valuation procedures and techniques were utilized in determining the fair value of the acquired in-process research and development. To determine the value of the technology in the development stage, we considered, among other factors, the stage of development of each project, the time and resources needed to complete each project, expected income and associated risks. Associated risks included the inherent difficulties and uncertainties in completing pharmaceutical research and development and obtaining regulatory approval to sell the resulting products. The analysis resulted in $14.3 million of the purchase price being charged to in-process research and development. The intangible assets, consisting of core technology, developed technology, assembled workforce and goodwill, were assigned a value of $6.7 million and will be amortized over their estimated useful lives of four to ten years. Management believes that the amounts are reasonable and reflect the fair value of the assets acquired. Goodwill and intangible assets are generally evaluated on an individual acquisition, market, or product basis whenever events or changes in circumstances indicate that such assets are impaired or the estimated useful lives are no longer appropriate. Periodically, the Company reviews its goodwill and other intangible assets for impairment based on estimated future undiscounted cash flows attributable to the assets. In the event such cash flows are not expected to be sufficient to recover the recorded value of the assets, the assets are written down to their estimated fair values. No such charges have been recorded in 2001 related to the SBS or any other of the Company's acquisitions. In conjunction with our acquisition of SBS in April 2001, we assumed Alabama State Industrial Development Bonds with remaining principal payments of $1.7 million and a current interest rate of 6.35% increasing each year up to 7.2% at maturity on November 1, 2009. As part of the acquisition agreement, we are required to guarantee and collateralize these bonds with a letter of credit of approximately $2.5 million that the Company deposited with a local bank in July 2001. Interest payments are due semi-annually and principal payments increase from $150,000 to $240,000 over the term of the bond until the principal is fully amortized in 2009. We have an option to call these bonds beginning in November 2001, which we may exercise. The call premium decreases annually from 1 1/2% if we call the bonds in November 2001 to 0% in November 2004. 9 Unaudited Pro Forma Information The following unaudited pro forma information presents the consolidated results of operations of the Company, excluding the charge for acquired in- process research and development, as if the acquisition of SBS had occurred at the beginning of fiscal 2000. The pro forma 2001 and 2000 results of operations combine the consolidated results of operations of the Company, excluding the charge for acquired in-process research and development attributable to SBS, for the six months ending June 30, 2001 and 2000 with the historical results of operations of SBS for the six months ended June 30, 2001 and 2000, respectively. The unaudited pro forma information does not purport to be indicative of what would have occurred had the acquisition been made as of the beginning of fiscal 2000 or of results which may occur in the future.
Six months ended (in thousands, except per share amounts) --------------------- June 30, --------------------- 2001 2000 -------- -------- Revenue.......................................................... $ 4,108 $ 2,807 Net loss......................................................... (13,080) (10,801) Net loss per common share, basic and diluted..................... $ (0.29) $ (1.48)
10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management's Discussion and Analysis of Financial Condition and Results of Operations as of June 30, 2001 and 2000 should be read in conjunction with our annual report on Form 10-K filed with the Securities and Exchange Commission and "Factors that May Affect Future Results" section included elsewhere in this Form 10-Q. This Form 10-Q contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. When used in this report or elsewhere by management from time to time, the words "believes," "anticipates," "intends," "plans," "estimates," "expects," and similar expressions are forward- looking statements. Such forward-looking statements contained herein are based on current expectations. Any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Actual events or results may differ materially from those discussed in the forward-looking statements as a result of various factors. For a more detailed discussion of such forward-looking statements and the potential risks and uncertainties that may impact upon their accuracy, see the "Factors that May Affect Future Results" and "Overview" sections of this Management's Discussion and Analysis of Financial Condition and Results of Operations. These forward-looking statements reflect our view only as of the date of this report. Except as required by law, we undertake no obligations to update any forward looking statements. You should also carefully consider the factors set forth in other reports or documents that we file from time to time with the Securities and Exchange Commission. Overview DURECT Corporation is pioneering the treatment of chronic diseases and conditions by developing and commercializing pharmaceutical systems to deliver the right drug to the right place in the right amount at the right time. These capabilities can enable new drug therapies or optimize existing ones based on a broad range of compounds, including small molecule pharmaceuticals as well as biotechnology molecules such as proteins, peptides and genes. We were founded in February 1998. During that year, we were engaged in negotiating a licensing agreement with ALZA Corporation to gain specified rights to its DUROS system, raising capital, recruiting scientific and management personnel and commencing research and development activities. In late 1998, we filed an investigational new drug application relating to our first product, Chronogesic(TM) (which we formerly referred to as "DUROS sufentanil"), a DUROS- based pharmaceutical system for the treatment of chronic pain. In 1999, we began a Phase I clinical trial for Chronogesic(TM) using an external pump to test the safety of continuous chronic infusion of this drug, initiated the development of a spinal hydromorphone product, and initiated the research and development of other products based on the DUROS system. In 2000, we prepared for and initiated our Phase II clinical trial for Chronogesic(TM) , which included the development of our manufacturing process, developed a prototype of our spinal hydromorphone product, and continued to research and develop other products based on the DUROS system. In the first six months of 2001, we completed the clinical portion of our Phase II clinical trial for Chronogesic(TM), secured a long-term supply agreement for our bulk drug requirements for Chronogesic(TM), and completed construction of our manufacturing facility. In addition, we completed our acquisition of Southern BioSystems, Inc. ("SBS") in the second quarter of 2001. SBS, a privately held Alabama corporation, designs, develops, licenses and manufactures controlled-release products, and through its wholly-owned subsidiary, Birmingham Polymers, Inc., also designs, develops and manufactures biodegradable polymers. With this acquisition, we have added three additional drug delivery platforms, the SABER(TM) delivery system, microspheres and drug loaded implants, from which to develop new products. Prior to our initial public offering in September 2000, we financed operations primarily through the sale of convertible preferred stock, resulting in net proceeds of $53.2 million. Our initial public offering together with the exercise in part of our underwriters' over-allotment option in November 2000, resulted in net proceeds of $84.0 million. 11 We have sustained losses since inception. As of June 30, 2001, we had an accumulated deficit of $57.4 million. Our net losses attributable to common stockholders were $20.8, $9.3, and $1.3 million for the fiscal years ended December 31, 2000, 1999, and 1998 respectively. These losses have resulted primarily from costs incurred in the research and development of our products, and to a lesser extent, selling, general and administrative costs associated with our operations and product sales. Our research and development expenses consist of salaries and related expenses for research and development personnel, contract research and development services, supplies and a portion of overhead operating expenses. We expense all of our research and development costs as they are incurred. We expect our research and development expenses to increase in the future as we expand clinical trials and research and development activities. Selling, general and administrative expenses consist primarily of salaries and related expenses for administrative, finance, marketing and executive personnel, legal, accounting and other professional fees and a portion of overhead operating expenses. To support our research and development activities and the additional obligations of a public reporting entity, we expect to increase our selling, general and administrative expenses. We also expect to incur substantial non-cash expenses relating to stock-based compensation and the amortization of acquired intangible assets. As a result of these factors, we expect to incur significant losses and negative cash flows from operations for the foreseeable future. Under the terms of the acquisition of SBS, we issued 1,355,235 shares of common stock, and agreed to issue up to 720,161 additional shares of common stock upon the exercise of outstanding SBS options and warrants, in exchange for all of SBS's outstanding equity interests, and assumed SBS's liabilities, including $1.7 million in debt. The total purchase price was $23.2 million. The transaction was accounted for as a purchase and is intended to qualify as a tax- free reorganization. At the time of the registration of these shares with the Securities and Exchange Commission, which is expected to be in the fourth quarter of 2001, we may be required to issue additional shares of common stock to former SBS shareholders, as well as reserve additional shares for issuance upon the exercise of outstanding SBS options and warrants, depending on our stock price at that time. Up to 4,150,854 additional shares may be issued and reserved for issuance upon the exercise of outstanding SBS options and warrants. The maximum total number of shares issued and shares reserved for issuance upon the exercise of outstanding SBS options and warrants in connection with our acquisition of SBS will be determined by dividing $24.9 million by the greater of $4.00 or the average closing sale price of the Company's stock during a specified time period proceeding the registration of shares, subject to certain conditions. Further information regarding the SBS acquisition is included in our current Report on Form 8-K filed with the SEC on May 15, 2001. We recorded $918,000 of unearned compensation related to the intrinsic value of approximately 152,000 unvested employee options assumed in connection with the acquisition. This amount will be expensed to stock compensation ratably over the vesting period. Direct transaction costs related to the acquisition were approximately $450,000. SBS, and its wholly owned subsidiary Birmingham Polymers, Inc., operates as a wholly owned subsidiary of DURECT, and our financial statements for the three months ended June 30, 2001 include the results of operations of SBS subsequent to the acquisition date. We do not anticipate revenues from our pharmaceutical systems, should they be approved, for at least several years. To date, our revenues have resulted from sales of the ALZET product line, which we acquired from ALZA in April 2000, polymer sales and contract research and development revenue from SBS, which we acquired in April 2001, and, to a lesser extent, from sales of ear catheter products, which we acquired as part of our acquisition of substantially all of the assets of IntraEAR, Inc. in October 1999. We have a limited history of operations and anticipate that our quarterly and annual results of operations will fluctuate for the foreseeable future. We believe that period-to-period comparisons of our operating results should not be relied upon as predictive of future performance. Our prospects must be considered in light of the risks, expenses and difficulties encountered by relatively new companies, particularly companies in new and rapidly evolving markets such as pharmaceuticals, drug delivery, and biotechnology. To address these risks, we must, among other things, obtain regulatory approval for and commercialize our products, which may not occur. We may not be successful in addressing these risks and difficulties. We may require additional funds to complete the development of our products and to fund operating losses to be incurred in the next several years. Results of Operations Three and six months ended June 30, 2001 and 2000 Revenue. Net revenues increased to $1.7 million and $3.1 million for the three and six months ended June 30, 2001, respectively, from $1.0 million and $1.1 for the corresponding periods in 2000. The increase in revenue in the three months ended June 30, 2001 compared to the corresponding period 12 in 2000 is attributable primarily to the acquisition of SBS in April 2001 and its related revenues from polymer sales and contract research and development. The increase in revenue in the six months ended June 30, 2001 compared to the corresponding period in 2000 is attributable to our selling the ALZET product line over the entire six month period in 2001, compared to the partial period following the acquisition of the ALZET product line in April of 2000, and to our acquisition of SBS and its related revenues. We consider our core business to be developing and commercializing pharmaceutical systems; we do not expect to generate revenues from our pharmaceutical systems, should they be approved, for at least several years. As such, and in the near future, we do not intend to significantly increase our investments in or efforts to sell or market any of our existing product lines or revenue generating businesses. As a result, we do not anticipate that our revenues will increase significantly, if it all, for several years. Cost of goods sold. Cost of goods sold was $974,000 and $1.6 million for the three and six months ended June 30, 2001, respectively, and $575,000 and $611,000 for the three and six months ended June 30, 2000, respectively. Cost of goods sold as a percent of net revenues was 58% and 51% for the three and six months ended June 30, 2001, respectively, and 58% and 57% for the corresponding periods in 2000. The decrease in cost of goods sold as a percentage of net revenues for the six months ended June 30, 2001 compared to the corresponding period in 2000 is attributable to manufacturing efficiencies related to our ALZET product, partially offset by the introduction of relatively higher costs from sales of polymers and contract research and development which commenced following our acquisition of SBS. Cost of good sold includes variances from expected costs that occur during the manufacturing processes for the Alzet and SBS product lines, which may be large relative to our sales. As a result, we expect cost of goods sold as a percentage of revenue related to these products to fluctuate. Research and Development. Research and development expenses increased to $5.3 million and $9.5 million for the three and six months ended June 30, 2001 respectively, from $3.2 million and $5.7 million for the corresponding periods in 2000. The increase was attributable to increased research and development activity, including expenses related to the company's Phase II clinical trial for our lead product, Chronogesic(TM). A significant portion of our research and development expenses in the first six months of 2001 related to the organization, enrollment, and treatment of approximately 50 patients at 10 clinical sites in this trial. The increase was also due to an increase in research and development personnel and related expenses. As of June 30, 2001, we had 62 research and development employees compared with 34 as of the corresponding date in 2000. We expect research and development expenses to increase as we begin Phase III clinical trials for Chronogesic(TM), continue to hire research and development personnel, continue to develop our spinal hydromorphone product, and research and develop other products, including products utilizing the SBS delivery technology. In addition, we expect research and development expenses to continue to increase in order to meet minimum product funding requirements under our license agreement with ALZA. To maintain our rights under this agreement, we must spend minimum amounts each year on product development, with the amount and duration of funding in each field varying over time. For our two products currently in development, we are required to fund each in the amount of at least $3.0 million per year until the time of commercialization. Funding requirements to maintain rights to additional products began in 2001. The future minimum annual product funding requirements for all fields of use are as follows:
(in thousands) ------------- Year ended December 31, 2001................................................................. $ 8,000 2002................................................................. 13,000 2003................................................................. 14,000 2004*................................................................ 17,000 ------- Total minimum funding required.......................................... $52,000 =======
________________ * Funding requirements after 2004 are to be mutually agreed upon by us and ALZA. Selling, General and Administrative. Selling, general and administrative expenses increased to $2.2 million and $4.0 million for the three and six months ended June 30, 2001 respectively, from $1.0 million and $2.0 million for the corresponding periods in 2000. The increase was primarily due to an increase in general and administrative personnel and related expenses necessary to support our growth. Selling expenses increased following the acquisition of the ALZET product line in April 2000. As of June 30, 2001, we had 48 sales and administrative personnel compared with 20 as of the corresponding date in 2000. We expect selling, general and administrative 13 expenses to continue to increase as we increase the number of personnel and related resources required to meet the obligations of a public company and support our growth. Amortization of intangible assets. In connection with our acquisitions of IntraEAR, Inc., the ALZET product line and SBS, we acquired goodwill of $4.5 million and other intangible assets of $8.3 million. Goodwill is amortized over the estimated useful life of 6 to 10 years; other intangible assets are amortized over their estimated useful lives, which are between 4 and 7 years. Amortization of intangible assets increased to $461,000 and $735,000 for the three and six months ended June 30, 2001, respectively, from $233,000 and $302,000 for the corresponding periods in 2000. Amortization of intangibles assets in the three months and six months ended June 30, 2000 resulted from the acquisition of the ALZET product line in April 2000 and IntraEAR, Inc. in October 1999. The increase in amortization of goodwill and other intangibles in the three months and six months ended June 30, 2001 resulted from the acquisition of SBS in April 2001, and the amortization of goodwill and other intangibles associated with the ALZET product line and the IntraEAR acquisition. The remaining goodwill and assembled workforce for these three acquisitions at June 30, 2001 was $4.0 million and $1.0 million, respectively, of which we will amortize $291,000 and $149,000, respectively, in the six months ending December 31, 2001. In subsequent periods, goodwill and assembled workforce will not be amortized, but will be periodically evaluated for impairment or obsolescence. An impairment would be deemed to have occurred when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition is less than the carrying amount. Impairment, if any, is assessed using discounted cash flows. Should the intangible assets become impaired, we may amortize them on an accelerated schedule or write them down to their estimated fair market value. Through June 30, 2001, there have been no such impairments. The remaining other intangible assets for these three acquisitions at June 30, 2001 was $6.1 million, which will be amortized as follows: $670,000 for the six months ending December 31, 2001, $1.3 million for each of the years ending December 31, 2002 and 2003, $1.2 million for each of the years ending December 31, 2004 and 2005, and $393,000 for the year ending December 31, 2006. We periodically evaluate acquired intangible assets for impairment or obsolescence. Should the intangible assets become impaired, we may amortize them on an accelerated schedule or write them down to their estimated fair market value. Stock-Based Compensation. We have recorded aggregate deferred compensation charges of $11.2 million in connection with stock options granted to employees and directors, including $918,000 that we recorded at the time of our acquisition of SBS in April 2001 for the assumption of outstanding stock options granted to employees and directors of that company. We have amortized $7.1 million through June 30, 2001. For the three months and six months ended June 30, 2001, we recorded $837,000 and $1.7 million of stock-based compensation, respectively, compared with $1.2 million and $2.1 million for the corresponding periods of 2000. Of these amounts, employee stock compensation related to the following: cost of goods sold of $65,000 and $87,000 for the three and six months ended June 30, 2001, respectively, and $21,000 and $21,000 for the corresponding periods in 2000; research and development expenses of $493,000 and $1.1 million for the three and six months ended June 30, 2001, respectively, and $845,000 and $1.5 million in the corresponding periods in 2000; and selling, general and administrative expenses of $280,000 and $522,000 in the three and six months ended June 30, 2001, respectively, and $363,000 and $644,000 in the corresponding periods of 2000. Non-employee stock compensation related to research and development expenses was $120,000 and $210,000 for the three and six months ended June 30, 2001, respectively, and $114,000 and $215,000 for the corresponding periods of 2000. Non-employee stock compensation related to selling, general and administrative expenses was $26,000 and $38,000 for the three months and six months ended June 30, 2001, respectively, and $44,000 and $190,000 for the corresponding periods in 2000. Expenses for non-employee stock options are recorded over the vesting period of the options, with the amount determined by the Black-Scholes option valuation method and remeasured over the vesting term. The remaining employee deferred stock compensation at June 30, 2001 was $4.1 million, which will be amortized as follows: $1.5 million for the six months ending December 31, 2001, $1.7 million for the year ending December 31, 2002, $739,000 for the year ending December 31, 2003, $111,000 for the year ending December 31, 2004, $18,000 for the year ending December 31, 2005, and $2,000 for the year ending December 31, 2006 . Termination of employment of option holders could cause stock-based compensation in future years to be less than indicated. Acquired in-process research and development. Acquired in-process research and development was $14.3 million for the three and six months ended June 30, 2001 compared to $0 for the corresponding periods in 2000. This write off resulted from the acquisition of SBS in April 2001. Actions and comments from the Securities and Exchange Commission have indicated that they are reviewing the current valuation methodology of purchased in-process technology relating to acquisitions. The Commission is concerned that some companies are writing off more of the value of an acquisition than is appropriate. We believe that we are in compliance with all of the rules and related guidance as they currently exist. However, the Commission may seek to reduce the amount of purchased in- process technology previously expensed by us. This would result in the restatement of previously filed financial statements of DURECT and could have a material adverse impact on the financial results for the period subsequent to the acquisition. Other Income (Expense). Interest income increased to $1.3 million and $2.9 million for the three and six months ended June 30, 2001, respectively, from $540,000 and $828,000 for the corresponding periods in 2000. The increase 14 in interest income was primarily attributable to higher average outstanding balances of cash and investments resulting from our initial public offering in September 2000. We expect our interest income to decline as our average outstanding balances of cash and investments decline; should yields on our investments decline with interest rates in general, our interest income will also decrease. Interest expense was $84,000 and $145,000 for the three and six months ended June 30, 2001, respectively, and $33,000 and $55,000 for the corresponding periods in 2000. The increase in interest expense was primarily due to an increase in debt obligations from equipment financings and the assumption of $1.7 million of debt as part of our acquisition of SBS. We expect interest expense to increase due to the structure of the payment schedule on our equipment loan and as we record interest on the debt assumed from SBS over an entire period. Liquidity and Capital Resources From inception through the time of our initial public offering in September 2000, we raised $53.2 million, net of issuance costs, through convertible preferred stock financings. On September 28, 2000 we raised $76.2 million, net of issuance costs, through an initial public offering of our common stock, and in November 2000, we raised $7.8 million from the exercise in part of our underwriters' over-allotment option. At June 30, 2001, we had cash, cash equivalents and investments totaling $94.2 million compared to $106.1 million at December 31, 2000. Working capital at June 30, 2001 was $68.9 million compared to $105.1 million at December 31, 2000. The decrease was primarily attributable to purchases of long-term investments, operating losses of $14.6 million, excluding acquired in-process research and development and an increase in accrued and other current liabilities of $1.3 million. We used $7.8 million of cash for operations for the six months ended June 30, 2001 and $8.0 million in the corresponding period in 2000. The increases in net loss and accounts receivable in the first six months in 2001 compared to the first six months of 2000 was offset by an increase in noncash charges for the amortization of certain intangible assets and by a decrease in accrued liabilities. As part of our purchase of the ALZET product line in April 2000, we acquired $3.5 million of inventory, $2.5 million of which was recorded as an accrued liability to a related party. We used $3.2 million of cash from investing activities for the six months ended June 30, 2001 compared to a receipt of $3.4 million for the corresponding period in 2000. The decrease was primarily due to an increase in purchases of investments and equipment, offset by an increase in proceeds from maturities of investments. We used $65,000 of cash in financing activities for the six months ended June 30, 2001 compared to a receipt of $25.9 million for the corresponding period in 2000. The decrease was primarily due to the receipt of proceeds from the issuance of preferred stock and an equipment financing received in 2000. We anticipate that cash used in operating and investing activities will increase significantly in the future as we research, develop, and manufacture our products, and, as discussed above, meet our product funding requirements under our agreement with ALZA. We anticipate incurring capital expenditures of at least $2.0 million over the next 9 months to construct, equip and validate our DUROS manufacturing facility. The amount and timing of these capital expenditures will depend on the success of clinical trials for our products. Assets relating to our manufacturing facilities will be depreciated over their estimated useful lives. In March 2001, we signed a noncancelable operating lease for an office facility. This lease commenced in June 2001, expires in May 2006, and has two options to extend the lease term for up to an additional eight years. The monthly payments under this noncancelable operating lease increase over the term of the lease from $102,000 to $119,000. In conjunction with our acquisition of SBS in April 2001, we assumed Alabama state Industrial Development Bonds with remaining principal payments of $1.7 million and current interest rate of 6.35%, increasing each year up to 7.2% at maturity on November 1, 2009. These bonds are guaranteed and collateralized by a letter of credit of approximately $2.5 million that the Company maintains with a local bank. Interest payments are due semi-annually and principal payments increase from $150,000 to $240,000 over the term of the bond until the principal is fully amortized in 2009. We have an option to call these bonds beginning in November 2001, which we may exercise. The call premium decreases annually from 1 1/2% if we call the bonds in November 2001 to 0% in November 2004. We believe that our existing cash, cash equivalents and investments will be sufficient to finance our planned operations and capital expenditures through at least the next 18 months. We may consume available resources more rapidly than currently anticipated, resulting in the need for additional funding. Accordingly, we may be required to raise additional capital through a variety of sources, including: 15 . the public equity market; . private equity financing; . collaborative arrangements; and . public or private debt. There can be no assurance that additional capital will be available on favorable terms, if at all. If adequate funds are not available, we may be required to significantly reduce or refocus our operations or to obtain funds through arrangements that may require us to relinquish rights to certain of our products, technologies or potential markets, either of which could have a material adverse effect on our business, financial condition and results of operations. To the extent that additional capital is raised through the sale of equity or convertible debt securities, the issuance of such securities would result in ownership dilution to our existing stockholders. Our cash and investments policy emphasizes liquidity and preservation of principal over other portfolio considerations. We select investments that maximize interest income to the extent possible given these two constraints. We satisfy liquidity requirements by investing excess cash in securities with different maturities to match projected cash needs and limit concentration of credit risk by diversifying our investments among a variety of high credit- quality issuers. Factors that May Affect Future Results In addition to the other information in this Form on 10-Q, the following factors should be considered carefully in evaluating our business and prospects: We have not completed development of any of our pharmaceutical systems, and we cannot be certain that our pharmaceutical systems will be able to be commercialized To be profitable, we must successfully research, develop, obtain regulatory approval for, manufacture, introduce, market and distribute our pharmaceutical systems under development. For each pharmaceutical system that we intend to commercialize, we must successfully meet a number of critical developmental milestones for each disease or medical condition that we target, including: . selecting and developing drug delivery platform technology to deliver the proper dose of drug over the desired period of time; . selecting and developing catheter technology, if appropriate, to deliver the drug to a specific location within the body; . determining the appropriate drug dosage for use in the pharmaceutical system; . developing drug compound formulations that will be tolerated, safe and effective and that will be compatible with the system; and . demonstrating the drug formulation will be stable for commercially reasonable time periods. The time frame necessary to achieve these developmental milestones for any individual product is long and uncertain, and we may not successfully complete these milestones for any of our products in development. We have not yet completed development of any pharmaceutical systems, and DURECT has limited experience in developing such products. For our lead product, Chronogesic(TM) and our second product, DUROS hydromorphone, we have not yet determined the drug dosages we intend to use for commercialization nor finalized the commercial design. We are continuing testing of these products and exploring possible design changes to address issues of safety, manufacturing efficiency and performance. We may not be able to complete the design of these products. In addition, we may not be able to develop dosages that will be safe and effective or compatible with the pharmaceutical system for a commercially reasonable treatment and storage period. If we are unable to complete development of these or other products, we will not be able to earn revenue from them, which would materially harm our business. We must conduct and satisfactorily complete clinical trials for our pharmaceutical systems 16 Before we can obtain government approval to sell any of our pharmaceutical systems, we must demonstrate through preclinical (animal) studies and clinical (human) trials that each system is safe and effective for human use for each targeted disease. We have completed an initial Phase I clinical trial for our lead product, Chronogesic(TM), using an external pump to test the safety of continuous chronic infusion of the drug, and we have completed the clinical portion of the Phase II clinical trial for this product in May 2001. We are conducting pre-clinical studies on our second product, DUROS hydromorphone. We plan to continue extensive and costly clinical trials to assess the safety and effectiveness of Chronogesic(TM), DUROS hydromorphone and our other potential products. We may not be permitted to begin or continue our planned clinical trials for our potential products or, if our trials are permitted, our potential products may not prove to be safe or produce their intended effects. The length of our clinical trials will depend upon, among other factors, the rate of trial site and patient enrollment. We may fail to obtain adequate levels of patient enrollment in our clinical trials. Delays in planned patient enrollment may result in increased costs, delays or termination of clinical trials, which could have a material adverse effect on us. In addition, even if we enroll the number of patients we expect in the time frame we expect, our clinical trials may not provide the data necessary for their successful completion. Additionally, we may fail to effectively oversee and monitor these clinical trials, which would result in increased costs or delays of our clinical trials. Even if these clinical trials are completed, we may fail to complete and submit a new drug application as scheduled. Even if we are able to submit a new drug application as scheduled, the Food and Drug Administration may not clear our application in a timely manner or may deny the application entirely. Data already obtained from preclinical studies and clinical trials of our pharmaceutical systems do not necessarily predict the results that will be obtained from later preclinical studies and clinical trials. Moreover, preclinical and clinical data such as ours is susceptible to varying interpretations, which could delay, limit or prevent regulatory approval. A number of companies in the pharmaceutical industry have suffered significant setbacks in advanced clinical trials, even after promising results in earlier trials. The failure to adequately demonstrate the safety and effectiveness of a product under development could delay or prevent regulatory clearance of the potential product, resulting in delays to the commercialization of our products, and could materially harm our business. Our clinical trials may not demonstrate the sufficient levels of safety and efficacy necessary to obtain the requisite regulatory approvals for our products, and thus our products may not be approved for marketing. Failure to obtain product approvals or comply with ongoing governmental regulations could delay or limit introduction of our new products and result in failure to achieve anticipated revenues The manufacture and marketing of our products and our research and development activities are subject to extensive regulation for safety, efficacy and quality by numerous government authorities in the United States and abroad. Before receiving FDA clearance to market a product, we will have to demonstrate that the product is safe and effective on the patient population and for the diseases that will be treated. Clinical trials, manufacturing and marketing of products are subject to the rigorous testing and approval process of the FDA and equivalent foreign regulatory authorities. The Federal Food, Drug and Cosmetic Act and other federal, state and foreign statutes and regulations govern and influence the testing, manufacture, labeling, advertising, distribution and promotion of drugs and medical devices. As a result, clinical trials and regulatory approval can take a number of years to accomplish and require the expenditure of substantial resources. Data obtained from clinical trials are susceptible to varying interpretations, which could delay, limit or prevent regulatory clearances. As of June 30, 2001, we have completed an initial Phase I clinical trial for our Chronogesic(TM) product using an external pump to test the safety of continuous chronic infusion of the drug, and have completed the clinical portion of a Phase II clinical trial, but have not begun our Phase III trial of this product, or initiated clinical trials for any other products. We are currently conducting prelinical studies on our second product, DUROS hydromorphone. If we fail to obtain timely clearance or approval for our products, we will not be able to market and sell our products, which will limit our ability to generate revenue. In addition, we may encounter delays or rejections based upon additional government regulation from future legislation or administrative action or changes in FDA policy during the period of product development, clinical trials and FDA regulatory review. We may encounter similar delays in foreign countries. Sales of our products outside the U.S. are subject to foreign regulatory approvals that vary from country to country. The time required to obtain approvals from foreign countries may be shorter or longer than that required for FDA approval, and requirements for foreign licensing may differ from FDA requirements. We may be unable to obtain requisite approvals from the FDA and foreign regulatory authorities, and even if obtained, such approvals may not be on a timely basis, or they may not cover the clinical uses that we specify. Marketing or promoting a drug for an unapproved use is subject to very strict controls. Furthermore, clearance may entail ongoing requirements for post- marketing studies. The manufacture and marketing of drugs are subject to continuing FDA and foreign regulatory review and requirements that we update our regulatory filings. Later discovery of previously unknown problems with a product, manufacturer or facility, or our failure to update regulatory files, may result in restrictions, including withdrawal of the product from the market. Any of the following events, if they were to occur, could delay or preclude us from further developing, marketing or realizing full commercial use of our products, which in turn would materially harm our business, financial condition and results of operations: . failure to obtain or maintain requisite governmental approvals; . failure to obtain approvals for clinically intended uses of our products under development; or . identification of serious and unanticipated adverse side effects in our products under development. Manufacturers of drugs also must comply with the applicable FDA good manufacturing practice regulations, which include production design controls, testing, quality control and quality assurance requirements as well as the corresponding maintenance of records and documentation. Compliance with current good manufacturing practices regulations is difficult and costly. Manufacturing facilities are subject to ongoing periodic inspection by the FDA and corresponding state agencies, including unannounced inspections, and must be licensed before they can be used for the commercial manufacture of our products. We or our present or future suppliers may be unable to comply with the applicable good manufacturing practice regulations and other FDA regulatory requirements. We have not been subject to a good manufacturing regulation inspection by the FDA relating to our pharmaceutical systems. If we do not achieve compliance for the products we manufacture, the FDA may withdraw marketing clearance or require product recall, which may cause interruptions or delays in the manufacture and sale of our products. We may not be able to manufacture sufficient quantities of our products to support our clinical and commercial requirements at an acceptable cost, and we have limited manufacturing experience We must manufacture our products in clinical and commercial quantities, either directly or through third parties, in compliance with regulatory requirements and at an acceptable cost. We have not yet completed development of the manufacturing process for any of our pharmaceutical systems, and DURECT has limited experience in developing such manufacturing processes. We are still optimizing our manufacturing process and exploring possible changes to increase efficiencies and lower costs. If we fail to develop manufacturing processes to permit us to manufacture our pharmaceutical systems at an acceptable cost, then we may not be able to commercialize our pharmaceutical systems. To date, we do not own manufacturing facilities capable of supplying clinical and commercial quantities of our products. Our current manufacturing facilities are only capable of manufacturing sub-assemblies of our DUROS-based pharmaceutical systems and cannot perform the final fill steps of our manufacturing process. We completed construction of a manufacturing facility for your DUROS-based pharmaceutical systems in May 2001 in accordance with our initial plans, and we anticipate that this facility, once it is ready for production, will be capable of manufacturing supplies for our Phase III clinical trial and commercial launch of our Chronogesic(TM) product and for clinical trials of our DUROS hydromorphone product as well as other products on a pilot scale. However, in order for the facility to be ready to produce clinical and anticipated commercial supplies of our products, we must still do work to ensure that the facility is compatible with the manufacturing process for our DUROS systems and meets all applicable regulatory standards, and we must complete validation and qualification of our facility. The manufacture of our DUROS-based pharmaceutical systems is a complex process, and federal, state and foreign regulatory standards relating to manufacture of pharmaceutical products are rigorous, complex and subject to varying interpretations. We may need to alter our facility design, install additional equipment or do additional construction or testing in order to adapt our facility to our current DUROS manufacturing process, meet regulatory requirements, optimize the production process, increase efficiencies or production capacity or for other reasons, which may result in additional cost to us or delay production of product needed for our clinical trials and commercial launch. We have commenced validating and qualifying the manufacturing facility but have not completed these processes. DURECT has no experience validating and qualifying manufacturing facilities. Furthermore, our new facility will be subject to government audits to determine compliance with good manufacturing practices regulations, and we may be unable to attain and maintain compliance with these regulations. If we are unable to ready our manufacturing facility for production in a timely manner or at an acceptable cost and attain and maintain compliance with applicable regulations, we could experience a delay in our clinical trials and the commercial sale of our DUROS- based pharmaceutical systems. We may also be required or choose to subcontract with third party contractors to perform the final manufacturing steps of our DUROS-based pharmaceutical systems in which case we will be subject to the schedule, expertise and performance of third parties as well as incur significant additional costs. See "We rely heavily on third parties to support development, clinical testing and manufacturing of our products." Under our development and commercialization agreement with ALZA, we cannot subcontract the manufacture of subassemblies of the DUROS system without approval from ALZA. If we cannot manufacture product in time to meet our clinical or commercial requirements or at an acceptable cost, our operating results will be harmed. In April 2000, we acquired the ALZET product and related assets from ALZA. We manufacture subassemblies of the ALZET product at our Vacaville facility. We currently rely on ALZA to perform the coating process for the manufacture of the ALZET product, but we will be required to perform this process ourselves starting April 2003. We have limited experience manufacturing this product, and we may not be able to successfully or consistently manufacture this product at an acceptable cost, if at all. Our agreement with ALZA limits our fields of operation for our DUROS-based pharmaceutical systems, requires us to spend significant funds on product development and gives ALZA a first right to distribute selected products for us, including Chronogesic(TM) In April 1998, we entered into a development and commercialization agreement with ALZA Corporation, which was amended and restated in April 1999 and April 2000. ALZA was acquired by Johnson & Johnson, Inc. in June 2001 and has since operated as a wholly owned subsidiary. This agreement gives us exclusive rights to develop, commercialize and manufacture products using ALZA's DUROS technology to deliver by catheter: . drugs to the central nervous system to treat select nervous system disorders; . drugs to the middle and inner ear; . drugs to the pericardial sac of the heart; and . select drugs into vascular grafts. We also have the right to use the DUROS technology to deliver systemically and by catheter: . sufentanil to treat chronic pain; and . select cancer antigens. We may not develop, manufacture or commercialize DUROS-based pharmaceutical systems outside of these specific fields without ALZA's prior approval. In addition, if we develop or commercialize any drug delivery technology for use in a manner similar to the DUROS technology in a field covered in our license agreement with ALZA, then we may lose our exclusive rights to use the DUROS technology in such field as well as the right to develop new products using DUROS technology in such field. Furthermore, to maintain our rights under this license agreement, we must meet annual minimum development spending requirements totaling $52.0 million to develop 17 products in some or all of these fields through 2004 and fund development of a minimum number of products per year up to a total of eight products through 2004. In order to maintain commercialization rights for our products in the U.S. and any foreign countries, we must diligently develop our products, procure required regulatory approvals and commercialize the products in these countries. If we fail to meet the various diligence requirements, we may: . close our rights to develop, commercialize and manufacture some of our DUROS-based pharmaceutical systems; . lose rights for products in some or all countries, including the U.S.; or . lose rights in some fields of use. These rights would revert to ALZA, which could then develop DUROS-based pharmaceutical products in such countries or fields of use itself or license others to do so. In addition, in the event that our rights terminate with respect to any product or country, or this agreement terminates or expires in its entirety (except for termination by us due to a breach by ALZA), ALZA will have the exclusive right to use all of our data, rights and information relating to the products developed under the agreement as necessary for ALZA to commercialize these products, subject to the payment of a royalty to us based on the net sales of the products by ALZA. Our agreement with ALZA gives us the right to develop and manufacture the DUROS pump component of our pharmaceutical systems in the fields described above. In the event of a change in our corporate control, including an acquisition of us, our right to manufacture and develop the DUROS pump would terminate and ALZA would have the right to manufacture and develop DUROS systems for us so long as ALZA can meet our specification and supply requirements following such change in control. Under the ALZA agreement, we must pay ALZA royalties on sales of DUROS- based pharmaceutical systems we commercialize and a percentage of any up-front license fees, milestone or special fees, payments or other consideration we receive, excluding research and development funding. In addition, commencing upon the commercial sale of a product developed under the agreement, we are obligated to make minimum product payments to ALZA on a quarterly basis based on our good faith projections of our net product sales of the product. These minimum payments will be fully credited against the product royalty payments we must pay to ALZA. ALZA also has an exclusive option to distribute our Chronogesic(TM) product in the U.S. and Canada and any DUROS-based pharmaceutical system we develop to deliver non-proprietary cancer antigens worldwide. The terms of any distribution arrangement have not been set and are to be negotiated in good faith between ALZA and ourselves. If ALZA chooses not to exercise its option to distribute our Chronogesic(TM) product, this may be interpreted as a negative factor, resulting in a decline in our stock price. ALZA's option to acquire distribution rights limits our ability to negotiate with other distributors for these products and may result in lower payments to us than if these rights were subject to competitive negotiations. We must allow ALZA an opportunity to negotiate in good faith for commercialization rights to our products developed under the agreement prior to granting these rights to a third party. These rights do not apply to products that are subject to ALZA's option or products for which we have obtained funding or access to a proprietary drug from a third party to whom we have granted commercialization rights prior to the commencement of human clinical trials. ALZA has the right to terminate the agreement in the event that we breach a material obligation under the agreement and do not cure the breach in a timely manner. In addition, ALZA has the right to terminate the agreement if, at any time prior to July 2002, we solicit for employment or hire, without ALZA's consent, a person who is or within the previous 180 days has been an employee of ALZA, or if at any time prior to July 2006, we solicit for employment or hire, without ALZA's consent, a person who is or within the previous 180 days has been an employee of ALZA in the DUROS technology group. Technologies and businesses which we have acquired may be difficult to integrate, disrupt our business, dilute stockholder value or divert management attention. We may also acquire additional businesses or technologies in the future, which could have these same effects We may acquire technologies, products or businesses to broaden the scope of our existing and planned product lines and technologies. For example, in October 1999, we acquired substantially all of the assets of IntraEAR, Inc., in April 2000 we acquired the ALZET product and related assets from ALZA and in April 2001, we completed the acquisition of SBS. These and our future acquisitions expose us to: . increased costs associated with the acquisition and operation of the new businesses or technologies and the management of geographically dispersed operations; 18 . the risks associated with the assimilation of new technologies, operations, sites and personnel; . the diversion of resources from our existing business and technologies; . the inability to generate revenues to offset associated acquisition costs; . the requirement to maintain uniform standards, controls, and procedures; and . the impairment of relationships with employees and customers as a result of any integration of new management personnel. Acquisitions may also result in the issuance of dilutive equity securities, the incurrence or assumption of debt or additional expenses associated with the amortization of acquired intangible assets or potential businesses. Past acquisitions, such as our acquisitions of IntraEAR, ALZET and SBS, as well future acquisitions, may not generate any additional revenue or provide any benefit to our business. 19 Our products contain controlled substances, the making, use, sale, importation and distribution of which are subject to regulation by state, federal and foreign law enforcement and other regulatory agencies 20 Our products currently under development contain, and our products in the future may contain, controlled substances which are subject to state, federal and foreign laws and regulations regarding their manufacture, use, sale, importation and distribution. Our first two products under development contain opioids which are classified as Schedule II controlled substances under the regulations of the U.S. Drug Enforcement Agency. For our products containing controlled substances, we and our suppliers, manufacturers, contractors, customers and distributors are required to obtain and maintain applicable registrations from state, federal and foreign law enforcement and regulatory agencies and comply with state, federal and foreign laws and regulations regarding the manufacture, use, sale, importation and distribution of controlled substances. These regulations are extensive and include regulations governing manufacturing, labeling, packaging, testing, dispensing, production and procurement quotas, record keeping, reporting, handling, shipment and disposal. Failure to obtain and maintain required registrations or comply with any applicable regulations could delay or preclude us from developing and commercializing our products containing controlled substances and subject us to enforcement action. In addition, because of their restrictive nature, these regulations could limit our commercialization of our products containing controlled substances. Our limited operating history makes evaluating our stock difficult You can only evaluate our business based on a limited operating history. We were incorporated in February 1998 and have engaged primarily in research and development, licensing technology, raising capital and recruiting scientific and management personnel. This short history may not be adequate to enable you to fully assess our ability to successfully develop our products, achieve market acceptance of our products and respond to competition. Acceptance of our products in the marketplace is uncertain, and failure to achieve market acceptance will delay our ability to generate or grow revenues Our future financial performance will depend upon the successful introduction and customer acceptance of our future products, including Chronogesic(TM). Even if approved for marketing, our products may not achieve market acceptance. The degree of market acceptance will depend upon a number of factors, including: . the receipt of regulatory clearance of marketing claims for the uses that we are developing; . the establishment and demonstration in the medical community of the safety and clinical efficacy of our products and their potential advantages over existing therapeutic products, including oral medication, transdermal drug delivery products such as drug patches, or external or implantable drug delivery products; and . pricing and reimbursement policies of government and third-party payors such as insurance companies, health maintenance organizations and other health plan administrators. Physicians, patients, payors or the medical community in general may be unwilling to accept, utilize or recommend any of our products. If we are unable to obtain regulatory approval, commercialize and market our future products when planned and achieve market acceptance, we will not achieve anticipated revenues. If users of our products are unable to obtain adequate reimbursement from third- party payors, or if new restrictive legislation is adopted, market acceptance of our products may be limited and we may not achieve anticipated revenues The continuing efforts of government and insurance companies, health maintenance organizations and other payors of healthcare costs to contain or reduce costs of health care may affect our future revenues and profitability, and the future revenues and profitability of our potential customers, suppliers and collaborative partners and the availability of capital. For example, in certain foreign markets, pricing or profitability of prescription pharmaceuticals is subject to government control. In the United States, recent federal and state government initiatives have been directed at lowering the total cost of health care, and the U.S. Congress and state legislatures will likely continue to focus on health care reform, the cost of prescription pharmaceuticals and on the reform of the Medicare and Medicaid systems. While we cannot predict whether any such legislative or regulatory proposals will be adopted, the announcement or adoption of such proposals could materially harm our business, financial condition and results of operations. Our ability to commercialize our products successfully will depend in part on the extent to which appropriate reimbursement levels for the cost of our products and related treatment are obtained by governmental authorities, private health insurers and other organizations, such as HMOs. Third-party payors are increasingly limiting payments or reimbursement for medical products and services. Also, the trend toward managed health care in the United States and the concurrent growth of organizations such as HMOs, which could control or significantly influence the purchase of health care services and products, as well as legislative proposals to reform health care or reduce government insurance programs, may limit reimbursement or payment for our products. The cost containment measures that health care payors and providers are instituting and the effect of any health care reform could materially harm our ability to operate profitably. We have a history of operating losses, expect to continue to have losses in the future and may never achieve or maintain profitability We have incurred significant operating losses since our inception in 1998 and, as of June 30, 2001, had an accumulated deficit of approximately $57.4 million. We expect to continue to incur significant operating losses over the next several years as we continue to incur increasing costs for research and development, clinical trials and manufacturing. Our ability to achieve profitability depends upon our ability, alone or with others, to successfully complete the development of our proposed products, obtain the required regulatory clearances and manufacture and market our proposed products. Development of pharmaceutical systems is costly and requires significant investment. In addition, we may choose to license either additional drug delivery platform technology or rights to particular drugs for use in our pharmaceutical systems. The license fees for these technologies or rights would increase the costs of our pharmaceutical systems. 21 To date, we have not generated significant revenue from the commercial sale of our products and do not expect to receive significant revenue in the near future. All revenues to date are from the sale of products we acquired in October 1999 in connection with the acquisition of substantially all of the assets of IntraEAR, Inc., the ALZET product we acquired in April 2000 from ALZA and the sale of biodegradable polymers and contract research and development revenues from our SBS subsidiary. We do not expect these revenues to increase significantly in future periods. We do not anticipate commercialization and marketing of our products in development in the near future, and therefore do not expect to generate sufficient revenues to cover expenses or achieve profitability in the near future. We do not control ALZA's ability to develop and commercialize DUROS technology outside of fields licensed to us, and problems encountered by ALZA could result in negative publicity, loss of sales and delays in market acceptance of our DUROS-based pharmaceutical systems ALZA retains complete rights to the DUROS technology for fields outside the specific fields licensed to us. Accordingly, ALZA may develop and commercialize DUROS-based products or license others to do so, so long as there is no conflict with the rights granted to us. ALZA recently received FDA approval to market its first DUROS-based product, Viadur (leuprolide acetate implants) for the palliative treatment of advanced prostate cancer. If ALZA fails to commercialize this product successfully, or encounters problems associated with this product, negative publicity could be created about all DUROS-based products, which could result in harm to our reputation and cause reduced sales of our products. In addition, if any third-party that may be licensed by ALZA fails to develop and commercialize DUROS-based products successfully, the success of all DUROS-based systems could be impeded, including ours, resulting in delay or loss of revenue or damage to our reputation, any one of which could harm our business. We do not own the trademark "DUROS" and any competitive advantage we derive from the name may be impaired by third-party use ALZA owns the trademark "DUROS." Because ALZA is also developing and marketing DUROS-based systems, and may license third parties to do so, there may be confusion in the market between ALZA, its potential licensees and us, and this confusion could impair the competitive advantage, if any, we derive from use of the DUROS name. In addition, any actions taken by ALZA or its potential licensees that negatively impact the trademark "DUROS" could negatively impact our reputation and result in reduced sales of our DUROS-based pharmaceutical systems. We may be sued by third parties which claim that our products infringe on their intellectual property rights, particularly because there is substantial uncertainty about the validity and breadth of medical patents We may be exposed to future litigation by third parties based on claims that our products or activities infringe the intellectual property rights of others or that we have misappropriated the trade secrets of others. This risk is exacerbated by the fact that the validity and breadth of claims covered in medical technology patents and the breadth and scope of trade secret protection involve complex legal and factual questions for which important legal principles are unresolved. Any litigation or claims against us, whether or not valid, could result in substantial costs, could place a significant strain on our financial resources and could harm our reputation. In addition, intellectual property litigation or claims could force us to do one or more of the following: . cease selling, incorporating or using any of our products that incorporate the challenged intellectual property, which would adversely affect our revenue; . obtain a license from the holder of the infringed intellectual property right, which license may be costly or may not be available on reasonable terms, if at all; or . redesign our products, which would be costly and time-consuming. If we are unable to adequately protect or enforce our intellectual property rights or secure rights to third-party patents, we may lose valuable assets, experience reduced market share or incur costly litigation to protect our rights 22 Our success will depend in part on our ability to obtain patents, maintain trade secret protection and operate without infringing the proprietary rights of others. As of June 30, 2001, we held four issued U.S. patents and one issued foreign patent. In addition, we have 17 pending U.S. patent applications and have filed 12 patent applications under the Patent Cooperation Treaty, from which 11 national phase applications are currently pending in Europe, Australia and Canada. As of June 30, 2001, our subsidiary SBS held 3 issued U.S. patents, 1 issued foreign patent and 6 pending U.S. patent applications and has filed 6 patent applications under the Patent Cooperation Treaty. To maintain the license rights to ALZA intellectual property granted to us under our development and commercialization agreement with ALZA, we must meet annual minimum development spending requirements and fund development of a minimum number of products. If we do not meet these diligence requirements, we may lose rights to one or more of our licensed fields. Also, under our agreement with ALZA, we must assign to ALZA any intellectual property rights relating to the DUROS system and its manufacture and any combination of the DUROS system with other components, active agents, features or processes. In addition, ALZA retains the right to enforce and defend against infringement actions relating to the DUROS system, and if ALZA exercises these rights, it will be entitled to the proceeds of these infringement actions. The patent positions of pharmaceutical companies, including ours, are uncertain and involve complex legal and factual questions. In addition, the coverage claimed in a patent application can be significantly reduced before the patent is issued. Consequently, our patent applications or those of ALZA that are licensed to us may not issue into patents, and any issued patents may not provide protection against competitive technologies or may be held invalid if challenged or circumvented. Our competitors may also independently develop products similar to ours or design around or otherwise circumvent patents issued to us or licensed by us. In addition, the laws of some foreign countries may not protect our proprietary rights to the same extent as U.S. law. We also rely upon trade secrets, technical know-how and continuing technological innovation to develop and maintain our competitive position. We require our employees, consultants, advisors and collaborators to execute appropriate confidentiality and assignment-of-inventions agreements with us. These agreements typically provide that all materials and confidential information developed or made known to the individual during the course of the individual's relationship with us is to be kept confidential and not disclosed to third parties except in specific circumstances, and that all inventions arising out of the individual's relationship with us shall be our exclusive property. These agreements may be breached, and in some instances, we may not have an appropriate remedy available for breach of the agreements. Furthermore, our competitors may independently develop substantially equivalent proprietary information and techniques, reverse engineer our information and techniques, or otherwise gain access to our proprietary technology. We may be unable to meaningfully protect our rights in trade secrets, technical know-how and other non-patented technology. We may have to resort to litigation to protect our intellectual property rights, or to determine their scope, validity or enforceability. Enforcing or defending our proprietary rights is expensive, could cause diversion of our resources and may not prove successful. Any failure to enforce or protect our rights could cause us to lose the ability to exclude others from using our technology to develop or sell competing products. 23 We rely heavily on third parties to support development, clinical testing and manufacturing of our products We rely on third party contract research organizations, service providers and suppliers to provide critical services to support development, clinical testing, and manufacturing of our pharmaceutical systems. For example, we currently depend on MDS Pharma, Inc. to perform blood plasma assays in connection with our clinical trials for Chronogesic(TM) and Nelson Laboratories, Inc. to perform quality control services related to components of our DUROS-based pharmaceutical systems. In the past, we relied on Chesapeake Biological Labs, Inc. to perform the final manufacturing steps of our Chronogesic(TM) product, and we may need to rely on a third party manufacturer again if we encounter delays in readying our manufacturing facility for production. See "We may not be able to manufacture sufficient quantities of our products to support our clinical and commercial requirements at an acceptable cost, and we have limited manufacturing experience." We anticipate that we will continue to rely on these and other third party contractors to support development, clinical testing, and manufacturing of our pharmaceutical systems. Failure of these contractors to provide the required services in a timely manner or on reasonable commercial terms could materially delay the development and approval of our products, increase our expenses and materially harm our business, financial condition and results of operations. Key components of our DUROS-based pharmaceutical systems are provided by limited numbers of suppliers, and supply shortages or loss of these suppliers could result in interruptions in supply or increased costs Certain components and drug substances used in our DUROS-based pharmaceutical systems are currently purchased from a single or a limited number of outside sources. The reliance on a sole or limited number of suppliers could result in: . delays associated with redesigning a product due to a failure to obtain a single source component; . an inability to obtain an adequate supply of required components; and . reduced control over pricing, quality and time delivery. We have a supply agreement with Mallinckrodt, Inc. for our sufentanil requirements for our Chronogesic(TM) product, which expires in September 2004. Additionally, we have a supply agreement with RMS Company under which RMS has agreed to supply us with titanium components of our DUROS-based pharmaceutical systems until April 2004. Other that these agreements, we do not have long-term agreements with any of our suppliers, and therefore the supply of a particular component could be terminated at any time without penalty to the supplier. Any interruption in the supply of single source components could cause us to seek alternative sources of supply or manufacture these components internally. If the supply of any components for our pharmaceutical systems is interrupted, components from alternative suppliers may not be available in sufficient volumes within required timeframes, if at all, to meet our needs. This could delay our ability to complete clinical trials and obtain approval for commercialization and marketing of our products, causing us to lose sales, incur additional costs and delay new product introductions and could harm our reputation. We lack marketing, sales and distribution experience for pharmaceutical systems and we may not be able to sell our products if we do not enter into relationships with third parties or develop a direct sales organization We have yet to establish marketing, sales or distribution capabilities for our pharmaceutical systems. We intend to enter into agreements with third parties to sell our products or to develop our own sales and marketing force. We may be unable to establish or maintain third-party relationships on a commercially reasonable basis, if at all. In addition, these third parties may have similar or more established relationships with our competitors. If we do not enter into relationships with third parties for the sales and marketing of our products, we will need to develop our own sales and marketing capabilities. DURECT has only limited experience in developing, training or managing a sales force. If we choose to establish a direct sales force, we will incur substantial additional expenses in developing, training and managing such an organization. We may be unable to build a sales force, the cost of establishing such a sales force may exceed our product revenues, or our direct marketing and sales efforts may be unsuccessful. In addition, we compete with many other companies that currently have extensive and well- funded marketing and sales operations. Our marketing and sales efforts may be unable to compete successfully against these other companies. We may be unable to establish a sufficient sales and marketing organization on a timely basis, if at all. We may be unable to engage qualified distributors. Even if engaged, these distributors may: . fail to satisfy financial or contractual obligations to us; . fail to adequately market our products; . cease operations with little or no notice to us; or . offer, design, manufacture or promote competing product lines. If we fail to develop sales, marketing and distribution channels, we would experience delays in product sales and incur increased costs, which would harm our financial results. If we are unable to train physicians to use our pharmaceutical systems to treat patients' diseases or medical conditions, we may incur delays in market acceptance of our products Broad use of our pharmaceutical systems will require extensive training of numerous physicians. The time required to begin and complete training of physicians could delay introduction of our products and adversely affect market acceptance of our products. We may be unable to rapidly train physicians in numbers sufficient to generate adequate demand for our pharmaceutical systems. Any delay in training would materially delay the demand for our systems. In addition, we may expend significant funds towards such training before any orders are placed for our products. We may have difficulty raising needed capital in the future 24 Our business currently does not generate sufficient revenues to meet our capital requirements and we do not expect that it will do so in the near future. We have expended and will continue to expend substantial funds to complete the research, development and clinical testing of our products. We will require additional funds for these purposes, to establish additional clinical- and commercial-scale manufacturing arrangements and facilities and to provide for the marketing and distribution of our products. Additional funds may not be available on acceptable terms, if at all. If adequate funds are unavailable from operations or additional sources of financing, we may have to delay, reduce the scope of or eliminate one or more of our research or development programs which would materially harm our business, financial condition and results of operations. We believe that our cash, cash equivalents and investments, will be adequate to satisfy our capital needs for at least the next 18 months. However, our actual capital requirements will depend on many factors, including: . continued progress and cost of our research and development programs; . progress with preclinical studies and clinical trials; . the time and costs involved in obtaining regulatory clearance; . costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims; . costs of developing sales, marketing and distribution channels and our ability to sell our products; . costs involved in establishing manufacturing capabilities for commercial quantities of our products; . competing technological and market developments; . market acceptance of our products; and . costs for recruiting and retaining employees and consultants. We may consume available resources more rapidly than currently anticipated, resulting in the need for additional funding. We may seek to raise any necessary additional funds through equity or debt financings, collaborative arrangements with corporate partners or other sources, which may be dilutive to existing stockholders. In addition, in the event that additional funds are obtained through arrangements with collaborative partners or other sources, we may have to relinquish rights to some of our technologies, product candidates or products under development that we would otherwise seek to develop or commercialize ourselves. If adequate funds are not available, we may be required to significantly reduce or refocus our product development efforts, or relinquish to ALZA rights to develop DUROS products in certain fields, resulting in loss of sales, increased costs, and reduced revenues. Future deferred compensation expenses and non-cash charges may adversely impact or delay our profitability To date, we have recorded deferred compensation expenses related to stock options grants, including stock options assumed in our acquisition of SBS, which will be amortized as follows: $1.5 million for the six months ending December 31, 2001, $1.7 million for the year ending December 31, 2002, $739,000 for the year ending December 31, 2003, $111,000 for the year ending December 31, 2004, $18,000 for the year ending December 31, 2005, and $2,000 for the year ending December 31, 2006. In addition, deferred compensation expense related to option awards to non-employees will be calculated during the vesting period of the option based on the then-current price of our common stock, which could result in significant charges that adversely impact or delay our profitability. Furthermore, we have issued a warrant to ALZA with a deemed value of approximately $6.5 million, which will be amortized over time based on sales of our products and which will also adversely impact or delay our profitability. We depend upon key personnel who may terminate their employment with us at any time, and we need to hire additional qualified personnel Our success will depend to a significant degree upon the continued services of key management, technical, and scientific personnel, including Felix Theeuwes, our Chairman and Chief Scientific Officer, James E. Brown, our 25 President and Chief Executive Officer and Thomas A. Schreck, our Chief Financial Officer. Although we have obtained key man life insurance policies for each of Messrs. Theeuwes, Brown and Schreck in the amount of $1 million, this insurance may not adequately compensate us for the loss of their services. In addition, our success will depend on our ability to attract and retain other highly skilled personnel. Competition for qualified personnel is intense, and the process of hiring and integrating such qualified personnel is often lengthy. We may be unable to recruit such personnel on a timely basis, if at all. Our management and other employees may voluntarily terminate their employment with us at any time. The loss of the services of key personnel, or the inability to attract and retain additional qualified personnel, could result in delays to product development or approval, loss of sales and diversion of management resources. We may not successfully manage our growth Our success will depend on the expansion of our operations and the effective management of growth, which will place a significant strain on our management and on our administrative, operational and financial resources. To manage such growth, we must expand our facilities, augment our operational, financial and management systems and hire and train additional qualified personnel. If we are unable to manage growth effectively our business would be harmed. The market for our products is new, rapidly changing and competitive, and new products or technologies developed by others could impair our ability to grow our business and remain competitive The pharmaceutical industry is subject to rapid and substantial technological change. Developments by others may render our products under development or technologies noncompetitive or obsolete, or we may be unable to keep pace with technological developments or other market factors. Technological competition in the industry from pharmaceutical and biotechnology companies, universities, governmental entities and others diversifying into the field is intense and is expected to increase. Many of these entities have significantly greater research and development capabilities than we do, as well as substantially more marketing, manufacturing, financial and managerial resources. These entities represent significant competition for us. Acquisitions of, or investments in, competing pharmaceutical or biotechnology companies by large corporations could increase such competitors' financial, marketing, manufacturing and other resources. We are a new enterprise and are engaged in the development of novel therapeutic technologies. As a result, our resources are limited and we may experience technical challenges inherent in such novel technologies. Competitors have developed or are in the process of developing technologies that are, or in the future may be, the basis for competitive products. Some of these products may have an entirely different approach or means of accomplishing similar therapeutic effects than our products. Our competitors may develop products that are safer, more effective or less costly than our products and, therefore, present a serious competitive threat to our product offerings. The widespread acceptance of therapies that are alternatives to ours may limit market acceptance of our products even if commercialized. Chronic pain can also be treated by oral medication, transdermal drug delivery systems, such as drug patches, or with other implantable drug delivery devices. These treatments are widely accepted in the medical community and have a long history of use. The established use of these competitive products may limit the potential for our products to receive widespread acceptance if commercialized. 26 We could be exposed to significant product liability claims which could be time consuming and costly to defend, divert management attention and adversely impact our ability to obtain and maintain insurance coverage The testing, manufacture, marketing and sale of our products involve an inherent risk that product liability claims will be asserted against us. Although we are insured against such risks up to a $5 million annual aggregate limit in connection with clinical trials and commercial sales of our products, our present product liability insurance may be inadequate and may not fully cover the costs of any claim or any ultimate damages we might be required to pay. Product liability claims or other claims related to our products, regardless of their outcome, could require us to spend significant time and money in litigation or to pay significant damages. Any successful product liability claim may prevent us from obtaining adequate product liability insurance in the future on commercially desirable or reasonable terms. In addition, product liability coverage may cease to be available in sufficient amounts or at an acceptable cost. An inability to obtain sufficient insurance coverage at an acceptable cost or otherwise to protect against potential product liability claims could prevent or inhibit the commercialization of our pharmaceutical systems. A product liability claim could also significantly harm our reputation and delay market acceptance of our products. Our business involves environmental risks and risks related to handling regulated substances In connection with our research and development activities and our manufacture of materials and products, we are subject to federal, state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, effluent discharge, handling and disposal of certain materials, biological specimens and wastes. Although we believe that we have complied with the applicable laws, regulations and policies in all material respects and have not been required to correct any material noncompliance, we may be required to incur significant costs to comply with environmental and health and safety regulations in the future. Our research and development involves the use, generation and disposal of hazardous materials, including but not limited to certain hazardous chemicals, solvents, agents and biohazardous materials. The extent of our use, generation and disposal of such substances has increased substantially since our acquisition of SBS, which, through its subsidiary Birmingham Polymers, Inc., is engaged in the business of manufacturing and selling biodegradable polymers. Although we believe that our safety procedures for storing, handling and disposing of such materials comply with the standards prescribed by state and federal regulations, we cannot completely eliminate the risk of accidental contamination or injury from these materials. We currently contract with third parties to dispose of these substances generated by us, and we rely on these third parties to properly dispose of these substances in compliance with applicable laws and regulations. If these third parties do not properly dispose of these substance in compliance with applicable laws and regulations, we may be subject to legal action by governmental agencies or private parties for improper disposal of these substances. The costs of defending such actions and the potential liability resulting from such actions are often very large. In the event we are subject to such legal action or we otherwise fail to comply with applicable laws and regulations governing the use, generation and disposal of hazardous materials and chemicals, we could be held liable for any damages that result, and any such liability could exceed our resources. Our stock price may fluctuate, and your investment in our stock could decline in value The average daily trading only volume of our common stock for the six months ending June 30, 2001, was 125,256 shares. The limited trading volume of our stock may contribute to its volatility, and an active trading market in our stock might not develop or continue. The market price of our common stock may fluctuate significantly in response to factors which are beyond our control. The stock market in general has recently experienced extreme price and volume fluctuations. In addition, the market prices of securities of technology and pharmaceutical companies have also been extremely volatile, and have experienced fluctuations that often have been unrelated or disproportionate to the operating performance of these companies. These broad market 27 fluctuations could result in extreme fluctuations in the price of our common stock, which could cause a decline in the value of your shares. Future sales of our common stock may depress our stock price Commencing on March 27, 2001, which was 180 days after the date of our initial public offering, as many as 34,173,026 shares of our common stock became available for sale in the public market, subject to applicable securities laws. Additionally, in connection with our acquisition of SBS, we are obligated to use our reasonable best efforts to prepare and file with the SEC a registration statement on Form S-3 (or such successor or other appropriate form) under the Securities Act with respect to the common stock issued to the former SBS shareholders on or before November 30, 2001. The common stock issued in connection with this acquisition shall become freely tradable in the public market after the registration statement has been declared effective by the Securities and Exchange Commission. Further information regarding the SBS acquisition is included in the company's current report on Form 8-K filed with the SEC on May 15, 2001. If substantial amounts of our common stock were to be sold in the public market, the market price of our common stock could fall. In addition, these sales could create the perception to the public of difficulties or problems in our business. As a result, these sales also might make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate. We have broad discretion over the use of our cash and investments, and their investment may not yield a favorable return Our management has broad discretion over how our cash and investments are used and may invest in ways with which our stockholders may not agree and that do not yield favorable returns. Executive officers, directors and entities affiliated with them have substantial control over us, which could delay or prevent a change in our corporate control favored by our other stockholders Our directors, executive officers and principal stockholders, together with their affiliates have substantial control over us. The interests of these stockholders may differ from the interests of other stockholders. As a result, these stockholders, if acting together, would have the ability to exercise control over all corporate actions requiring stockholder approval irrespective of how our other stockholders may vote, including: . the election of directors; . the amendment of charter documents; . the approval of certain mergers and other significant corporate transactions, including a sale of substantially all of our assets; or . the defeat of any non-negotiated takeover attempt that might otherwise benefit the public stockholders. Our certificate of incorporation, our bylaws, Delaware law and our stockholder rights plan contain provisions that could discourage another company from acquiring us Provisions of Delaware law, our certificate of incorporation, bylaws and stockholder rights plan may discourage, delay or prevent a merger or acquisition that stockholders may consider favorable, including transactions in which you might otherwise receive a premium for your shares. These provisions include: . authorizing the issuance of "blank check" preferred stock without any need for action by stockholders; . providing for a dividend on our common stock, commonly referred to as a "poison pill", which can be triggered after a person or group acquires 17.5% or more of common stock; . providing for a classified board of directors with staggered terms; . requiring supermajority stockholder voting to effect certain amendments to our certificate of incorporation and by-laws; 28 . eliminating the ability of stockholders to call special meetings of stockholders; . prohibiting stockholder action by written consent; and . establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted on by stockholders at stockholder meetings. Investors may experience substantial dilution of their investment In the past, we have issued options to acquire common stock at prices below the initial public offering price. To the extent these outstanding options are ultimately exercised, there will be dilution to investors. In connection with our acquisition of SBS we issued 1,355,235 shares of common stock, and agreed to issue up to 720,161 additional shares of common stock upon the exercise of outstanding SBS options and warrants, in exchange for all of SBS's outstanding equity interests, and assumed SBS's liabilities, including $1.7 million in debt. At the time of the registration of these shares with the Securities and Exchange Commission, which is expected to be in the fourth quarter of 2001, we may be required to issue additional shares of common stock to former SBS shareholders, as well as reserve additional shares for issuance upon the exercise of outstanding SBS options and warrants, depending on our stock price at that time. Up to 4,150,854 additional shares may be issued and reserved for issuance upon the exercise of outstanding SBS options and warrants. The maximum total number of shares issued and shares reserved for issuance upon the exercise of outstanding SBS options and warrants in connection with our acquisition of SBS will be determined by dividing $24.9 million by the greater of $4.00 or the average closing sale price of the Company's stock during a specified time period proceeding the registration of shares, subject to certain conditions. If we are obligated to issue additional shares to the former SBS shareholders and reserve additional shares for issuance upon the exercise of outstanding SBS options and warrants, there will be additional dilution to our investors. Further information regarding the SBS acquisition is included in the company's current Report on Form 8-K filed with the SEC on May 15, 2001. 29 ITEM 3. Quantitative and Qualitative Disclosures about Market Risk Interest Rate Sensitivity Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio and long-term debt obligations. Our primary investment objective is to preserve principal while at the same time maximizing yields without significantly increasing risk. Our portfolio includes money markets funds, commercial paper, medium-term notes, corporate notes, government securities, auction rate securities, corporate bonds and market auction preferreds. The diversity of our portfolio helps us to achieve our investment objective. As of June 30, 2001, approximately 73% of our investment portfolio is composed of investments with original maturities of one year or less and approximately 38% of our investment portfolio matures less than 90 days from the date of purchase. In October 1998, the Company financed the purchase of certain equipment through a bank loan with a variable interest rate. The average interest rates were 8.26% and 10.40% during 3 months ended June 30, 2001 and June 30, 2000, respectively. At June 30, 2001 and June 30, 2000, the Company had loans outstanding in the amounts of $122,000 and $256,000, respectively. The following table presents the amounts of our cash equivalents and investments that may be subject to interest rate risk and the average interest rates as of June 30, 2001 by year of maturity (dollars in thousands):
2001 2002 2003 Total -------- -------- -------- --------- Cash equivalents: Fixed rate............................ $21,873 -- -- $21,873 Average fixed rate.................... 3.86% -- -- 3.86% Variable rate......................... $14,546 -- -- $14,546 Average variable rate................. 4.82% -- -- 4.82% Short-term investments: Fixed rate............................ $14,063 $15,229 -- $29,292 Average fixed rate.................... 5.77% 5.76% -- 5.77% Variable rate......................... $ 3,800 -- -- $ 3,800 Average variable rate................. 3.90% -- -- 3.90% Long-term investments: Fixed rate............................ $ -- $13,322 $12,154 $25,476 Average fixed rate.................... -- 5.74% 4.80% 5.20% ------- ------- ------- ------- Total investment securities.............. $54,282 $28,551 $12,154 $94,987 ------- ------- ------- ------- Average rate............................. 4.87% 5.76% 4.80% 5.14% ------- ------- ------- -------
30 The following table presents the amounts of our cash equivalents and investments that may be subject to interest rate risk and the average interest rates as of December 31, 2000 by year of maturity (dollars in thousands):
2001 2002 Total -------- -------- --------- Cash equivalents: Fixed rate................................... $ 21,610 -- $ 21,610 Average fixed rate........................... 6.58% -- 6.58% Variable rate................................ $ 25,280 -- $ 25,280 Average variable rate........................ 6.82% -- 6.82% Short-term investments: Fixed rate................................... $ 52,830 -- $ 52,830 Average fixed rate........................... 6.58% -- 6.58% Variable rate................................ $ 4,900 -- $ 4,900 Average variable rate........................ 6.75% -- 6.75% Long-term investments: Fixed rate................................... $ -- $1,652 $ 1,652 Average fixed rate........................... -- 7.26% 7.26% -------- ------ -------- Total investment securities..................... $104,620 $1,652 $106,272 -------- ------ -------- Average rate.................................... 6.63% 7.26% 6.65% -------- ------ --------
PART II--OTHER INFORMATION ITEM 1. Legal Proceedings None ITEM 2. Changes in Securities and Use of Proceeds On September 27, 2000, in connection with our initial public offering, a Registration Statement on Form S-1 (No. 333-35316) was declared effective by the Securities and Exchange Commission, pursuant to which 7,000,000 shares of our common stock were offered and sold for our account at a price of $12.00 per share, generating gross offering proceeds of $84 million. The managing underwriters were Morgan Stanley Dean Witter, Chase H&Q, and CIBC World Markets. Our initial public offering closed on October 3, 2000. After deducting underwriters' discounts and commissions and other offering expenses, the net proceeds were approximately $76.2 million. On November 1, 2000, the underwriters exercised in part their over-allotment option in part and purchased an additional 700,000 shares at the initial public offering price of $12.00 per share. The net proceeds of the over-allotment option, after deducting underwriters' discounts and other offering expenses, were approximately $7.8 million. After giving effect to the sale of the over-allotment shares, a total of 7,700,000 shares of common stock were offered and sold in the initial public offering with total net proceeds of $84.0 million. None of the payments for underwriting discounts and commissions and other transaction expenses represented direct or indirect payments to directors, officers or other affiliates of the Company. As of June 30, 2001, we used $18.7 million for development expenses related to our products, including the allocation of certain general and administrative costs, $5.3 million for the construction and validation our new manufacturing facility, and, under the terms of our agreement to purchase the ALZET product line from ALZA Corporation, we were required to make our final payment for inventory following the completion of our initial public offering, in the amount of $805,000. We invested the remainder of the net proceeds in investment grade securities. We intend to use the net proceeds of the initial public offering as follows: . approximately $40-$60 million to fund development expenses related to our products, including clinical trial expenses; . approximately an additional $2.0-$4.0 million to fund the development, construction and validation of our manufacturing facility; 31 . to fund the commercialization of our products, once approved; and . for working capital and general corporate purposes. We may use a portion of the net proceeds to fund, acquire or invest in complementary businesses or technologies. The amount of cash that we actually expend for any of the described purposes will vary significantly based on a number of factors, including the progress of our research and development and clinical trials, the establishment of collaborative relationships, the cost and pace of establishing and expanding our manufacturing capabilities, the development of sales and marketing activities if undertaken by us and competing technological and market developments. Our management will have significant discretion in applying the net proceeds of this offering. On May 11, 2001, in connection with an Exclusive Trademark License and Assignment Agreement with Daniel Carr dated May 11, 2001, we issued to Daniel Carr a warrant to purchase 770 shares of our common stock at an exercise price of $8.50 per share, which represented the closing sale price of our common stock on May 11, 2001. This issuance was deemed exempt from registration under the Securities Act in reliance on Section 4(2) of the Securities Act as transactions by an issuer not involving a public offering. ITEM 3. Defaults Upon Senior Securities None ITEM 4. Submission of Matters to a Vote of Security Holders On June 27, 2001, the Annual Meeting of Stockholders of DURECT Corporation. was held in Cupertino, California. An election of Class I directors was held with the following individuals being elected to our Board of Directors to serve until our annual meeting of stockholders for the year ending December 31, 2004: Felix Theeuwes (28,784,504 votes for, 1,193,941 votes withheld) Albert L. Zesiger (29,806,839 votes for, 171,606 votes withheld) Other matters voted upon and approved at the meeting and the number of affirmations, negative votes cast and abstentions with respect to each such matter were as follows: . To ratify the appointment of Ernst & Young LLP as our independent auditors for the fiscal year ending December 31, 2001 (29,954,210 votes in favor, 8,375 votes opposed, 15,860 votes abstaining). ITEM 5. Other Information None ITEM 6. Exhibits and Reports on Form 8-K (a) Exhibits: None (b) Reports on From 8-K: Durect filed a Report on Form 8-K and Form 8-K/A on May 15, 2001 and June 29, 2001, respectively, regarding the completion of its acquisition of Southern BioSystems, Inc. 32 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. DURECT CORPORATION By: /s/ Thomas A. Schreck --------------------------------------- Thomas A. Schreck Chief Financial Officer (Principal Financial Officer) Date: August 14, 2001 By: /s/ Jon W. Kawaja -------------------------------------- Jon W. Kawaja Sr. Director of Finance Date: August 14, 2001 33