10KSB 1 v040443_10ksb.txt ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 ------------ Form 10-KSB |X| ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2005 OR |_| TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 0-935 ----------------- Molecular Diagnostics, Inc. (Name of small business issuer in its charter) Delaware 36-4296006 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 414 N. Orleans St., Suite 502, Chicago, IL 60610 (Address of principal executive offices) (Zip Code) (312) 222-9550 (Issuer's Telephone Number, Including Area Code) Securities registered under Section 12(b) of the Exchange Act: Title of each class Name of each exchange on which registered ------------------- ----------------------------------------- None Not Applicable Securities registered under Section 12(g) of the Exchange Act: Common Stock, $0.001 par value (Title of class) Check whether the issuer is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act. |_| Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure will be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. |-| Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes |_| No |X| The Company's revenues for the fiscal year ended December 31, 2005 were $117,000. The aggregate market value of the common stock held by non-affiliates of the Company as of March 31, 2006 was $22,534,000, based upon the closing price of shares of the Company's common stock, $0.001 par value per share, of $0.11 as reported on the Over-the-Counter Bulletin Board on such date. The number of shares of common stock outstanding as of March 31, 2006 was 204,850,027. Documents Incorporated By Reference Portions of the Registrant's Definitive Proxy Statement to be filed no later than 120 days after the end of the fiscal year ended December 31, 2005 in connection with the Registrant's 2005 Annual Meeting of Stockholders are incorporated by reference into Part III of this Form 10-KSB. Transitional Small Business Disclosure Format (Check one): Yes |_| No |X| MOLECULAR DIAGNOSTICS, INC. Annual Report on Form 10-KSB December 31, 2005 TABLE OF CONTENTS
PART I Page ---- Item 1. Description of Business Overview ........................................................................................ 1 Recent Developments.............................................................................. 1 Strategic Partner Agreement................................................................. 1 Satisfaction of Delinquent Tax Liabilities.................................................. 2 Short-term Liquidity Problems............................................................... 2 Insurance................................................................................... 2 Information About Industry Segments.............................................................. 2 Description of Business.......................................................................... 2 Products.................................................................................... 2 InPath(TM) Systems................................................................. 2 Automated Microscopy Instruments................................................... 3 AcCell(TM)......................................................................... 3 AIPS(TM)........................................................................... 4 Drug Delivery System............................................................... 4 Markets and Distribution.................................................................... 5 Government Regulation, Clinical Studies and Regulatory Strategy............................. 5 Competition................................................................................. 8 Operations.................................................................................. 9 Intellectual Property....................................................................... 10 Research and Development.................................................................... 11 Component and Raw Materials................................................................. 11 Working Capital Practices................................................................... 12 Employees................................................................................... 12 Financial Information About Foreign and Domestic Operations and Export Sales..................... 12 Risk Factors..................................................................................... 12 Item 2. Description of Property.......................................................................... 16 Item 3. Legal Proceedings................................................................................ 16 Item 4. Submission of Matters to a Vote of Security Holders.............................................. 19 PART II Item 5. Market for Common Equity and Related Stockholder Market Information............................................................................... 19 Holders ........................................................................................ 19 Dividends........................................................................................ 19 Stock Transfer Agent............................................................................. 20 Securities Authorized for Issuance under Equity Compensation Plans............................... 20 Recent Sales of Unregistered Securities and Use of Proceeds from Registered Securities........... 22 Issuance of Securities ..................................................................... 22 Conversions ................................................................................ 22 Purchases of Equity Securities by the Small Business Issuer and Affiliated Purchasers ........... 23 Item 6. Management's Discussion and Analysis or Plan of Operation........................................ 23
Forward-Looking Statements....................................................................... 23 Overview ........................................................................................ 24 Critical Accounting Policies and Significant Judgments and Estimates............................. 24 Results of Operations............................................................................ 25 Revenue..................................................................................... 25 Costs and Expenses.......................................................................... 25 Cost of Goods Sold...................................................................... 25 Research and Development................................................................ 25 Selling, General and Administrative..................................................... 26 Other Income and Expense................................................................ 26 Interest Income.................................................................... 26 Interest Expense................................................................... 27 Restructuring Settlements.......................................................... 27 Loss on Litigation Settlements..................................................... 27 Other Income and Expense, Net...................................................... 27 Net Loss.................................................................................... 28 Liquidity and Capital Resources.................................................................. 28 Off-Balance Sheets Arrangements.................................................................. 29 Item 7. Financial Statements............................................................................. 29 Item 8. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure............. 29 Resignation of Auditors.......................................................................... 29 Item 8A. Controls and Procedures.......................................................................... 29 Evaluation of Disclosure Controls and Procedures................................................. 29 Changes in Internal Controls..................................................................... 29 Item 8B. Other Information................................................................................ 29 PART III Item 9. Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act.................................................................. 30 Code of Ethics .................................................................................. Item 10. Executive Compensation........................................................................... 30 Item 11. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.................................................................. 30 Item 12. Certain Relationships and Related Transactions................................................... 30 Item 13. Exhibits ........................................................................................ 30 Item 14. Principal Accountant Fees and Services........................................................... 38 Signatures ........................................................................................ 39 Index to Financial Statements Reports of Independent Registered Public Accounting Firm...................................................... F-1 Consolidated Balance Sheets at December 31, 2005 and 2004..................................................... F-2 Consolidated Statements of Operations for the two years ended December 31, 2005 and 2004...................... F-3 Consolidated Statements of Cash Flows for the two years ended December 31, 2005 and 2004...................... F-4 Consolidated Statement of Stockholder's Equity (Deficit) for the two years ended December 31, 2005 and 2004... F-5 Notes to Consolidated Financial Statements.................................................................... F-7
PART I Item 1. Description of Business Overview Molecular Diagnostics, Inc. ("MDI" or the "Company") is a biomolecular diagnostics company engaged in the design, development and commercialization of cost-effective screening systems to assist in the early detection of cancer. MDI is currently focused on the design and development of a fully-automated, objective analysis and diagnostic system for cervical cancer screening that can be used at the point of service. MDI was incorporated in Delaware in December 1998 as the successor to Bell National Corporation, a company incorporated in California in 1958. In December 1998, Bell National, which was then a shell corporation without any business activity, acquired InPath, LLC, a development stage company engaged in the design and development of products used in screening for cervical and other types of cancer. For accounting purposes, the acquisition was treated as if InPath had acquired Bell National. However, Bell National continued as the legal entity and the registrant for Securities and Exchange Commission filing purposes. Bell National merged into Ampersand Medical Corporation ("Ampersand"), its wholly-owned subsidiary, in May 1999 in order to change the state of incorporation of the company to Delaware. In September 2001, we acquired 100% of the outstanding stock of AccuMed International, Inc. ("AccuMed") by means of a merger of AccuMed into our wholly-owned subsidiary. Shortly after the AccuMed merger we changed our corporate name to Molecular Diagnostics, Inc. The name change was effected by the merger of our wholly-owned subsidiary, Molecular Diagnostics, Inc., with and into Ampersand. Except where the context otherwise requires, "MDI," the "Company," "we" and "our" refers to Molecular Diagnostics, Inc. and our subsidiaries and predecessors. MDI is currently focused on the design, development and marketing of its InPath(TM) System and related image analysis systems. The component products of the InPath System are intended to screen for, at the earliest possible stage, cancer and cancer-related diseases and may be used in a laboratory, clinic or doctor's office. We have designed and manufactured the AcCell(TM) computer-aided automated microscopy instrument and the AcCell Savant(TM), an instrument that includes an AcCell instrument and software and which collects quantitative cellular information used in support of a diagnostic process. These instruments have been sold to laboratories and medical diagnostic companies for use in the customers' proprietary applications, although based on a settlement entered into with MonoGen, Inc. in 2004, we have transferred certain patents and intellectual property rights for the AcCell instrument to MonoGen. MDI also entered into a settlement agreement with Dr. Bruce Patterson and Invirion, Inc. over the validity of a certain technology license. MDI agreed to the termination and return of the license to Dr. Patterson and Invirion. The Company now is focused on marketing a new, fully-integrated workstation - the Automated Image Proteomic System or "AIPS(TM)" - based on updated technology. We expect that the new platform will be marketed through a distribution partner and, in certain instances, will be placed in a customers' facility on a fee-for-use basis. Nearly all of our reported revenue to date has been from single customer slide review, the sale of AcCell products and services and from discontinued operations. Recent Developments Strategic Partner Agreement On January 27, 2006, the Company entered into a research license agreement with University Hospitals of Cleveland (UHC). Under the professional guidance of Dr. George Gorodeski, UHC will perform core research for gynecological disorders including cervical dysplasia and cervical cancer, enabling us to access and utilize world-class scientists, clinicians and facilities. See "Products - Drug Delivery System" below for a more complete description. 1 Satisfaction of Delinquent Tax Liabilities MDI was delinquent in paying a portion of its federal and state employee and employer payroll taxes for the fourth quarter of fiscal 2005 tax liabilities remain unpaid. MDI is also delinquent in filing certain federal and state income tax returns for 2004, 2003 and 2002 and is working to complete and file the returns. The delinquent federal and state income tax returns for 2001 were filed in March 2005. Short-term Liquidity Problems During the first quarter of fiscal 2006, MDI continued to experience severe liquidity problems and had insufficient cash on hand to effectively manage its business. During such period, the Company raised $907,500 from the issuance of common stock to accredited investors. MDI has continued to raise operating cash pursuant to the issuance of additional shares of restricted common stock, and our management is in the process of negotiating additional financing. Insurance Due to MDI's liquidity problems, the Company was unable to pay insurance premiums for policies covering Directors and Officers Liability, Public Liability and Property Damage. These policies were all cancelled retroactive to October 29, 2002. MDI was issued a Directors and Officers Liability coverage in 2004 for the policy year July 2004 through July 2005. MDI subsequently issued a Directors and Officers Liability coverage for 2005 for the policy year September 2005 through September 2006. Information About Industry Segments We operate in one industry segment involving medical screening devices, diagnostics, and supplies. All of our operations during the reporting period were conducted and managed within this segment, with a single management team that reports directly to our Chairman and Chief Executive Officer. Description of Business MDI is a biomolecular diagnostics company engaged in the design, development and commercialization of cost-effective screening systems to assist in the early detection of cancer. MDI is currently focused on the design, development and marketing of its InPath System and related image analysis systems. The InPath System and related products are intended to detect cancer and cancer-related diseases, and may be used in a laboratory, clinic or doctor's office. The science of medical diagnostics has advanced significantly during the past decade. Much of this advance has come as a result of new knowledge of the human genome and related proteins, which form the foundation of cell biology and the functioning of the human body. Our goal is to utilize this research as a base to develop screening and diagnostic testing products for cancer and cancer-related diseases. We believe that the success of these products will improve patient care through more accurate test performance, wider product availability and more cost-effective service delivery. We have developed an FDA-approved sample collection device, and are developing chemical and biological tests and analysis instruments and related software. Our strategy is to develop products through internal development processes, strategic partnerships, licenses and acquisitions of companies. This strategy has required and will continue to require significant additional capital. As a result, we will incur substantial operating losses until we are able to successfully market some, or all, of our products. Products The InPath(TM) System 2 We are currently developing and testing a family of products for use in cancer screening and diagnosis. We call this family of products the InPath System. The core of the InPath System is a combination of protein antibodies- the Cocktail-CVX(TM) and Cocktail-GCI(TM) - that allow the system to detect and highlight abnormal cervical cells in a rapid and objective fashion. In the future, we intend to use different antibody combinations to detect and diagnose different types of cancer and other cancer-related diseases. The initial application of the InPath System is designed to enhance the current cervical cancer screening process performed in laboratories, commonly referred to as the Pap test. Our ultimate goal is to perform this screening test in less time, possibly at the point of service, either in a doctor's office, clinic or mobile medical vehicle. The InPath System includes the following components: o MDI's FDA-approved unique sample collection device, referred to as the e(2) Collector(TM), consisting of a small disposable balloon, shaped to fit the cervix. The device is intended to replace the spatula and brush currently used to collect patient cytology samples. o The Cocktail-CVX(TM) and Cocktail-GCI(TM), are fully-automated biochemical assays that get applied to a sample to identify abnormal cells. o In the laboratory version of the InPath System slide-based test, this biochemical assay is applied to sample cells released from a collection device into a liquid preservative and deposited on a glass slide. o An instrument that performs an automated analysis of a sample by means of an optical scan that detects the presence of multiple wavelengths of fluorescent light. This light is produced by fluorescent reporter tags, which are attached to certain components used in the Cocktail-CVX(TM) and Cocktail-GCI(TM) biochemical assays. o In the laboratory version of the InPath System, our new fully-integrated workstation - the Automated Image Proteomic System or "AIPS" workstation - uses a camera to read the various wavelengths of light from the sample. o Custom-designed image analysis software that controls the automated instruments and analyzes the captured wavelengths of light. Automated Microscopy Instruments AcCell(TM) In November 2001, Ventana Medical Systems, Inc. ("Ventana") agreed to purchase and distribute AcCell instruments with their image analysis software. The AcCell product is a computer-aided automated microscopy instrument designed to help medical specialists examine and diagnose specimens of human cells. During 2002, we agreed that Ventana would assume responsibility for manufacturing the AcCell 2500 instruments directly, rather than purchasing them from us. MDI subsequently elected not to develop the 2500 model and, in November 2003, MDI and Ventana entered into a settlement agreement providing for a non-exclusive, royalty-free license from MDI to Ventana to the source code for the AcCell 2500 for Ventana's internal use or in the creation of executable code for its customers. In addition, as part of the settlement, MDI agreed to provide two workstations valued at $49,500 and issued a promissory note for approximately $63,000 in return for forgiveness of approximately $375,000 of advances against future sales. As of December 31, 2005, MDI still owes Ventana approximately $21,000 on the promissory note. In October 2004, MDI agreed to settle an arbitration proceeding instituted by MonoGen, Inc. ("MonoGen") against the Company through the transfer to MonoGen of certain patents, patent applications and other intellectual property rights relating to the AcCell technology as well as inventory and a unsecured installment note for $305,000. MonoGen granted MDI a non-exclusive license agreement for the use of the patent rights and technology as they relate to cervical and ovarian cancer in exchange for a three percent royalty on all gross sales of licensed products. 3 AIPS(TM) MDI has elected to proceed with the development of its new, fully-integrated AIPS workstation. This product may be delivered with a variety of features including: o Robotic slide-feeding systems to load and unload multiple cassettes and slides to the image system; o Bar code readers to ensure proper identification of samples being analyzed; o Unique image analysis software; o Electro-mechanical scanning stages to facilitate accurate slide screening; o Automated cellular focusing on slides; and o Data management software to facilitate primary or secondary review of samples and report results into record-keeping systems. This workstation is a key tool of our research process, clinical trials, and the InPath System laboratory-based test. Drug Delivery System The Drug Delivery System is comprised of an applicator handle and drug-delivery modality in the form of a patch that provides a timed release of a therapeutic agent directly to the surface of the cervix. The applicator handle is a further development of MDI's e(2) Collector(TM) handle, which has been designed to quickly, safely and accurately position and deposit the patch on the cervix. In November 2004, the Company entered into a strategic alliance agreement with the biotechnology division of a Fortune 500 healthcare company. The alliance calls for the manufacture and distribution of MDI's AIPS workstation. In addition, the two companies will collaborate and develop proprietary antibodies to be used in the MDI proteomic cell-based assay systems, the first of which is the CVX cervical screening system. Under terms of the five-year agreement, MDI's strategic alliance partner will manufacture the MDI-designed AIPS hardware and then distribute these systems through its international sales organization. The terms of the agreement provide an exclusive right to market and distribute the AIPS system into the histology and immunohistochemistry markets and a co-exclusive right to market the products into markets other than MDI's exclusive market of cytology. The complementary image analysis software, running on the AIPS platform, was developed by MDI for the CVX system. MDI plans to sell and market these instruments exclusively into the cytology market to potential customers, original equipment manufacturer laboratories and into the diagnostics marketplace. The AIPS platform is currently a development stage product with design requirements complete and the prototype and software development in process. In January 2006, the Company entered into a research license agreement with University Hospitals of Cleveland ("UHC"). Under the professional guidance of Dr. George Gorodeski, UHC will perform core research for gynecological disorders including cervical dysplasia and cervical cancer, enabling MDI to access and utilize world-class scientists, clinicians and facilities. This research license agreement provides MDI with significant strategic advantages, such as: o Positioning MDI to grow from a cyto-screening focused company to a cyto-diagnostic company o Positioning MDI to develop commercial products based on a new biomarker that detects both cervical and endometrial cancers 4 o Granting MDI rights to commercialize a unique drug delivery system to apply FDA approved drugs to existing cervical lesions o Leveraging MDI technology previously developed for the e(2) Collector(TM) handle o When combined with MDI's existing Cocktail-CVX(TM) assay, initial results indicate the new biomarker significantly improves the accuracy of cervical cancer screening o Additional applications may develop in other types of epithelial cancers and could become the basis for diagnostic testing rather than screen testing o Providing physicians with a non-surgical therapeutic treatment option for cervical lesions Markets and Distribution We do not plan to develop and train a large direct sales force to distribute and sell the InPath System. Our initial strategy is to market the laboratory version of the InPath System to participants in the principal market for the system - namely, major laboratory organizations in the United States. Once the InPath System has been successfully established in the laboratory market, our strategy is to form alliances with these laboratories and other medical products distribution companies and utilize their sales forces to broaden sales of the InPath System to other markets, including hospitals, clinics, managed care organizations and office-based physician groups. The cost of the Pap test outside of the United States varies widely from country to country. Outside of the United States, most healthcare services are provided by governmental organizations. Healthcare in many of these countries is managed by governmental agencies, often at the local level, making the precise number of tests performed difficult to validate. In developing countries where healthcare, especially cancer screening, may be minimal, non-profit organizations often supplement government health programs. We intend to distribute the InPath System worldwide pursuant to any statutory regulatory approvals we receive. Government Regulation, Clinical Studies and Regulatory Strategy The development, manufacture, sale, and distribution of some of our products is regulated by the U.S. Food and Drug Administration and comparable authorities in certain states and foreign countries. In the United States, the Food, Drug and Cosmetic Act (the "FD&C Act") and related regulations apply to some of our products. These products cannot be shipped in interstate commerce without prior authorization from the FDA. Medical devices may be authorized by the FDA for marketing in the United States either pursuant to a pre-market notification under Section 510(k) of the FD&C Act, commonly referred to as a "510(k) notification," or a pre-market approval application or "PMA". The process of obtaining FDA marketing clearance and approval from other applicable regulatory authorities is costly and there can be no guarantee that the process will be successful. The 510(k) notifications and PMAs typically require preliminary internal studies, field studies, and/or clinical trials, in addition to the submission of other design and manufacturing documentation. We manage the regulatory process through the use of consultants and clinical research organizations. A 510(k) notification, among other things, requires an applicant to show that its products are "substantially equivalent" in terms of safety and effectiveness to an existing FDA-cleared predicate product. An applicant may only market a product submitted through a 510(k) notification after the FDA has issued a written notification determining the product has been found to be substantially equivalent. The Company's e(2) Collector was approved for marketing by the FDA on May 31, 2002 under the 510(k) notification process. 5 To obtain PMA approval for a device, an applicant must demonstrate, independent of other similar devices, that the device in question is safe and effective for its intended uses. A PMA must be supported by extensive data, including pre-clinical and clinical trial data, as well as extensive literature and design and manufacturing documentation to prove the safety and effectiveness of the device. The PMA process is substantially longer than the 510(k) notification process. During the review period, the FDA may conduct in-depth reviews of our clinical trial center documentation and our manufacturing facilities and processes or those of our strategic partners. In addition, the FDA may request additional information and clarifications and convene a medical advisory panel to assist in its determination. The FD&C Act generally bars advertising, promoting, or other marketing of medical devices that the FDA has not approved or cleared. Moreover, FDA enforcement policy strictly prohibits the promotion of known or approved medical devices for non-approved or "off-label" uses. In addition, the FDA may withdraw product clearances or approvals for failure to comply with regulatory standards. Our prospective foreign operations are also subject to government regulation, which varies from country to country. Many countries, directly or indirectly through reimbursement limitations, control the price of most healthcare products. Developing countries put restrictions on the importation of finished products, which may delay such importation. European directives establish the requirements for medical devices in the European Union. The specific directives are the Medical Device Directive (MDD 93/42/EEC) and the In-Vitro Diagnostics Device Directive (IVDD/98/79/EEC). The International Organization for Standardization ("ISO") establishes standards for compliance with these directives, particularly for quality system requirements. The FDA has adopted regulations governing the design and manufacture of medical devices that are, for the most part, harmonized with the good manufacturing practices and ISO quality system standards for medical devices. The FDA's adoption of the ISO's approach to regulation and other changes to the manner in which the FDA regulates medical devices will increase the cost of compliance with those regulations. We will also be subject to certain registration, record-keeping and medical device reporting requirements of the FDA. Our manufacturing facilities, or those of our strategic partners, will be obligated to follow the FDA's Quality System Regulation and be subject to periodic FDA inspections. Any failure to comply with the FDA's Quality System Regulation or any other FDA or other government regulations could have a material adverse effect on our future operations. The Cocktail-CVX, as part of the InPath System, will need to be cleared for marketing under a PMA by the FDA, as described above, prior to its sale and use in the U.S. clinical market. We cannot be sure whether or when the FDA will clear this or other components of the InPath System or the system itself. Internationally, the InPath System may be subject to various government regulations, which may delay the introduction of new products and services and adversely affect our business. The InPath System also may be subject to regulation in the United States under the Clinical Laboratory Improvement Act ("CLIA"). CLIA establishes quality standards for laboratories conducting testing to ensure the accuracy, reliability and timeliness of patient test results, regardless of where the test is performed. The requirements for laboratories vary depending on the complexity of the tests performed. Thus, the more complicated the test, the more stringent the requirement. Tests are categorized as high complexity, moderate complexity (including the category of provider-performed microscopy) and waived tests. CLIA specifies quality standards for laboratory proficiency testing, patient test management, quality control, personnel qualifications and quality assurance, as applicable. The FDA is responsible for the categorization of commercially-marketed laboratory tests. The Centers for Disease Control is responsible for categorization of laboratory procedures such as provider-performed microscopy. For commercially-marketed tests, the FDA now determines the appropriate complexity category as it reviews pre-market submissions for clinical laboratory devices. Manufacturers are asked to include an extra copy of the package insert identified as "FOR CLIA CLASSIFICATION" in the submission for product commercialization (i.e., 510(k) or PMA). Manufacturers are notified of the assigned complexity through routine FDA correspondence (that is, as an enclosure with a clearance or approval letter or as a separate letter in response to other submissions). Categorization is effective as of the date of the written notification to the manufacturer. 6 We are developing the InPath System to be user-friendly, require minimum operator training, and have safety and operating checks built into the functionality of the instruments. We believe that our efforts may result in receiving the lowest possible classification for the InPath System. If, however, these products are classified into a higher category, it may have a significant impact on our ability to market the products in the United States. We plan to resume conducting clinical studies and trials on our InPath System during its development. These studies and trials vary in terms of number of patient samples, individual product components, specific processes and conditions, purpose, and other factors, which may affect the results. We have publicly reported the results of some of the studies of the InPath System and Cocktail-CVX at various medical meetings, in publications and in public announcements. Such studies demonstrate the system's capability to detect cervical cellular abnormalities. The sensitivity factor, the test's performance in detecting versus missing actual diseases, commonly called false negatives, is critical in terms of patient health. In each of the reported studies and trials, the InPath System demonstrated superior sensitivity in detecting high-grade cervical disease and cancer. In addition, the results demonstrate that the InPath System produces more accurate results than the current PAP test. A statistical analysis conducted in 2000 on the PAP test, which reviewed the results of 94 previous studies, showed an average sensitivity of 74% and an average specificity of 68%. In a presentation of early results of the clinical trial of the InPath System's e2 Collector, data showed that the cytology reports on samples collected with the e(2) Collector were at least as accurate as those collected with the conventional brush/spatula method. The collector also proved to be more comfortable for the patient, provided less blood and mucus, and required only one device to collect both endocervical and ectocervical cells. The results of the additional clinical tests were submitted in January 2002 and we received FDA clearance to market the collector on May 31, 2002. We believe the results of these studies support the continued development of the InPath System. We moved ahead with additional studies and clinical trials in late 2001 and others began in 2002. Due to capital limitations we were forced to suspend all of our ongoing studies during the last half of 2002. During 2004 and 2005, MDI continued to refine and optimize the Cocktail-CVX and develop the AIPS platform. We plan to begin the final phase of our clinical studies for the InPath System during the first half of 2007 and we hope to complete this last phase during the second half of 2007, contingent on our securing adequate financing for our operations. At the conclusion of the studies, the data will be submitted to the FDA as a PMA and will form the basis of our substantiation of the clinical and economic value of the InPath System. The product may also be offered for sale as an Analyte Specific Reagent ("ASR"), which is defined as the specific ingredient required for a laboratory to create its own screening test, in the United States and for full-scale commercial and clinical use in selected international markets, where import and regulatory approvals allow. We are not permitted to market non-ASR products in the United States with clinical or diagnostic claims until we have received clearance from the FDA. ASR tests make no medical claims but may be used by laboratories that are qualified to perform highly complex tests, and physicians as components of ASR procedures. In other countries, we may need regulatory and importation approval; however, such approvals are generally based on the data submitted to the FDA. We are pursuing regulatory approval of the InPath System products through a series of submissions and, in some cases, using data from a single clinical study. This tiered approach is designed to accelerate revenue opportunities for the InPath System in the short term and to drive adoption of our innovative products over the long term, while minimizing the expense and time involved in undertaking the appropriate study. The first stage of the overall strategy involved the submission of our e(2) Collector for approval as a substantially equivalent device to the brush and spatula method of gathering samples used in the current Pap tests. The 510(k) notification was completed and filed in late September 2001. Additional data was furnished to the FDA in the first quarter of 2002 and subsequent to that submission we received approval to market the collector in the United States. MDI must now initiate the full-scale manufacturing process through contract manufacturing, and intends to introduce the e(2) Collector into the commercial market in the fourth quarter 2006. 7 The second stage of our overall strategy involves the continuing study of the InPath System and Cocktail-CVX and Cocktail-GCI, as described above. This research will determine whether the InPath System is a means to eliminate true negative samples from further review. We anticipate completion of this portion of the study and submission of the data to the FDA during 2008, contingent on our securing adequate financing for our operations. We will also submit the data to foreign regulatory authorities that have jurisdiction over these products. Subsequently, we will continue to collect and submit data for the InPath System point of service test. If the submissions for the various InPath System products are cleared by the FDA for sale in the U.S. market or approved for sale by foreign regulatory agencies, we intend to sell the cleared products in their respective clinical markets. InPath System Product Introduction Timelines
Product Process Timeline ------- ------- -------- e(2) Collector............. Clinical trials Completed Regulatory submission & review September 2001 Regulatory clearance received May 2002 Sales (1) Q4 2006 Cocktail-CVX & GCI......... Clinical trials (1) Q2-4 2007 Regulatory submission & review (1) Q1 2008 Regulatory clearance projected (1) Q1 2008 U.S. sales (1) Q1 2008 International sales (1) Q1 2008 AIPS ...................... Product development & pre production mfg (1) Q4 2006 Sales (1) Q1 2007 Drug Delivery System....... Clinical Trials (1) Q3-4 2007 Regulatory submission & review (1) Q1 2008 Regulatory clearance (1) Q2 2008 Sales (1) Q3 2008
(1) All of the above target dates are contingent on our securing adequate funding by June 30, 2006. We currently distribute automated microscopy instruments into commercial markets that do not require regulatory clearance. In order to distribute products not yet approved by the FDA for use in certain clinical applications, we will be required to conduct clinical trials and to make submissions to applicable regulatory agencies for clearance. We do not have any current plans to make any submissions to the FDA or foreign regulatory agencies covering these products. In the future, some of our customers may include these products in submissions to the FDA or foreign regulatory agencies covering their use in a customer's proprietary diagnostic or clinical process. Competition Historically, competition in the healthcare industry has been characterized by the search for technological innovations and efforts to market such innovations. The cost of healthcare delivery has always been a significant factor in markets outside of the United States. In recent years, the U.S. market has also become much more cost conscious. We believe technological innovations incorporated into certain of our products offer cost-effective benefits that address this particular market opportunity. 8 Competitors may introduce new products that compete with ours, or those which we are developing. We believe the portion of our research and development efforts devoted to continued refinement and cost reduction of our products will permit us to remain or become competitive in the markets in which we presently distribute or intend to distribute our products. The market for our cancer screening and diagnostic product line is significant, but highly competitive. We are unaware of any other company that is duplicating our efforts to develop a fully-automated, objective analysis and diagnostic system for cervical cancer screening that can be used at the point of service. Our competition includes many companies with financial, marketing, and research and development resources substantially greater than ours. There can be no assurance that our technological innovations will provide us with a competitive advantage. There are several U.S. and foreign companies that produce automated and quantitative microscopy instruments. In the past, the market for these instruments has been primarily limited to research applications. However, as a result of recent advances in the area of molecular diagnostics, we believe the market for such instruments and applications will increase over the next several years. We believe our instruments are the most versatile cost-effective platforms available in the current market whether as an outright purchase or a fee-for-use application. In general, we believe that our products must compete primarily on the basis of accuracy, functionality, product features and effectiveness of the product in standard medical applications. We also believe that cost control and cost effectiveness are additional key factors in achieving or maintaining a competitive advantage. We focus a significant amount of product development effort on producing systems and tests that will not add to overall healthcare cost. Specifically, there are several companies whose technologies are similar, adjunctive to, or may overlap with that of MDI. These include Cytyc Corporation, Tripath Imaging Inc., Diamics, Inc., Digene Corporation, Ventana Medical Systems, Inc., Clarient, Inc., and Applied Imaging Corp. However, we do not believe any of these companies have developed the fully-integrated solution necessary to deliver a fully-automated, proteomic-based solution. To develop fully-automated solutions, companies must have technologies that fully integrate microscopy instruments, imaging software and cancer-detecting biochemistry. Operations We conduct research and development work for the InPath System using a combination of our full-time and part-time employees and contract workers in our Chicago, Illinois laboratory. We do not intend to invest capital to develop our own distribution and sales organizations, or construct and maintain a medical-products manufacturing facility and all its related quality systems requirements. Our strategy is to utilize the operations, quality systems and facilities of a contract manufacturer specializing in medical products manufacturing to meet our current and future needs in the United States and international markets. This strategy covers manufacturing requirements related to the InPath System's chemical components, plastic and silicone parts for the e(2) Collector, InPath System instruments and the AIPS instruments. To this end, we are negotiating agreements, including design and development work, with manufacturers of medical-grade components to supply the silicone balloon and other components of the sample collection device. We are negotiating additional agreements with manufacturers to supply much higher volumes that will be needed once we begin to sell the sample collection device. These manufacturers have the capacity to handle high volume production through facilities in both the United States and several foreign countries. We currently have a sufficient supply of workstation platforms. The computers, cameras, automated slide staining equipment and slide preparation equipment, which make up the remainder of the laboratory version of the InPath System, are available from several manufacturers. These instruments are used in a sequential process. The platform on which the actual sample screening is done is computer-controlled by our proprietary software. As previously discussed, MDI currently has a strategic alliance agreement with a biotechnology division of a Fortune 500 healthcare company and the agreement calls for the manufacture and distribution of MDI's AIPS platform. 9 Intellectual Property We rely on a combination of patents, licenses, trade names, trademarks, know-how, proprietary technology and policies and procedures to protect our intellectual property. We consider such security and protection a very important aspect of the successful development and marketing of our products in the U.S. and foreign markets. In the United States, we follow the practice of filing a provisional patent application for each invention as soon as it has been determined that the invention meets the minimum standards for patentability. While a provisional patent application does not provide any formal rights or protections, it does establish an official priority date for the invention that carries over to any utility patent applications that are derived from the provisional application within the next 12 months. A utility patent application begins the process that can culminate in the issuance of a U.S. patent. We convert each outstanding provisional patent application into some number of utility patent applications within this 12-month period. In most cases each provisional application results in one utility filing. However, in some cases a single provisional application has generated two independent utility filings, or multiple (up to five) provisional applications have been consolidated into a single utility application. During the examination of a utility application, the U.S. Patent and Trademark Office may require us to divide the application into two or more separate applications or we may file a continuation-in-part patent application that expands upon the technology claimed in another patent application and which has the potential of superseding the earlier application. For these reasons, estimating the number of patents that are likely to be issued based upon the numbers of provisional and utility applications filed is difficult. Prior to filing a utility application in the United States, we review the application to determine whether obtaining patent coverage for the invention outside of the United States is necessary or desirable to support our business model. If so, a patent application is filed under the Patent Cooperation Treaty ("PCT") at the same time that the U.S. filing is made. Depending upon the nature of the invention and business considerations, we typically specify the patent offices in three to six countries to which the PCT application is to be submitted after the initial examination is completed. As of March 2006, we had filed five U.S. utility patent applications. Three of the U.S. utility applications have been issued as U.S. patents. Two U.S. and five foreign patent applications are filed and pending. In order to reduce the expenses related to patent prosecution, we are currently treating these applications as inactive and taking only those actions needed to keep them in effect. This group of patents and patent applications covers all aspects of the InPath System including, but not limited to, the point of service instrument, the personal and physicians' collectors, and the slide-based test. As a result of the acquisition of AccuMed, we acquired 33 issued U.S. patents, one U.S. patent application, and nine foreign patents, of which a combined total of 17 were transferred to a third party under a license agreement. Twenty-four additional foreign patent applications primarily covering the AcCell and AcCell Savant technology and related software were also acquired. We also held an exclusive license from Invirion, Inc. and Dr. Bruce Patterson covering a patent and certain medical technology for detection of certain genes in cancer-causing types of Human Papilloma Virus ("HPV") virus. We purchased the license for cash, future royalties, and other considerations. Pursuant to a settlement agreement entered into with Dr. Patterson and Invirion in the fourth quarter of 2004, however, the Company agreed to the termination of such license and related agreements, the transfer and assignment back to Invirion of such patent and medical technology and all of MDI's right, title and interest therein and intellectual property rights associated therewith, and to cease the development or sale of any such technology. We intend to prepare additional patent applications for processes and inventions arising from our research and development process. The protections provided by a patent are determined by the claims that are allowed by the patent office that is processing the application. During the patent prosecution process it is not unusual for the claims made in the initial application to be modified or deleted or for new claims to be added to the application. For this reason, it is not possible to know the exact extent of protection provided by a patent until it issues. Patent applications filed prior to November 29, 2000 in the United States are maintained in secrecy until any resulting patent is issued. As there have been examples of U.S. patent applications that have remained "in prosecution" and, therefore, secret for decades, it is not possible to know with certainty that any U.S. patent that we may own, file for or have issued to us will not be pre-empted or impaired by patents filed before ours and that subsequently are issued to others. Utility patent applications filed in the United States after November 29, 2000 are published 18 months after the earliest applicable filing date. As this revised standard takes full effect, the chances that such a "submarine" patent will impair our intellectual property portfolio are significantly reduced. Foreign patent applications are automatically published 18 months after filing. As the time required to prosecute a foreign utility patent application generally exceeds 18 months and the foreign patents use a "first to file" rather than a "first to invent" standard, we do not consider submarine patents to be a significant consideration in our patent protection outside of the United States. 10 Our products are or may be sold worldwide under trademarks that we consider to be important to our business. We own the trade names of "InPath," "e(2) Collector," and "Cocktail-CVX." We may file additional U.S. and foreign trademark applications in the future. Our future technology acquisition efforts will be focused toward those technologies that have strong patent or trade secret protection. We cannot be sure that patents or trademarks issued or which may be issued in the future will provide us with any significant competitive advantages. We cannot be sure any of our patent applications will be granted or that validity or enforceability will not be successfully challenged. The cost of any patent-related litigation could be substantial even if we were to prevail. In addition, we cannot be sure that someone will not independently develop similar technologies or products, duplicate our technology or design around the patented aspects of our products. The protection provided by patents depends upon a variety of factors, which may severely limit the value of the patent protection, particularly in foreign countries. We intend to protect much of our core technology as trade secrets, either because patent protection is not possible or, in our opinion, would be less effective than maintaining secrecy. However, we cannot be sure that our efforts to maintain secrecy will be successful or that third parties will not be able to develop the technology independently. Research and Development Our research and development efforts are focused on introducing new products as well as enhancing our existing product line. We utilize both in-house and contracted research and development efforts. We believe research and development is critical to the success of our business strategy. During the years 2005 and 2004, our research and development expenditures were approximately ($100,000) and $834,000, respectively, all of which were borne by MDI. The design and validation of the laboratory version of the InPath System, including image analysis software, is currently in process. We examined samples from patients with normal and abnormal (those with cancer or its precursors) pathology reports in our studies. Our research work in the area of chemical and biological components will continue for the foreseeable future as we seek to refine the current process and add additional capabilities to our analysis procedure, including the detection of other forms of cancer and precursors to cancer. We have established a relationship with a strategic alliance partner and have developed the next generation automated microscopy instrument platform known as the Automated Image Proteomic System or AIPS. The design requirements are complete and the prototypes and software development are in process. We anticipate the need to invest a substantial amount of capital in the research and development process, including the cost of clinical trials, required to complete the development and use of the InPath System and bring it to market. Components and Raw Materials Low-cost products are a key component of our business strategy. We designed the e(2) Collector sample collection device using widely available and inexpensive silicone and plastic materials. These materials are available from numerous sources and can be fabricated into finished devices by a variety of worldwide manufacturers based on our proprietary designs. The instrument components of the laboratory version of the InPath System are also available from a number of sources. Computers, cameras, automated slide-staining instruments and automated slide-preparation instruments are currently available from several large manufacturers. We currently have an adequate supply of workstations used in the InPath System and have contracted for the design and manufacture of the next generation of the workstation platform. 11 Working Capital Practices During the fiscal year ended December 31, 2005, we did not sell any InPath System products. During 2005 and 2004, we sold several AcCell instrument platforms and billed and received fees under an AcCell fee-for-use contract. Based on certain settlement agreements, we have given up all our rights to sell the AcCell instrument platforms. MDI has instead elected to proceed with the development of its new fully-integrated AIPS workstation, and with our strategic alliance partner we intend to distribute this new platform. We have financed our U.S. operations and research and development by raising funds through the sale of debt or equity securities. We will continue to use these methods to fund our operations until such time as we are able to generate adequate revenues and profits from the sale of some or all of our products. We believe that future sales of the InPath System or other products into foreign markets may result in collection periods that may be longer than those expected for domestic sales of these products. Our strategy will be to use letters of credit or other secured forms of payment, whenever possible, in sales of products in foreign markets. Employees As of March 31, 2006, we employed a total of one full-time employee and five part-time employees supplemented by additional consultants in the United States. The staff reductions from prior years were undertaken in order to conserve our limited operating funds. Financial Information About Foreign and Domestic Operations and Export Sales Markets outside of North America are an important factor in our business strategy. Any business that operates on a worldwide basis and conducts its business in one or more local currencies is subject to the risk of fluctuations in the value of those currencies against the dollar. Such businesses are also subject to changing political climates, differences in culture and the local practices of doing business, as well as North American and foreign government actions such as export and import rules, tariffs, duties, embargoes and trade sanctions. We do not regard these risks, however, as a significant deterrent to our strategy to introduce our InPath System to foreign markets in the future. As we begin to market and sell our InPath System, we will closely review our foreign operational practices. We will attempt to adopt strategies to minimize risks of changing economic and political conditions within foreign countries. During the fiscal year ended December 31, 2005, the Company did not have any foreign operations and was not conducting any foreign sales of its products. Risk Factors The risks described below are not the only ones we face. Additional risks are described elsewhere in this report under the Recent Developments and Legal Proceedings sections, among others. There may also be risks not presently known to us or that we currently deem immaterial that may also impair our business operations. Our business, financial condition or results of operations could be materially and adversely affected by any of these risks, and the trading price of our common stock could decline. There is a limited market for "penny stocks" such as our common stock. Our common stock is considered a "penny stock" because, among other things, our price is below $5 per share, it trades on the Over-the-Counter Bulletin Board and we have net tangible assets of less than $2,000,000. As a result, there may be little or no coverage by security analysts, the trading price may be lower, and it may be more difficult for our stockholders to dispose of, or to obtain accurate quotations as to the market value of, the common stock. Being a penny stock also could limit the liquidity of our common stock. The historically volatile market price of our common stock may affect the value of our stockholders' investments. 12 The market price of our common stock, like that of many other medical products and biotechnology companies, has in the past been highly volatile. This volatility is likely to continue for the foreseeable future. Factors affecting potential volatility include: o general economic and other external market factors; o announcements of mergers, acquisitions, licenses and strategic agreements; o announcements of private or public sales of securities; o announcements of new products or technology by us or our competitors; o ability to finance our operations; o fluctuations in operating results; and o announcements of the FDA relating to products. Our common stock is unlikely to produce dividend income for the foreseeable future. We have never paid a cash dividend on our common stock and we do not anticipate paying cash dividends for the foreseeable future; our ability to declare dividends on our common stock is further limited by the terms of certain of the Company's other securities, including several series of its preferred stock. We intend to reinvest any funds that might otherwise be available for the payment of dividends in further development of our business. Our common stock is subject to dilution, and an investor's ownership interest and related value may decline. We are authorized to issue up to 10,000,000 shares of preferred stock. As of December 31, 2005, we had 82,655 shares of Series A convertible preferred stock outstanding, which convert into approximately 36,102 shares of our common stock; 365,106 shares of Series B convertible preferred stock outstanding, which convert into approximately 1,460,424 shares of our common stock; 245,833 shares of Series C convertible preferred stock outstanding, which convert into approximately 1,229,165 shares of our common stock; 175,000 shares of Series D convertible preferred stock outstanding, which convert into approximately 1,750,000 shares of our common stock; and 233,598 shares of Series E convertible preferred stock outstanding, which convert into approximately 6,423,938 shares of our common stock. There are cumulative dividends due on the Series B, Series C, Series D, and Series E convertible preferred stock, which may be paid in kind in shares of our common stock. Our Certificate of Incorporation (as amended to date) gives our board of directors authority to issue the remaining undesignated shares of preferred stock with such voting rights, if any, designations, rights, preferences and limitations as the Board may determine. At December 31, 2005, we had outstanding warrants to purchase an aggregate 32,558,111 shares of our common stock, outstanding options to purchase approximately 4,003,991 shares of our common stock, and 450,000 stock appreciation rights, which are convertible into approximately 289,286 shares of common stock. At December 31, 2005, outstanding convertible promissory notes were convertible into approximately 22,735,000 shares of our common stock. Under the provisions of certain outstanding convertible promissory notes, the holders have the right to receive a warrant to purchase additional shares of common stock upon exercise of the conversion right. We are unable to determine the exact number of additional warrants to purchase shares of our common stock that will be issuable upon conversion of the notes, although it could be approximately 5,684,000 shares. At December 31, 2005, we had approximately 15,123,000 shares of our common stock reserved for future stock options under our 1999 Equity Incentive Plan and 160,000 shares of our common stock reserved for future sale to employees under our 1999 Employee Stock Purchase Plan. The issuance of shares of our common stock upon the conversion of our preferred stock or notes, or upon exercise of outstanding options and warrants, would cause dilution of existing stockholders' percentage ownership of the Company. Holders of our common stock do not have preemptive rights, meaning that current stockholders do not have the right to purchase any new shares in order to maintain their proportionate ownership in the Company. Such stock issuances and the resulting dilution could also adversely affect the price of our common stock. 13 We have a limited operating history and there are doubts as to our being a going concern. We have a limited operating history. Our revenues, from inception in March 1998 through 2003, were derived almost entirely from sales by Samba Technologies SARL ("Samba"), our former wholly-owned subsidiary. The assets of Samba were sold in December 2003 as part of the French Commercial Court ordered liquidation and MDI lost all rights and title to the assets, including Samba's software. MDI has sold only a very limited amount of our InPath System products to date and cannot be certain as to when sales of the Company's products might occur in the future. We expect to devote substantial resources to product development. We anticipate that we will continue to incur significant losses unless and until some or all of our products have been successfully introduced, if ever, into the marketplace. We have incurred substantial losses and have limited financial resources. Consequently, our independent auditors have noted that these conditions raise substantial doubt as to our ability to continue as a going concern. Our financial statements do not include any adjustments relating to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that may result from the outcome of this uncertainty. Moreover, the going concern explanatory paragraph may make obtaining additional financing more difficult or costly. We continue to have severe liquidity problems. We have a history of losses and continue to experience severe liquidity problems, which affect our overall ability to operate our business, including the ability to employ adequate staff and conduct ongoing studies and clinical trials of our products. Failure to raise adequate financing to meet our business needs could materially jeopardize MDI and its ability to conduct business. There can be no assurance that we will be able to secure necessary funds. We may not be able to meet our short-term capital requirements. We believe that our existing capital resources are not sufficient to meet the short-term requirements of the Company. These short-term requirements include a significant amount of liabilities and promissory notes in arrears. It is unlikely that we will be able to meet our short-term funding requirements through the sale of our products and services. We anticipate that these short-term funding needs will require the sale or issuance of additional shares of common stock or instruments convertible into common stock. Such sales or issuances, if any, would have a dilutive effect on the holdings of our stockholders and the value of our common stock. We cannot be certain what level of dilution, if any, may occur or if we will be able to complete any such sales of common stock or other securities in the future. Our operating business plan for 2005 anticipated that we would need to raise new equity. We were not able to raise the necessary level of new equity and had to reduce our operations significantly during the year. The lack of sufficient new equity continued through the first quarter of 2006. A failure to raise sufficient additional funds would adversely affect our ability to meet our short-term capital requirements, resume our clinical tests and meet our product timelines, and/or continue as a going concern. We may not be able to meet our long-term capital requirements. We do not know if we will be able to sustain our long-term operations through future revenues. Whether we will need to raise additional funds to support our long-term operations is influenced by many factors, including the costs, timing and success of efforts to develop products and market acceptance of our products. Our products are subject to government regulation and they may not receive necessary government approvals. 14 The sale and use of our products in the United States is regulated by the FDA. We must meet significant FDA requirements before we receive clearance to market our products. Included in these FDA requirements is the conduct of lengthy and expensive clinical trials to prove the safety and efficacy of the products. Until we complete such clinical trials, our products may be used only for research purposes or to provide supplemental diagnostic information in the United States. We have FDA approval for one of our products, the e(2) Collector. We plan to start clinical trials for the Cocktail-CVX and Cocktail GCI in 2007 (although such trials are contingent on the receipt of adequate capital). We cannot be certain that our product development plans will allow these additional trials to commence or be completed according to plan or that the results of these trials, or any future trials, when submitted to the FDA along with other information, will result in FDA clearance to market our products in the United States. Sales of medical devices and diagnostic tests outside the United States are subject to foreign regulatory requirements that vary from country to country. The time required to obtain regulatory clearance in a foreign country may be longer or shorter than that required for FDA marketing clearance. Export sales of certain devices that have not received FDA marketing clearance may be subject to regulations and permits, which may restrict our ability to export the products to foreign markets. If we are unable to obtain FDA clearance for our products, we may need to seek foreign manufacturing agreements to be able to produce and deliver our products to foreign markets. We cannot be certain that we will be able to secure such foreign manufacturing agreements on acceptable terms, if at all. We may not be able to compete with companies that are larger and have more resources. We compete in the medical device and diagnostics marketplace with companies that are much larger and have greater financial resources than the Company. We may not succeed in developing technologies and products that are more effective than those being developed by our competitors. Our technologies and products may be rendered obsolete or noncompetitive as a result of products introduced by our competitors. Most of our competitors have substantially greater financial and technical resources, production and marketing capabilities, and related experience, which may enable them to develop, manufacture and market their products more successfully and at a lower cost. In addition, many of our competitors have significantly greater experience in conducting preclinical testing and clinical trials of products and obtaining regulatory approvals to market such products. Accordingly, our competitors may succeed in obtaining FDA approval for products more rapidly, which may give them an advantage in achieving market acceptance of their products. We may not be able to market our products. We do not intend to maintain a direct sales force to market and sell our products. Therefore, in order to successfully market and sell our products, we must be able to negotiate profitable marketing and sales agreements with organizations that have direct sales forces calling on domestic and foreign market participants that may use our products. If we are not able to successfully negotiate such agreements, we may be forced to market our products through our own sales force. We cannot be certain that we will be successful in developing and training such a sales force, should one be required, or that we will have the financial resources to carry out such development and training. We may not be able to adequately protect our intellectual property. We hold a variety of patents and trademarks and have applied for a significant number of additional patents and trademarks with the U.S. Patent and Trademark Office and foreign patent authorities. We intend to file additional patent and trademark applications as dictated by our research and development projects and business interests. We cannot be certain that any of the currently pending patent or trademark applications, or any of those which may be filed in the future, will be granted or that they will provide any meaningful protection for our products or technologies. We protect much of our core technology as trade secrets because our management believes that patent protection would not be possible or would be less effective than maintaining secrecy. We cannot be certain that we will be able to maintain secrecy or that a third-party will not be able to develop technology independently. 15 The cost of litigation to uphold the validity of a patent or patent application, prevent infringement or protect trade secrets can be substantial, even if we are successful. Furthermore, we cannot be certain that others will not develop similar technology independently or design around the patent aspects of our products. Management turnover could cause our business to suffer. MDI has experienced significant turnover in its senior management in the past and there can be no assurance that we will be able to attract and retain key personnel. Item 2. Description of Property We occupy approximately 2,540 square feet of leased space at 414 N. Orleans St., Suites 502 and 503, Chicago, Illinois 60610, under a five-year lease that expires in October 2008. This space houses our executive offices, research laboratory, and engineering development facilities. We consider our facilities to be well utilized, well maintained, and in good operating condition. Further, we consider the facilities to be suitable for their intended purposes and to have capacities adequate to meet current and projected needs for our operations. MDI does not have any policies regarding investing in real estate, and has not had in the past and does not expect in the future to invest in real estate. Item 3. Legal Proceedings Settled in 2005 The Cleveland Clinic Foundation. In March 2003, The Cleveland Clinic Foundation filed suit against MDI (U.S. District Court for the Northern District of Ohio, Eastern Division (Case No. 1:03CV056)) seeking approximately $315,000 for certain clinical trial work conducted by the Foundation in the Peoples Republic of China on behalf of MDI. In June 2005, the parties executed a settlement agreement and in September 2005, MDI made final payment of $85,000 in full satisfaction of the settlement agreement and requested that the Foundation take all steps necessary to file a satisfaction of judgment. MDI has no further monetary obligations under this settlement. Daniel Kussworm, Jennifer Kawaguchi, and Susan Keesee. In February 2004, former MDI employees Daniel Kussworm, Jennifer Kawaguchi, and Susan Keesee filed suit against MDI and former Chairman Peter Gombrich, in the Circuit Court of Cook County, Illinois (04 L 1941) to recover wages and other compensation allegedly due them. These claims were settled and fully satisfied in January 2005, and the lawsuit has been dismissed. Ungaretti & Harris. In May 2004, the law firm Ungaretti & Harris LLP filed an amended complaint against MDI in the Circuit Court of Cook County, Illinois (04 L 1101), to collect fees for services rendered prior to December 31, 2003. In January 2005, the court entered summary judgment in favor of Ungaretti & Harris and against MDI in the amount of $195,500, plus costs of suit. The parties subsequently entered into a settlement agreement to satisfy the judgment. MDI has one final payment to make in June of 2006. The Lash Group, Inc. In June 2004, The Lash Group, Inc., a healthcare consulting firm, filed a lawsuit against the Company in the General Court of Justice, Superior Court Division, in Mecklenburg County, North Carolina (04 CVS 10367). The Lash Group sought approximately $94,000, plus interest, attorney fees, and court costs, for the alleged breach of an agreement, with respect to which Peter Gombrich, our former Chairman and Chief Executive Officer, and MDI were sought to be held primarily liable. In October 2005, MDI entered into a settlement agreement with The Lash Group, which required The Lash Group to file a voluntary dismissal with prejudice of the lawsuit. In March 2006, MDI made its final payment in full satisfaction of the settlement agreement. MDI has no further monetary obligations under this settlement. Eric Gombrich. In May 2004, former MDI officer Eric Gombrich filed suit against MDI, Denis M. O'Donnell, M.D., Peter Gombrich, Dennis Bergquist, and Michael Brodeur (some of whom are no longer officers or directors of the Company) in the Circuit Court of Cook County, Illinois (04 L 05661). Mr. Gombrich claimed that MDI breached a written employment contract and that it owed him $631,258 (plus interest) and 300,000 shares of MDI stock. In October 2005, MDI entered into a settlement agreement with Mr. Gombrich pursuant to which MDI agreed to pay Mr. Gombrich an aggregate $116,000 in three scheduled payments and issue him a warrant to purchase 300,000 shares of the Company's common stock at an exercise price of $.10 per share exercisable until July 31, 2009. The parties also agreed to a release and covenant not to sue for any and all claims arising out of Mr. Gombrich's employment. Pursuant to the settlement, the case against all defendants was dismissed in November 2005. MDI has made the three scheduled payments and has no further monetary obligations under this settlement. 16 Kanan, Corbin, Schupak & Aronow, Inc. In August 2004, Kanan, Corbin, Schupak & Aronow, Inc. ("KCSA") filed suit against AccuMed International, Inc. f/d/b/a Molecular Diagnostics, Inc., in the Circuit Court of Cook County, Illinois (04 L 9109), seeking $59,678, plus interest and court costs, for services provided. The parties agreed to a settlement in 2005, which was paid in full. MDI has no further monetary obligation under this settlement. Reid Jilek. In October 2004, Reid Jilek filed a lawsuit against MDI in the Circuit Court of Cook County, Illinois (04 CH 17375). Mr. Jilek claimed that MDI had breached a 2003 services agreement and that MDI subsequently breached a 2004 settlement agreement. Mr. Jilek sought $180,000 pursuant to the services agreement or, alternatively, $114,000 pursuant to the settlement agreement. Mr. Jilek also sought a court order that MDI issue him 1,500,000 warrants to purchase MDI stock at $0.17 per share pursuant to the services agreement. MDI previously issued to Mr. Jilek warrants to purchase 500,000 shares of its common stock at $0.17 per share. MDI entered into a settlement agreement with Mr. Jilek in December 2005 pursuant to which MDI paid Mr. Jilek $15,000 for attorney fees, issued him warrants to purchase 1,000,000 shares at $.04 per share (in exchange for the cancellation of the previously issued warrants to purchase 500,000 shares) and has agreed to pay Mr. Jilek $5,000 each month for the next 30 months. The first four payments have been made as scheduled. Esoterix, Inc. Esoterix, Inc. made a claim against MDI for $19,725 arising from a laboratory services agreement that it maintained MDI breached. In March 2005, Esoterix filed suit against MDI to collect this claim in the Circuit Court of Cook County, Illinois (05 M1 116482). MDI entered into a settlement agreement with Esoterix in October 2005 pursuant to which MDI agreed to pay Esoterix $13,000 in full satisfaction of its claims. The case was dismissed following payment in October 2005. The parties also agreed to a mutual release of all claims. Pending as of December 31, 2005 and Settled in 2006 Arthur Lipper III. In July 2004, Arthur Lipper III filed a lawsuit against MDI in the Circuit Court of Cook County, Illinois (04 L 7671). Mr. Lipper claims that MDI breached a consulting services agreement and sought $60,000, plus interest and court costs. MDI entered into a settlement agreement with Mr. Lipper in February of 2006 pursuant to which MDI has agreed to pay Mr. Lipper $60,000 in full satisfaction of his claims. Under the agreement, MDI's payments to Mr. Lipper will conclude in April of 2006. The lawsuit has been dismissed. Diamics LLC. In October 2005, the Company filed suit against Diamics LLC and related parties in the U.S. District Court, Northern District of California (C05-4282). Diamics was formed by Peter Gombrich, MDI's former Chairman of the Board and CEO. MDI alleged that Mr. Gombrich and a former employee misappropriated MDI's proprietary information, trade secrets and patented products, and the suit charged Diamics with misappropriation of trade secrets, unfair business practices, conversion, and patent and copyright infringement. MDI's suit against Diamics was in part a response to a suit filed by Diamics against MDI in June 2005 in the U.S. District Court, Northern District of California (C05-02549). The complaint in that suit sought declaratory judgment of no misappropriation, conversion, libel or unjust enrichment, and requested that the court enter judgment as follows: declaration that Diamics has not directly or indirectly misappropriated MDI's trade secrets, confidential and proprietary intellectual property, reputation, or goodwill; declaration that Diamics has not converted MDI's confidential and proprietary intellectual property; declaration that Diamics has not been unjustly enriched; and for an order enjoining MDI and its officers, agents, servants, and employees from asserting that Diamics or its employees engaged in the above mentioned conduct. These cases were settled and MDI has no further monetary obligations under the settlement. Pending as of December 31, 2005 and March 31, 2006 17 Hill & Barlow LLP. In February 2003, Hill & Barlow LLP, a now defunct law firm, filed a complaint against MDI in the Trial Court of the Commonwealth of Massachusetts (000740), seeking the collection of unpaid legal fees. Judgment was entered against MDI in the amount of $16,842, plus costs and interest. In April 2004, the parties entered into a settlement agreement. The terms of settlement have not been fully satisfied by the parties because a dispute has arisen concerning the return of MDI's files. Given that the law firm has dissolved, management does not expect a final resolution of this matter. Medical College of Georgia Research Institute, Inc. In November 2003, the Medical College of Georgia Research Institute, Inc. filed suit against MDI in the Superior Court of Richmond County, Georgia (Case No. 2003-RCCV-1211) to collect amounts allegedly due pursuant to an agreement to provide a clinical study for MDI. Georgia Research Institute claimed that the principal amount of the obligation due from MDI was approximately $86,700, but sought to collect approximately $315,300 pursuant to an interest provision of 10% per month. In October 2004, the court entered summary judgment in favor of Georgia Research Institute and against MDI in the amount of $68,404. The Regents of the University of California. In May 2004, The Regents of the University of California filed suit against MDI in the Superior Court of California, County of San Francisco (CGC-04-431944). The University of California claims that MDI breached an agreement to sponsor a research project for a period of one year. The complaint seeks compensatory damages in the amount of $57,530 and additional lost opportunity damages in the amount of $75,220. In January 2005, the University of California requested that the court enter a default judgment against MDI in the amount of $132,827, which includes court costs. The parties have been involved in settlement negotiations with respect to this matter. Peter Gombrich. In April 2005, former MDI officer Peter Gombrich filed suit against MDI and MDI's former Chief Executive Officer Denis M. O'Donnell, M.D. in the Circuit Court of Cook County, Illinois (05 L 4543). Mr. Gombrich claims that MDI breached a written employment contract and that it owes him in excess of $849,500 (plus interest and attorneys' fees). Mr. Gombrich also alleged a claim against MDI for contribution and indemnification regarding agreements he allegedly signed as a personal guarantor for certain alleged MDI obligations. MDI filed a motion to compel the case to arbitration, consistent with Mr. Gombrich's employment agreement. This motion was granted in August 2005. In late 2005, MDI filed its answer and affirmative defenses, and has asserted numerous counterclaims against Mr. Gombrich. The hearing on the parties' counterclaims is currently proceeding before the arbitrator. Miscellaneous Other Creditors; Wage and Related Claims. MDI is a defendant in a few lawsuits brought by current or former unsecured creditors to collect past due amounts for goods and services. MDI has recorded the amounts due in its records and is attempting to settle these suits and unfiled claims. MDI is also currently negotiating the settlement of wage claims brought by a former employee and a former consultant seeking to collect for unpaid wages and severance benefits. MDI has recorded the amounts due in its records and is attempting to settle these claims. MDI does not consider any of these claims to be material. The Lumber Company (formerly Garrett Realty, Inc.). Prior to MDI's acquisition of AccuMed, Garrett Realty, Inc. filed suit against AccuMed for unpaid rent and related expenses under a lease for office space located in Chicago, Illinois (Circuit Court of Cook County, Illinois (Case No. 01 M1 725821)). In July 2002, judgment was entered in favor of Garrett in the amount of approximately $157,000. In December 2002, pursuant to a court order, Garrett seized approximately $12,500 from an MDI bank account as a partial payment against the judgment amount. MDI recorded a $290,000 lease obligation in accounting for the AccuMed merger based on the present value of the future payments, but contested the right of Garrett to pursue collection of the judgment against the assets of MDI. During the first quarter of 2004, MDI reached a preliminary settlement on the outstanding judgment amounting to approximately $157,000 (plus interest) at that time, which required six monthly payments. In 2004, MDI made the first four required monthly payments. MDI also agreed to issue shares of its common stock as part of the final settlement. In March 2005, Garrett assigned its right, title and interest in the judgment to The Lumber Company (the "Lumber Co."). In March 2006, MDI and Lumber Co. entered into a formal settlement agreement under the same general terms reflected above. In connection with that March 2006 agreement, MDI paid to Lumber Co. $27,449. MDI also issued to Lumber Co. 823,466 shares of MDI common stock. Final payment was made in April 2006. MDI has no further monetary obligations under this settlement. 18 Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted to a vote of stockholders during the fourth quarter of 2005. PART II Item 5. Market for Common Equity and Related Stockholder Matters Market Information Our common stock is quoted on the Over-the-Counter Bulletin Board under the symbol "MCDG.OB." The following table lists the high and low bid information for our common stock for the periods indicated, as reported on the Over-the-Counter Bulletin Board. These quotations reflect inter-dealer prices, and may not include retail mark-ups, mark-downs, or commissions, and may not reflect actual transactions. Range of Common Stock ----- High Low ---- --- Year Ended December 31, 2005 1st Quarter........................................ $ 0.12 $ 0.07 2nd Quarter........................................ $ 0.07 $ 0.05 3rd Quarter........................................ $ 0.16 $ 0.02 4th Quarter........................................ $ 0.10 $ 0.04 Year Ended December 31, 2004 1st Quarter........................................ $ 0.37 $ 0.11 2nd Quarter........................................ $ 0.26 $ 0.10 3rd Quarter........................................ $ 0.16 $ 0.09 4th Quarter........................................ $ 0.12 $ 0.05 Holders As of March 31, 2006, we had approximately 1,413 record holders of our shares of common stock. This number does not include other persons who may hold only a beneficial interest, and not an interest of record, in our common stock. Dividends We have not paid a cash dividend on shares of our common stock, and the Board of Directors is not contemplating paying dividends at any time in the foreseeable future. The terms of certain of the Company's securities, including its Series B, C, D and E preferred stock, provide that so long as such security is outstanding the Company shall not declare any dividends on its common stock (or any other stock junior to such security) except for dividends payable in shares of stock of the Company of any class junior to such security, or redeem or purchase or permit any subsidiary to purchase any shares of common stock or such junior stock, or make any distributions of cash or property among the holders of the common stock or any junior stock by the reduction of capital stock or otherwise, if any dividends on the security are then in arrears. We paid non-cash dividends, in the form of newly issued shares of our common stock, amounting to $20,000 and $1,325,000 during 2005 and 2004, respectively, to holders of shares of our preferred stock who elected to convert their preferred stock and cumulative dividends thereon into shares of our common stock. We have a contingent obligation to pay cumulative dividends on various series of our convertible preferred stock in the aggregate amount of approximately $3,819,000, which we intend to pay through the issuance of shares of our common stock, if and when the holders of the preferred shares elect to convert their shares into common stock. Cumulative and deemed dividends for the various series of convertible preferred stock were approximately $4,453,000 at December 31, 2005, including $634,000 in deemed dividends arising as a result of beneficial conversion features on Series B and Series C convertible preferred stock sold during 2001. 19 Stock Transfer Agent Our stock transfer agent is LaSalle Bank NA, 135 South LaSalle Street, Chicago, IL 60603, and its telephone number is (312) 904-2000. Securities Authorized for Issuance under Equity Compensation Plans The following table presents information about the equity compensation plans of the Company as of fiscal-year end December 31, 2005. See also Note 8 - Stockholders' Equity and Note 11 - Equity Incentive Plan and Employee Stock Purchase Plan in the Notes to our Consolidated Financial Statements for further information. 20 Equity Compensation Plan Information
Number of securities Plan category Number of securities remaining available for to be issued upon Weighted-average future issuance under equity exercise of exercise price of compensation plans outstanding options, outstanding options, (excluding securities warrants and rights warrants, and rights reflected in column (a)) Equity Compensation Plans Approved by Security (a) (b) (c) Holders 1999 Equity Incentive Plan (as amended) - 20,000,000 shares 4,003,992 $0.4029 15,123,342 1999 Employee Stock Purchase Plan - 200,000 shares -- -- 160,415 Equity Compensation Plans Not Approved by Security Holders Warrants issued with debt (1) 10,119,945 $ 0.2987 0 Warrants issued for financial services (2) 8,117,817 $ 0.3026 0 Warrants issued for IR services (3) 980,000 $ 0.4745 0 Warrants issued of other services (4) 1,076,493 $ 0.0887 0 Warrants issued for asset acquisitions (5) 172,120 $ 0.8200 0 Warrants from AccuMed acquisition (6) 39,834 $15.0600 0 Warrants issued in settlement of debt (7) 7,003,984 $ 0.2902 0 --------------------- -------------------- ---------------------------- Total 31,514,185 $ 0.3309 10,426,577 ===================== ==================== ============================
1) MDI has and will most likely continue to attach warrants to issuances of debt as an additional consideration to debt holders in lieu of payment of higher interest rates that likely would be required based on market interest rates prevalent at the time of the debt issuance and the significant level of risk involved based on the financial condition of MDI. 2) MDI has and will most likely continue to issue warrants to financial advisors who assist with the placement of MDI's debt or equity instruments. The issuance of warrants to these advisors significantly reduces the cash costs that would otherwise be associated with raising capital. 3) MDI has generally included warrants in compensation agreements for providers of investor relations and/or public relations services. This practice significantly reduces the cash costs to MDI to obtain these services. 4) From time to time, MDI has issued warrants to providers of legal and consulting services in lieu of cash payments for those services. 5) During 2001, MDI issued warrants under an agreement to acquire a thirty percent interest in Cell Solutions, LLC, a company assisting in the development of MDI's products. 6) In September 2001, MDI completed the acquisition of AccuMed by merging it into a wholly-owned subsidiary of MDI. As a result, MDI assumed stock options and warrants outstanding on the records of AccuMed at the time of the acquisition. The remainder of the options that were assumed in the acquisition are included in total options outstanding under the Company's 1999 Equity Incentive Plan. 7) During 2004, MDI issued warrants in the settlement of outstanding accounts payable vendor amounts. 21 Recent Sales of Unregistered Securities; Use of Proceeds from Registered Securities Issuance of Securities Common Stock. During fiscal 2005, MDI offered common stock to accredited investors in exchange for cash. In the first quarter of fiscal 2005, the Company received net aggregate proceeds of $505,000 and issued an aggregate 9,608,334 shares of restricted common stock. In the second quarter of fiscal 2005, the Company received net aggregate proceeds of $96,000 and issued an aggregate 2,250,000 shares of restricted common stock. In the third quarter of fiscal 2005, the Company received net aggregate proceeds of $580,000 from accredited investors in exchange for 29,660,000 unregistered subscribed shares of common stock at $0.025 per share. In the fourth quarter of fiscal 2005, the Company received net aggregate proceeds of $302,000 from accredited investors in exchange for 12,850,496 unregistered subscribed shares of common stock at $0.025 per share. Warrants. Beginning in December 2004 and ending in June 2005, MDI offered common stock to accredited investors in exchange for cash. As part of the offering, MDI granted each investor a warrant to purchase common stock at an exercise price of $0.10 per share, with the first $250,000 of investment to receive 50% warrant coverage and subsequent investments in excess of $250,000 to receive 25% coverage. In February 2005, MDI issued warrants to purchase 200,000 shares of common stock with an exercise price of $0.06 per share to a non-employee financial consultant for past financial services. MDI valued the warrants at $16,260 using the Black-Scholes valuation model and recorded this as an administrative expense for the first quarter of fiscal 2005. In February 2005, MDI issued warrants to purchase an aggregate 6,500,000 shares of common stock of the Company with an exercise price of $0.30 per share to Azimuth Corporation and Cadmus Corporation in exchange for such warrant holders' agreement to cancel certain other warrants containing anti-dilution provisions unfavorable to the Company. MDI valued the warrants at $420,551 using the Black-Scholes valuation model and recorded the amount as an administrative expense in the first quarter ended March 31, 2005. In May 2005, MDI issued warrants to purchase 556,500 shares of common stock with an exercise price of $0.06 per share to a non-employee financial consultant for past financial services. MDI valued the warrants at $25,265 using the Black-Scholes valuation model and recorded the amount to additional paid-in-capital - warrants for the second quarter of fiscal 2005. In general, each of the above warrants expires five years from the date of issuance and is exercisable immediately upon issuance. None of the warrants are subject to any vesting schedules or conditions other than those imposed by applicable securities laws. The exercise price and number of shares issuable upon exercise of the warrants are subject to anti-dilution protection in the event the Company effects a subdivision or combination of its common stock or declares or pays a dividend or distribution in common stock; the warrants also provide for adjustments in the event the Company declares or pays a dividend or other distribution in other securities or property of the Company or is a party to a reorganization, reclassification, merger or similar event. Conversions Bridge I. During the fiscal year ended December 31, 2005, holders of an aggregate $250,000 principal amount of Bridge I Convertible Promissory Notes elected to convert their notes and related accrued interest of approximately $51,000 into 2,008,962 shares of unregistered common stock of the Company. 22 Bridge III. During the fiscal year ended December 31, 2005, holders of an aggregate $1,360,000 principal amount of Bridge III Convertible Promissory Notes elected to convert their notes and related accrued interest of approximately $208,000 into 15,282,236 shares of unregistered common stock of the Company. Bridge IV. During the fiscal year ended December 31, 2005, holders of an aggregate $2,574,000 principal amount of Bridge IV Convertible Promissory Notes elected to convert their notes, consented to waive accrued interest of $332,000, and elected to convert related remaining accrued interest of approximately $47,000 into 25,605,000 shares of unregistered common stock of the Company. Preferred Stock. During the fiscal year ended December 31, 2005, a shareholder converted an aggregate 17,000 shares of Series C convertible preferred stock, including cumulative dividends due thereon, into 118,260 shares of unregistered common stock. Please refer to Note 6 - Notes Payable -Related Parties, Note 7 - Notes Payable and Note 8 - Stockholders' Equity in the Notes to our Consolidated Financial Statements for more information on the Bridge I, III and IV promissory notes and the Company's preferred stock. MDI issued such securities in reliance on the safe harbor and exemptions from registration provided under Rule 506 of Regulation D and/or Section 4(2) of the Securities Act of 1933, as amended. No advertising or general solicitation was employed in offering the securities. The offerings and sales or issuances were made to a limited number of persons, all of whom were accredited investors, and transfer was restricted by the Company in accordance with the requirements of applicable law. In addition to representations by the above-referenced persons, the Company has made independent determinations such that it reasonably believes that all of the investors were accredited or sophisticated investors, and that they were capable of analyzing the merits and risks of their investment, and that they understood the speculative nature of their investment. Furthermore, these investors were provided with access to MDI's filings with the Securities and Exchange Commission. Purchases of Equity Securities by the Small Business Issuer and Affiliated Purchasers During the fourth quarter of fiscal 2005, neither the Company nor any affiliated purchaser of the Company purchased equity securities of MDI. Item 6. Management's Discussion and Analysis or Plan of Operation Forward-Looking Statements Certain statements contained in this discussion and analysis that are not related to historical results are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Statements that are predictive, that depend upon or refer to future events or conditions, or that include words such as "expects," "anticipates," "intends," "plans," "believes," "estimates," "hopes," or similar expressions constitute forward-looking statements. In addition, any statements concerning future financial performance (including future revenues, earnings or growth rates), ongoing business strategies or prospects, or possible future actions by us are also forward-looking statements. These forward-looking statements are based on beliefs of our management as well as current expectations, projections and assumptions currently available to the Company and are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or those anticipated or implied by such forward-looking statements. These risks are described more fully under the caption "Risk Factors" herein and include our ability to raise capital; our ability to settle litigation; our ability to retain key employees; economic conditions; technological advances in the medical field; demand and market acceptance risks for new and existing products, technologies, and healthcare services; the impact of competitive products and pricing; manufacturing capacity; new plant start-ups; U.S. and international regulatory, trade, and tax policies; product development risks, including technological difficulties; ability to enforce patents; and foreseeable and unforeseeable foreign regulatory and commercialization factors. 23 Should one or more of such risks or uncertainties materialize or should underlying expectations, projections or assumptions prove incorrect, actual results may vary materially from those described. Those events and uncertainties are difficult to predict accurately and many are beyond our control. We believe that our expectations with regard to forward-looking statements are based upon reasonable assumptions within the bounds of our current business and operational knowledge, but we cannot be sure that our actual results or performance will conform to any future results or performance expressed or implied by any forward-looking statements. We assume no obligation to update these forward-looking statements to reflect events or circumstances that occur after the date of these statements except as specifically required by law. Accordingly, past results and trends should not be used to anticipate future results or trends. Overview Molecular Diagnostics, Inc., is a biomolecular diagnostics company engaged in the design, development and commercialization of cost-effective screening systems to assist in the early detection of cancer. MDI is currently focused on the design, development and marketing of its InPath(TM) System and related image analysis systems. The InPath System and related products are intended to detect cancer and cancer-related diseases, and may be used in a laboratory, clinic or doctor's office. The science of medical diagnostics has advanced significantly during the past decade. Much of this advance has come as a result of new knowledge of the human genome and related proteins, which form the foundation of cell biology and the human body. Our goal is to utilize this research as a base to develop screening and diagnostic testing products for cancer and cancer-related diseases. We believe that the success of these products will improve patient care through more accurate test performance, wider product availability and more cost-effective service delivery. We are developing a series of products to address these criteria including sample collection devices, chemical and biological tests, and analysis instruments and related software. Our strategy is to develop products through internal development processes, strategic partnerships, licenses and acquisitions of companies. This strategy has required and will continue to require significant additional capital. As a result, we will incur substantial operating losses until we are able to successfully market some, or all, of our products. The Company has incurred significant operating losses since its inception. The Company has raised approximately $37,000,000 since March 1998. Management expects that significant on-going operating expenditures will be necessary to successfully implement its business plan and to develop, manufacture and market its products. These circumstances raise substantial doubt about the Company's ability to continue as a going concern. Implementation of the Company's plans and its ability to continue as a going concern depend upon it securing substantial additional financing. During 2005 and 2004, MDI raised zero and $4,236,000, respectively, through the issuance of convertible debt. In addition, during 2005 and 2004 MDI raised approximately $1,483,000 and $810,000, respectively, through the issuance of common stock. From January 1, 2006 through March 31, 2006, MDI raised an additional $907,500 through the issuance of common stock. Management's plans include substantial efforts to obtain additional capital. If the Company is unable to obtain additional capital or generate profitable sales revenues, however, it may be required to curtail its product development and other activities and may be forced to cease operations. Critical Accounting Policies and Significant Judgments and Estimates Revenue Recognition. The Company recognizes revenue upon shipment of product and invoicing. Revenue from training services and professional services is recognized when the service is completed. Licenses, Patents, and Technology. Licenses, patents, and purchased technology are recorded at their acquisition cost. Costs to prepare patent filings are capitalized when incurred. Costs related to abandoned or denied patent applications are written off at the time of abandonment or denial. Amortization is begun as of the date of acquisition or upon the grant of the final patent. Costs are amortized over the asset's useful life, which can range from two to 17 years. The Company assesses licenses, patents, & technology periodically for impairment. 24 Stock Compensation. As permitted by the Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," MDI uses the intrinsic value method to account for stock options as set forth in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees Share-Based Payment. The "Share-Based Payment" Statement of Financial Accounting Standards No. 123(R) establishes accounting standards for transactions in which a company exchanges its equity instruments for goods or services. In particular, this Statement will require companies to record compensation expense for all share-based payments, such as employee stock options, at fair market value. This statement is effective as of the beginning of the first interim or annual reporting period that begins after December 15, 2005. Adoption of this financial statement is not expected to have a material impact on the Company's consolidated financial position or results of operations. Application of Black-Scholes Valuation Model. In applying the Black-Scholes valuation model, the Company has used an expected dividend yield of zero, a risk-free interest rate of 4.61% and 4.85% for the 2005 and 2004 periods, respectively, a volatility factor of 277% and 131%, respectively, and a fair value of the underlying common shares of closing market price on the date of the grant for both periods. The expected life equaled the term of the warrants, options, or restricted shares. For a more detailed discussion, see Note 2 - Summary of Significant Accounting Policies in the Notes to our Consolidated Financial Statements included herewith. Results of Operations Fiscal Year Ended December 31, 2005 as compared to Fiscal Year Ended December 31, 2004 Revenue Revenues of $117,000 for the fiscal year ended December 31, 2005 represented a decrease of $126,000, or 52%, over revenues of $243,000 in 2004. The 2005 revenue decrease was the result of decreases in the sales of AccuMed-related products and services. Based on a settlement with MonoGen at the end of fiscal 2004, MDI will no longer sell AccuMed and AcCell systems, but will sell its new fully integrated AIPS workstation through a distribution partner. Revenues of $243,000 for the fiscal year ended December 31, 2004 represented a decrease of $136,000, or 36%, over revenues of $379,000 for 2003. The 2004 revenue decrease was the result of decreases in the sales of AccuMed-related products and services. Based on a settlement with MonoGen at the end of fiscal 2004, MDI no longer sells AccuMed and AcCell systems, but sells its new fully integrated AIPS workstation through a distribution partner. Costs and Expenses Cost of Goods Sold Cost of goods sold for the fiscal year ended December 31, 2005 amounted to $21,000, a decrease of $3,000 or 13% over 2004 cost of goods sold of $24,000. The overall decrease was due to the reduction in the number of AcCell instruments sold and the receipt of royalty-related income only for the year based on the two AccuMed systems under a license agreement and this decrease was offset by a $21,000 charge to increase inventory reserve in 2005 based upon net realizable inventory value. Cost of goods sold for the fiscal year ended December 31, 2004 amounted to $24,000, a decrease of $119,000 or 83% over 2003 cost of goods sold of $143,000. The cost of goods sold amount for the fiscal year ended December 31, 2004 was related to the shipment of the two automated microscopy systems during the year. The overall decrease was due to the reduction in the number of AcCell instruments sold and the receipt of royalty-related income only for the year based on the two AccuMed systems under a license agreement. Research and Development 25 Research and development expenses consist of costs related to specific development programs with scientists and researchers at universities and hospitals; full scale device development contracts begun during 1999 with industrial design and manufacturing companies covering the disposable and instrument components of the InPath System; payments to medical and engineering consultants for advice related to the design and development of our products and their potential uses in the medical technology marketplace; and payroll-related costs for in-house engineering, scientific, laboratory, software development, and research management staff. In 2005, our research and development expenses were ($100,000), a decrease of $934,000, or 112% over 2004 research and development expenses of $834,000. Research and development expenses were negative, a gain, due to favorable legal settlement results. The decrease also was the result of the elimination in 2005 of preliminary preparation activities for the clinical trial process as a result of the reduction in Company funding during fiscal 2005. In 2004, our research and development expenses were $834,000, an increase of $254,000, or 44% over 2003. The increase was the result of preliminary preparation activities for the clinical trial process during 2004, which accounted for a $211,000 increase in trial costs and related payroll of $135,000. These increases were offset by a decrease in medical advisory consulting fees of $92,000. Selling, General and Administrative Significant components of selling, general and administrative expenses are compensation costs for executive, sales and administrative personnel; professional fees primarily related to legal and accounting services; travel costs; fees for public and/or investor relations services; insurance premiums; recruitment fees; marketing-related costs; and amortization and depreciation. Selling, general and administrative expenses totaled $1,346,000 for the twelve months ended December 31, 2005, a decrease of $2,763,000 or 67% over 2004 selling, general and administrative expenses of $4,109,000. The decrease primarily results from the reduction of funding during 2005 over 2004. The decrease includes reductions totaling $1,454,000 in financing costs, $957,000 in professional fees, and $579,000 in payroll expenses generated by the Company's overall expense reduction plan offset by an increase of $227,000 in other general and administrative costs. In 2004, selling, general and administrative expenses were $4,109,000, a decrease of $2,121,000 or 34% over the year ended December 31, 2003. The decrease included reductions amounting to $763,000 in financing costs, $269,000 in investor relations costs, $250,000 in depreciation and amortization and $300,000 in professional and other general and administrative costs generated by the Company's overall expense reduction plan. These reductions were offset by an increase in legal costs of $130,000 related to the negotiation and execution of various legal settlements the Company entered into during 2004 and $438,000 with respect to a legal judgment awarded to Monsun in a case against Mr. Gombrich with respect to his personal guaranty of a Company note. See also Restructuring Settlements reclassification detail below. In order to reduce our cash selling, general and administrative expenses, we may issue shares of our common stock (with restrictions attached) or grant options or warrants to purchase shares of our common stock, in lieu of compensation or payments for financial advisory work, including advice on deal structure, professional fees, investor relations and introductory services, and general financial and investment advice. If the services are completed, we record an expense based on the value of the services. If the services are to be completed over a future period of time, we are required to calculate a market value for the shares, options, or warrants at the end of each reporting period until the services are completed. Included in the above selling, general and administrative expense amounts for 2005 and 2004 are non-cash expenses of $58,000 and $1,455,000, respectively, related to the calculated cost of these share awards, options and warrants, charged to expense in each period. Other Income and Expense Interest Income We had no interest income during 2005 or 2004. 26 Interest Expense Interest expense, including interest expense to related parties, increased $1,164,000 for the fiscal year ended December 31, 2005 to $3,176,000, an increase of 58% over the same period of 2004. The increase resulted from an aggregate Bridge I, III, and IV beneficial conversion feature recognition. Bridge I, II, III, IV, and related party convertible promissory notes in principal amounts totaled $2,158,000 and $6,341,000 for the fiscal years ended December 31, 2005 and 2004, respectively. The decrease in convertible promissory notes principal amounts of $4,183,000 resulted from Bridge I, III and IV conversions in the third quarter of fiscal 2005. Interest expense, including interest expense to related parties, decreased $1,252,000 for the fiscal year ended December 31, 2004 to $2,003,000, a decrease of 39% over the same period of 2003. Bridge I, II, III, IV, and related party convertible promissory notes in principal amounts totaled $6,341,000 and $6,208,000 for the fiscal years ended December 31, 2004 and 2003, respectively. The change included an increase in interest expense of $228,000 related to the increase in the notes and a decrease of $1,423,000 related to the amortization of debt discount arising from the beneficial conversion feature of certain of the notes. The amortized debt discount amount decreased due to an increase in the duration of the new Bridge III and IV notes issued during the period ended December 31, 2004 in relation to the shorter maturity periods of the Bridge I and II notes issued during 2001 through 2003. Restructuring Settlements For the fiscal year ended December 31, 2005, MDI recorded $530,000 as a gain from the settlement of various litigation and vendor negotiations. The Company recorded and netted these gains concurrently in the respective original expense categories as instructed by the Securities and Exchange Commission. For the fiscal year ended December 31, 2004, MDI recorded $1,008,000 as a gain from the settlement of various litigation and credit payment matters. For the fiscal year ended December 31, 2004, the Company has reclassified the $1,008,000 gain comparable to fiscal 2005 in order to conform to the 2005 expense presentation. Loss on Litigation Settlements During 2005, no legal settlements involving intangible assets were recorded by the Company. During 2004, the Company was party to legal settlements involving intangible assets of the Company and as part of the agreement terms, recorded a loss as described in the following table:
Issuance of Promissory Note to MonoGen, Inc. $ 305,000 Inventory given in settlement to MonoGen, Inc. 57,000 Net book value of AccuMed intangible assets given in settlement to MonoGen 5,919,000 Net book value of HPV technology license agreement cancelled in settlement with Invirion, Inc. 569,000 ----------- Total Loss on Litigation Settlements $ 6,850,000 ===========
(See Note 13 - Legal Proceedings in the Notes to our Consolidated Financial Statements for a discussion of these cases and related settlement agreements.) Other Income and Expense, Net All gains or losses on sale of fixed assets were recorded and netted in general and administrative expenses. For fiscal 2005 and 2004, the loss on sale of fixed assets totaled $3,000 and the gain on sale of fixed assets totaled $100,000, respectively. For the twelve months ended December 31, 2005 and 2004, the Company recorded zero and $10,000 in Other Income, respectively, related to gain on foreign currency. 27 Net Loss The net loss for the fiscal year ended December 31, 2005 before preferred dividends totaled $4,326,000 compared with $13,567,000 for the same period in 2004, a decrease of $9,241,000 or 68%. The decrease resulted primarily from a reduction in general and administrative expenses in 2005 from 2004 and and the fact that there was a one-time write-off of approximately $6,850,000 in connection with legal settlements entered into by the Company in the fourth quarter of 2004. This charge consisted primarily of a non-cash write-off of intangible assets. In addition, cumulative dividends paid on the outstanding Series B, Series C, Series D and Series E convertible preferred stock totaled $20,000 for the fiscal year ended December 31, 2005, compared with $1,034,000 for the same period in 2004. The combined net loss applicable to common stockholders for the fiscal year ended December 31, 2005 was $4,346,000, or $0.04 per share, on 110,037,893 weighted average common shares outstanding, compared with the net loss and net loss available to common stockholders for the fiscal year ended December 31, 2004 of $14,601,000, or $0.19 per share, on 76,964,553 weighted average common shares outstanding. The weighted average shares outstanding during the fiscal year ended December 31, 2005 include shares issued or issuable for the conversion of Bridge I, Bridge III and Bridge IV convertible promissory notes. The Bridge I, III and IV note conversions resulted in the issuance of an additional 42,896,198 shares of common stock. Liquidity and Capital Resources The Company's capital resources and liquidity are generated primarily from external individual investors and institutional investors. The Company generates nominal liquidity resources from internal operations. Research and development, clinical trials and other studies of the components of our InPath System, conversions from designs and prototypes into product manufacturing, initial sales and marketing efforts, medical consultants and advisors, and research, administrative, and executive personnel are and will continue to be the principal basis for our cash requirements. We have provided operating funds for the business since its inception through private offerings of debt and equity securities to limited numbers of U.S. and foreign accredited investors. We will be required to make additional offerings in the future to support the operations of the business until some or all of our products are introduced into the market. We used $1,363,000 and $3,962,000 during 2005 and 2004, respectively, to fund our operating activities. We experienced severe liquidity problems during the fiscal year 2005 and the second half of 2004. As a result, we were forced to cut staff and reduce our operations to a minimum level. Officers refrained from drawing salaries during portions of the third and fourth quarters of 2004 and for much of 2005 in order to reduce demands on our limited cash position. We were able to raise funds under the Bridge III and Bridge IV convertible promissory notes as well as the sale of common stock during 2004 and 2005, although the proceeds of these note and common stock offerings were used to satisfy certain obligations coming due at those times as well as for the payment of a limited amount of current operational expenses. At December 31, 2005, we had $0 cash on hand, a decrease of $11,000 over cash on hand at December 31, 2004. This cash position results from our loss from operations and our inability to raise sufficient new capital due to very unfavorable conditions in financing markets, both public and private, for companies in general, and especially for small life sciences companies such as ours. We were unable to raise sufficient funds during the year to maintain adequate cash reserves and to meet the ongoing operational needs of the business. We incurred approximately $27,000 and $187,000 in capital expenditures for the years ended December 31, 2005 and 2004, respectively. Capital expenditures are defined as disbursements for laboratory equipment, leasehold improvements, software, and furniture/fixtures with a purchase price in excess of $1,000 per item and a useful life in excess of one year. The decrease in 2005 capital expenditures resulted from a decrease in design and tooling costs of approximately $159,000 related to the re-design of the e(2) Collector handle and new AIPS integrated workstation. To the extent available, we intend to use some proceeds from our financing in the fiscal year 2006 for completion of the e(2) Collector production molds, completion of the AIPS final design changes and additional laboratory equipment as necessary. 28 Our operations have been, and will continue to be, dependent upon management's ability to raise operating capital in the form of debt or equity. We have incurred significant operating losses since inception of the business. We expect that significant on-going operating expenditures will be necessary to successfully implement our business plan and develop, manufacture and market our products. These circumstances raise substantial doubt about our ability to continue as a going concern. There can be no assurance that we will be able to obtain additional capital to meet our current operating needs or to complete pending or contemplated licenses or acquisitions of technologies. If we are unable to raise sufficient adequate additional capital or generate profitable sales revenues, we may be forced to substantially curtail product research and development and other activities and may be forced to cease operations. Off-Balance Sheet Arrangements The Company does not have any off-balance sheet arrangements. Item 7. Financial Statements Our consolidated financial statements for the years ended December 31, 2005 and 2004, together with the report of Altschuler, Melvoin and Glasser LLP dated April 13, 2006 thereon and the notes thereto are filed as part of this Annual Report on Form 10-KSB commencing on page F-1 and are incorporated herein by reference. Item 8. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure Resignation of Auditors Effective immediately after rendering an audit opinion and an audit consent for the Company's 10-KSB for the fiscal year ended December 31, 2005, Altschuler, Melvoin and Glasser LLP will resign as the independent registered public accounting firm for the Company. The Company is currently interviewing other potential replacement independent registered public accounting firms. Item 8A. Controls and Procedures Evaluation of Disclosure Controls and Procedures The Company's chief executive officer and chief financial officer have reviewed and evaluated the effectiveness of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this annual report. Based on that review and evaluation, the chief executive officer and chief financial officer have concluded that the Company's current disclosure controls and procedures, as designed and implemented, are reasonably adequate to ensure that such officers are provided with information relating to the Company required to be disclosed in the reports the Company files or submits under the Exchange Act and that such information is recorded, processed, summarized and reported within the specified time periods. Changes in Internal Controls During the fourth fiscal quarter of 2005, there was no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Item 8B. Other Information None. 29 PART III Item 9. Directors, Executive Officers, Promoters and Control Persons; compliance with Section 16(a) of the Exchange Act The information required by this Item 9 is contained in the definitive Proxy Statement for the Company's 2006 Annual Meeting of Stockholders to be held on June 16, 2006 (the "2006 Proxy Statement") under the caption "Proposal No. 1 - Election of Directors" and is incorporated herein by reference. We expect to file the 2006 Proxy Statement within 120 days after the close of the fiscal year ended December 31, 2005. Code of Ethics The Company has adopted its Code of Ethics and Business Conduct for Officers, Directors and Employees that applies to all of the officers, directors and employees of the Company, including the Company's principal executive officer, principal financial officer, principal accounting officer or controller or persons performing similar functions. The Company filed its code as an exhibit to its Annual Report on Form 10-KSB for the fiscal year ended December 31, 2003 as filed with the Securities and Exchange Commission on April 14, 2004. Item 10. Executive Compensation The information required by this Item 10 is contained in the 2006 Proxy Statement under the captions "Compensation" and "Proposal No. 1 - Election of Directors" and is incorporated herein by reference. Item 11. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item 11 is contained in the 2006 Proxy Statement under the caption "Security Ownership of Certain Beneficial Owners and Management" and is incorporated herein by reference. See also the information included in Item 5 of this Form 10-KSB relating to the Company's equity compensation plans and Note 11 - Equity Incentive Plan and Employee Stock Purchase Plan in the Notes to our Consolidated Financial Statements. Item 12. Certain Relationships and Related Transactions The information required by this Item 12 is contained in the 2006 Proxy Statement under the caption "Certain Relationships and Related Transactions" and is incorporated herein by reference. Item 13. Exhibits (*) Denotes an exhibit filed herewith. (+) Denotes a management contract or compensatory plan, contract or arrangement. Exhibit No. Description 2.1 Stock and Membership Interest Exchange Agreement dated as of December 4, 1998 among Bell National Corporation, InPath, LLC and the InPath Members (as such term is defined therein). (Incorporated herein by reference to Appendix A to the Bell National Corporation Definitive Proxy Statement on Schedule 14A, filed on April 30,1999 (the "1999 Proxy Statement").) 30 Exhibit No. Description 2.2 Agreement and Plan of Merger of Bell National Corporation and Ampersand Medical Corporation. (Incorporated herein by reference to Appendix C to 1999 Proxy Statement.) 2.3 Agreement and Plan of Merger by and among AccuMed International, Inc., AccuMed Acquisition Corp. and Ampersand Medical Corporation, dated as of February 7, 2001, and Amendment No. 1 thereto. (Incorporated herein by reference to Appendix I to Registration Statement (as amended) on Form S-4, No. 333-61666, as filed on May 25, 2001 (the "May 2001 S-2").) 3.1 Certificate of Incorporation of Ampersand Medical Corporation, as amended. (Incorporated herein by reference to Appendix D to 1999 Proxy Statement.) 3.2 By-laws of Ampersand Medical Corporation. (Incorporated herein by reference to Appendix E to the 1999 Proxy Statement.) 3.3 Certificate of Designation, Preferences and Rights of Series A Convertible Preferred Stock of Ampersand Medical Corporation. (Incorporated herein by reference to Exhibit 3.5 to the Ampersand Medical Corporation Annual Report on Form 10-K (as amended) for the fiscal year ended December 31, 2000, as filed on March 29, 2001 (the "2000 10-K").) 3.4 Certificate of Designation, Preferences and Rights of Series B Convertible Preferred Stock of Ampersand Medical Corporation. (Incorporated herein by reference to Exhibit 3.6 to the 2000 10-K.) 3.5 Certificate of Incorporation of Molecular Diagnostics, Inc., as amended. (Incorporated herein by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K dated September 26, 2001.) 3.6 Section 6 of Article VII of the By-laws of Ampersand Medical Corporation, as amended. (Incorporated herein by reference to Exhibit 3.3 to the May 2001 S-2.) 3.7 Certificate of Designation, Preferences and Rights of Series C Convertible Preferred Stock of Molecular Diagnostics, Inc. (Incorporated herein by reference to Exhibit 3.4 to the Company's Registration Statement on Form S-2 (as amended), File No. 333-83578, as filed on February 28, 2002 (the "February 2002 S-2").) 3.8 Certificate of Amendment of Certificate of Designation, Preferences and Rights of Series C Convertible Preferred Stock. (Incorporated herein by reference to Exhibit 3.5 to the February 2002 S-2.) 3.9 Certificate of Amendment of Amended Certificate of Designation, Preferences and Rights of Series C Convertible Preferred Stock. (Incorporated herein by reference to Exhibit 3.6 to the February 2002 S-2.) 3.10 Certificate of Designations, Preferences and Rights of Series D Convertible Preferred Stock. (Incorporated herein by reference to Exhibit 3.7 to the February 2002 S-2.) 3.11 Certificate of Designation, Preferences and Rights of Series E Convertible Preferred Stock. (Incorporated herein by reference to Exhibit 3.8 to the February 2002 S-2.) 3.12 Certificate of Amendment to Certificate of Incorporation of the Company, dated August 5, 2004. (Incorporated herein by reference to Exhibit 3.1 to the Company's Form 10-QSB for the quarter ended June 30, 2004, as filed on August 16, 2004 (the "2004 2Q 10-QSB").) 31 Exhibit No. Description 4.1 Form of Common Stock Purchase Warrant, as executed by Bell National Corporation on December 4, 1998, with respect to each of Peter P. Gombrich, Theodore L. Koenig, William J. Ritger, Fred H. Pearson, Walter Herbst, AccuMed International, Inc., Northlea Partners Ltd., and Monroe Investments, Inc. (collectively, the "InPath Members"). (Incorporated herein by reference to Exhibit 3 of the Schedule 13D filed jointly by the InPath Members on December 14, 1998.) 4.2 Common Stock Purchase Warrant issued to Holleb & Coff on July 4, 1999 representing the right to purchase 250,000 shares of Common Stock of Ampersand Medical Corporation. (Incorporated herein by reference to Exhibit 4.3 to the Ampersand Medical Corporation Annual Report on Form 10-K for the fiscal year ended December 31, 1999, as filed on March 31, 2000 (the "1999 10-K").) 4.3 Common Stock Purchase Warrant dated August 17, 2001 in favor of Azimuth Corporation with an issue date of August 6, 2001, representing the right to purchase 250,000 shares of common stock of Ampersand Medical Corporation. (Incorporated herein by reference to Exhibit 4.24 to the Registration Statement on Form S-4 (as amended), File No. 333-61666, as filed on August 24, 2001 (the "August 2001 S-4").) 4.4 Common Stock Purchase Warrant issued to Cadmus Corporation on July 26, 2001 representing the right to purchase 250,000 shares of common stock of Ampersand Medical Corporation. (Incorporated herein by reference to Exhibit 4.23 to the August 2001 S-4.) 4.5 Common Stock Purchase Warrant dated August 17, 2001 in favor of Northlea Partners, Ltd. with an issue date of August 6, 2001, representing the right to purchase 62,500 shares of common stock of Ampersand Medical Corporation. (Incorporated herein by reference to Exhibit 4.27 to the August 2001 S-4.) 4.6 Common Stock Purchase Warrant dated August 17, 2001 in favor of Azimuth Corporation with an issue date of July 26, 2001, representing the right to purchase 500,000 shares of common stock of Ampersand Medical Corporation. (Incorporated herein by reference to Exhibit 4.25 to the August 2001 S-4.) 4.7 Common Stock Purchase Warrant issued to Azimuth Corporation on August 17, 2001 representing the right to purchase 25,000 shares of common stock of Ampersand Medical Corporation. (Incorporated herein by reference to Exhibit 4.26 to the August 2001 S-4.) 4.8 Common Stock Purchase Warrant issued to Tucker Anthony Incorporated on July 10, 2001 representing the right to purchase 150,000 shares of common stock of Ampersand Medical Corporation. (Incorporated herein by reference to Exhibit 4.25 to the February 2002 S-2). 4.9 Common Stock Purchase Warrant issued to Schwartz, Cooper, Greenberger & Krauss, Chartered on February 13, 2002 representing the right to purchase 750,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.30 to Amendment No. 1 to the Registration Statement on Form S-2, File No. 333-83578, as filed on June 21, 2002 (the "June 2002 S-2").) 4.10 Common Stock Purchase Warrant issued to Monsun AS on April 1, 2002 representing the right to purchase 200,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.31 to the June 2002 S-2.) 4.11 Form of Common Stock Purchase Warrant issued to Cell Solutions, LLC on October 11, 2001 representing the right to purchase 172,120 shares of common stock. (Incorporated herein by reference to Exhibit 4.32 to the June 2002 S-2.) 32 Exhibit No. Description 4.12 Form of Common Stock Purchase Warrant issued in connection with certain Bridge I financing in June 2002. (Incorporated herein by reference to Exhibit 4.33 to the June 2002 S-2.) 4.13 Common Stock Purchase Warrant issued to Richard A. Domanik, M.D, with an issue date of May 31, 2002, representing the right to purchase 51,493 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.34 to the Registration Statement on Form S-2, File No. 333-100150, as filed on September 27, 2002 (the "September 2002 S-2").) 4.14 Amendment No. 1, dated August 19, 2002, to the Common Stock Purchase Warrant issued in connection with certain Bridge I financing. (Incorporated herein by reference to Exhibit 4.36 to the Company's Annual Report on Form 10-K for the year ended December 31, 2002, as filed on July 21, 2003 (the "2002 10-K").) 4.15 Form of Common Stock Purchase Warrant to be issued in connection with certain Bridge II Financing beginning in October 2002. (Incorporated herein by reference to Exhibit 4.37 to the 2002 10-K.) 4.16 Common Stock Purchase Warrant issued to Qwestar Resources on November 1, 2002 representing the right to purchase 200,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.38 to the 2002 10-K.) 4.17 Common Stock Purchase Warrant issued to Suzanne M. Gombrich on April 2, 2003 representing the right to purchase 1,000,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.39 to the Company's Quarterly Report on Form 10-QSB for the quarter ended June 30, 2003, as filed on August 13, 2003 (the "2003 2Q 10-QSB").) 4.18 Common Stock Purchase Warrant issued to Dan Burns on August 20, 2003 representing the right to purchase 1,100,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.40 to the Company's Quarterly Report on Form 10-QSB for the quarter ended September 30, 2003, as filed on November 19, 2003 (the "2003 3Q 10-QSB").) 4.19 Common Stock Purchase Warrant issued to Dan Burns on September 16, 2003 representing the right to purchase 935,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.41 to the 2003 3Q 10-QSB.) 4.20 Common Stock Purchase Warrant issued to David Weissberg on September 16, 2003 representing the right to purchase 400,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.42 to the 2003 3Q 10-QSB.) 4.21 Common Stock Purchase Warrant issued to Reid Jilek on September 2, 2003 representing the right to purchase 500,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.43 to the 2003 3Q 10-QSB.) 4.22 Common Stock Purchase Warrant issued to Dan Burns on March 19, 2004 representing the right to purchase 500,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.1 to the Company's Quarterly Report on Form 10-QSB for the quarter ended March 31, 2004, as filed on May 18, 2004 (the "2004 1Q 10-QSB").) 4.23 Common Stock Purchase Warrant issued to Dan Burns on March 4, 2004 representing the right to purchase 67,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.2 to the 2004 1Q 10-QSB.) 33 Exhibit No. Description 4.24 Common Stock Purchase Warrant issued to Dan Burns on May 5, 2004 representing the right to purchase 500,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.1 to the Company's Form 10-QSB for the quarter ended June 30, 2004, as filed on August 16, 2004 (the "2004 2Q 10-QSB").) 4.25 Common Stock Purchase Warrant issued to Dan Burns on June 4, 2004 representing the right to purchase 530,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.2 to the 2004 2Q 10-QSB.) 4.26 Common Stock Purchase Warrant issued to Don Hancock on June 4, 2004 representing the right to purchase 250,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.3 to the 2004 2Q 10-QSB.) 4.27 Form of common stock purchase warrant issued to private placement agents on June 15, 2004 representing the right to purchase an aggregate 681,625 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.4 to the 2004 2Q 10-QSB.) 4.28 Form of common stock purchase warrant issued to vendors as part of restructuring settlements during the quarter ended June 30, 2004 representing the right to purchase an aggregate 483,984 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.5 to the 2004 2Q 10-QSB.) 4.29 Common Stock Purchase Warrant issued to Reid Jilek on August 26, 2004 representing the right to purchase 500,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.1 to the Company's Quarterly Report on Form 10-QSB for the quarter ended September 30, 2004, as filed on November 15, 2004 (the "2004 3Q 10-QSB").) 4.30 Common Stock Purchase Warrant issued to Ken Sgro on September 15, 2004 representing the right to purchase 192,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.2 to the 2004 3Q 10-QSB.) 4.31 Common Stock Purchase Warrant issued to James Fallon on September 15, 2004 representing the right to purchase 8,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.3 to the 2004 3Q 10-QSB.) 4.32 Common Stock Purchase Warrant issued to Jorge Leon, Ph.D., on September 15, 2004 representing the right to purchase 25,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.4 to the 2004 3Q 10-QSB.) 4.33 Common Stock Purchase Warrant issued to Jan L. Dorfman on September 15, 2004 representing the right to purchase 20,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.5 to the 2004 3Q 10-QSB.) 4.34 Common Stock Purchase Warrant with an issue date of July 18, 2003 in favor of Azimuth Corporation representing the right to purchase 2,875,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.39 of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2004, as filed on April 14, 2005 (the "2004 10-K").) 4.35 Common Stock Purchase Warrant with an issue date of July 18, 2003 in favor of Cadmus Corporation representing the right to purchase 3,625,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.40 to the 2004 10-K.) 34 Exhibit No. Description 4.36 Common Stock Purchase Warrant issued to Michael Pasini on February 15, 2005 representing the right to purchase 200,000 shares of common stock of the Company. (Incorporated herein by reference to Exhibit 4.1 to the Company's Quarterly Report on Form 10-QSB for the quarter ended March 31, 2005, as filed on August 16, 2005.) 4.37 Common Stock Purchase Warrant issued to Dan Burns on May 2, 2005 representing the right to purchase 556,500 shares of common stock. (Incorporated herein by reference to Exhibit 4.1 to Company's Quarterly Report on Form 10-QSB for the quarter ended June 30, 2005, as filed on May 20, 2005.) 4.38* Form of subscription agreement to purchase common stock of the Company at $0.025 per share. 4.39* Form of common stock purchase warrant issued as part of 2005 financings representing the right to purchase shares of common stock of the Company at $0.10 per share 4.40* Common Stock Purchase Warrant issued to Reid Jilek on March 1, 2006 representing the right to purchase 1,000,000 shares of common stock. 4.41* Common Stock Purchase Warrant issued to Eric Gombrich on March 1, 2006 representing the right to purchase 300,000 shares of common stock. 10.1+ Employment Agreement, dated May 1, 1998, between Peter P. Gombrich and InPath, LLC, as amended on December 4, 1998. (Incorporated herein by reference to Exhibit 10.6 of the Ampersand Medical Corporation Annual Report on Form 10-K for the fiscal year ended December 31, 1998, as filed on March 31, 1999(the "1998 10-K").) 10.2+ 1999 Equity Incentive Plan established as of June 1, 1999, as amended. (Incorporated herein by reference to Appendix B to the Company's Definitive Proxy Statement on Schedule 14A, as filed on July 1, 2004.) 10.3+ 1999 Employee Stock Purchase Plan. (Incorporated herein by reference to Appendix G to the 1999 Proxy Statement.) 10.4 $500,000 Convertible Promissory Note issued to Monsun, AS on November 1, 2000. (Incorporated herein by reference to Exhibit 10.23 to the 2000 10-K.) 10.5 Lease Agreement between Ampersand Medical Corporation and O.P., L.L.C, dated May 18, 2000, pertaining to premises located at 414 N. Orleans, Suite 510, Chicago, Illinois 60610. (Incorporated by reference to Exhibit 10.32 to the 2000 10-K.) 10.6 First Amendment to Lease Agreement between Ampersand Medical Corporation and O.P., L.L.C., dated February 13, 2001, pertaining to additional premises at 414 N. Orleans, Suite 503, Chicago, Illinois 60610 and extending the term of the original lease until February 28, 2006. (Incorporated by reference to Exhibit 10.33 to the 2000 10-K.) 10.7 $25,000 Promissory Note issued to Northlea Partners, Ltd. on August 6, 2001. (Incorporated herein by reference to Exhibit 10.41 to the August 2001 S-4.) 10.8 Form of Convertible Promissory Note issued in connection with certain Bridge I financing beginning in March 2002. (Incorporated herein by reference to Exhibit 10.42 to the 2002 10-K.) 10.9 Amendment No. 1 to Convertible Promissory Note issued in connection with certain Bridge I financing dated August 20, 2003. (Incorporated herein by reference to Exhibit 10.43 to the 2002 10-K.) 35 Exhibit No. Description 10.10 Form of Bridge II Convertible Promissory Note Indenture, including Form of Convertible Promissory Note, Form of Security Agreement, Form of Collateral Sharing Agreement, and Form of Warrant issued in connection with certain Bridge II Financing beginning in October 2002. (Incorporated herein by reference to Exhibit 10.44 to the 2002 10-K.) 10.11 Consulting Agreement, made as of November 11, 2003, by and between the Company and CEOCast, Inc. (Incorporated herein by reference to Exhibit 10.45 to the Company's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2003, as filed April 14, 2004 (the "2003 10-KSB").) 10.12 Amendment No.1 to the 12% Convertible Secured Promissory Note issued in connection with certain Bridge II financing in October 2002. (Incorporated herein by reference to Exhibit 10.47 to the 2003 3Q 10-QSB.) 10.13 Amendment No. 1 dated July 31, 2003 to the Indenture dated October 1, 2002 issued in connection with certain Bridge II financing in October 2002 (Incorporated herein by reference to Exhibit 10.48 to the 2003 3Q 10-QSB.) 10.14 Form of consulting agreement with Dan Burns and Eugene Martineau. (Incorporated herein by reference to Exhibit 10.49 to the 2003 3Q 10-QSB.) 10.15 Proposal for consulting agreement with Reid Jilek. (Incorporated herein by reference to Exhibit 10.50 to the 2003 3Q 10-QSB.) 10.16 Form of Subscription Agreement for Bridge III $1,500,000 minimum offering/$4,000,000 Maximum Offering placed by Bathgate Capital Partners LLC. (Incorporated herein by reference to Exhibit 10.47 to the 2003 10-KSB.) 10.17 Form of Note for Bridge III $1,500,000 minimum offering/$4,000,000 Maximum Offering placed by Bathgate Capital Partners LLC. (Incorporated herein by reference to Exhibit 10.48 to the 2003 10-KSB.) 10.18 Form Registration Rights Agreement issued in connection with Bridge III Offering. (Incorporated herein by reference to Exhibit 10.49 to the 2003 10-KSB.) 10.19 Form of General Security Agreement by the Company in connection with Bridge III Offering. (Incorporated herein by reference to Exhibit 10.50 to the 2003 10-KSB.) 10.20 Form of Warrant issued in connection with Bridge III Offering. (Incorporated herein by reference to Exhibit 10.51 to the 2003 10-KSB.) 10.21 Form of Subscription Agreement for Bridge IV Offering. (Incorporated herein by reference to Exhibit 4.3 to the 2004 1Q 10-QSB.) 10.22 Form of Note for Bridge IV Offering. (Incorporated herein by reference to Exhibit 4.4 to the 2004 1Q 10-QSB.) 10.23 Form of General Security Agreement for Bridge IV Offering. (Incorporated herein by reference to Exhibit 4.5 to the 2004 1Q 10-QSB.) 10.24 Form of Registration Rights Agreement for Bridge IV Offering. (Incorporated herein by reference to Exhibit 4.6 to the 2004 1Q 10-QSB.) 36 Exhibit No. Description 10.25 Form of Subscription Agreement for the Company's August 2004 common stock offering. (Incorporated herein by reference to Exhibit 4.6 to the 2004 3Q 10-QSB.) 10.26 Settlement Agreement, effective as of October 14, 2004, by and among the Company, AccuMed and MonoGen, Inc. and accompanying License Agreement, made as of October 14, 2004, by and between MonoGen, Inc., the Company and AccuMed. (Incorporated herein by reference to Exhibit 4.8 to the Company's Form 10-QSB/A for the quarter ended September 30, 2004, as filed on November 17, 2004.) 10.27 Form of Subscription Agreement for the Company's common stock offering beginning in December 2004. (Incorporated herein by reference to Exhibit 10.28 to the 2004 10-K.) 10.28 General Release and Settlement Agreement, effective as of July 18, 2003, by and among the Company, Azimuth Corporation and Cadmus Corporation. (Incorporated herein by reference to Exhibit 10.29 to the 2004 10-K.) 10.29 Agreement, made as of December 31, 2004, between British Columbia Cancer Agency Branch and the Company, AccuMed and Oncometrics. (Incorporated herein by reference to Exhibit 10.30 to the 2004 10-K.) 10.30 Settlement Agreement, entered into as of December 2004, by and between Bruce Patterson and Invirion, Inc. and the Company. (Incorporated herein by reference to Exhibit 10.31 to the 2004 10-K.) 10.31 Lease proposal letter agreement, dated September 22, 2004, from Spectrum Real Estate Services to the Company pertaining to the lease of premises located at 414 N. Orleans, Suite 510, Chicago, Illinois 60610 to be effective as third amendment to original lease. (Incorporated herein by reference to Exhibit 10.32 to the 2004 10-K.) 10.32 Strategic alliance agreement entered into by the Company in November 2004. (Incorporated herein by reference to Exhibit 10.33 to the 2004 10-K.) 10.33 Settlement Agreement and Mutual Release effective June 7, 2005, by and between the Cleveland Clinic Foundation and the Company. (Incorporated herein by reference to Exhibit 10.1 to the 2005 3Q 10-QSB.) 10.34 General Release and Confidentiality Agreement, entered into October 2005, by and between Eric Gombrich and the Company. (Incorporated herein by reference to Exhibit 10.2 to the 2005 3Q 10-QSB.) 10.35 Settlement Agreement and Mutual Release, entered into October 2005, by and among the Lash Group Inc., Peter Gombrich and the Company. (Incorporated herein by reference to Exhibit 10.3 to the 2005 3Q 10-QSB.) 10.36* Clinical Study Agreement, entered into January 2006, between University Hospitals of Cleveland and the Company. 10.37* Separation Agreement, entered into December 31, 2005, between Denis M. O'Donnell, M.D. and the Company. 14 Code of Ethics and Business Conduct of Officers, Directors and Employees of Molecular Diagnostics, Inc. (Incorporated herein by reference to Exhibit 99.1 to the 2003 10-KSB.) 37 Exhibit No. Description 21* Subsidiaries of the Company 23.1* Consent of Altschuler, Melvoin and Glasser LLP 31.1* Certification of the Chief Executive Officer of Molecular Diagnostics, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2* Certification of the Chief Financial Officer of Molecular Diagnostics, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1* Certification of the Chief Executive Officer of Molecular Diagnostics, Inc. Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2* Certification of the Chief Financial Officer of Molecular Diagnostics, Inc., Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Item 14. Principal Accountant Fees and Services The information required by this Item 14 is contained in the 2006 Proxy Statement under the caption "Independent Registered Public Accounting Firm" and is incorporated herein by reference. 38 SIGNATURES In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MOLECULAR DIAGNOSTICS, INC. By: /s/DAVID WEISSBERG, M.D. ------------------------------------ David Weissberg, M.D. Chairman and Chief Executive Officer By: /s/ROBERT MCCULLOUGH, JR ------------------------------------ Robert McCullough, Jr. Chief Financial Officer Date: April 14, 2006 In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Title Date --------- ----- ---- /S/ DAVID WEISSBERG, M.D. Chairman of the Board and Chief Executive April 14, 2006 -------------------------- David Weissberg, M.D. Officer (Principal Executive Officer) /s/ ROBERT MCCULLOUGH, JR Chief Financial Officer April 14, 2006 -------------------------- Robert McCullough, Jr (Principal Accounting Officer) /s/ ALEXANDER M. MILLEY Director April 14, 2006 -------------------------- Alexander M. Milley /S/ JOHN ABELES Director April 14, 2006 -------------------------- John Abeles 39
Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders of Molecular Diagnostics, Inc. We have audited the accompanying consolidated balance sheets of Molecular Diagnostics, Inc. and Subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, cash flows and changes in stockholders' equity (deficit) for the years then ended. Our audits also included the financial statement schedule listed in the index at item 14. These consolidated financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Molecular Diagnostics, Inc. and Subsidiaries as of December 31, 2005 and 2004 and the results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has suffered recurring substantial net losses from operations and has a net capital deficiency that raises substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ ALTSCHULER, MELVOIN AND GLASSER LLP Chicago, Illinois April 13, 2006 F-1 PART I--FINANCIAL INFORMATION MOLECULAR DIAGNOSTICS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except per share amounts)
December 31, ---------------------- 2005 2004 -------- -------- Assets Current Assets: Cash and cash equivalents ................................................... $ -- $ 11 Accounts receivables, net of allowance for doubtful accounts of $0 and $0 at December 31, 2005 and 2004, respectively .............................. 38 30 Inventories ................................................................. 26 48 Deferred financings costs ................................................... -- 80 Prepaid expenses and other current assets ................................... 73 14 -------- -------- Total current assets ................................................... 137 183 Fixed Assets, net .............................................................. 233 326 Other Assets: Licenses, patents, and technology, net of amortization ...................... 20 20 -------- -------- Total assets ........................................................... $ 390 $ 529 ======== ======== Liabilities and Stockholders' Equity (Deficit) Current Liabilities: Checks issued in excess of amounts on deposit ............................... $ 5 $ -- Accounts payable ............................................................ 3,714 4,426 Accrued payroll costs ....................................................... 643 1,084 Accrued expenses ............................................................ 2,292 1,944 Deferred revenue ............................................................ 25 25 Due to stockholder .......................................................... 37 38 Lease obligation ............................................................ 96 110 Notes payable--related parties .............................................. 70 70 Notes payable ............................................................... 3,557 4,955 -------- -------- Total current liabilities .............................................. 10,439 12,652 -------- -------- Stockholders' Equity (Deficit): Preferred stock; $0.001 par value; shares authorized 10,000,000; 1,102,192 and 1,119,192 shares issued and outstanding at December 31, 2005 and 2004, respectively (Liquidation value of all classes of preferred stock of $9,459 at December 31, 2005) ................................................ 7,716 7,767 Common stock, $0.001 par value; 375,000,000 shares authorized; 154,665,084 and 99,792,292 shares issued and 154,472,995 and 99,600,204 shares outstanding at December 31, 2005 and 2004, respectively .......................................................... 155 100 Additional paid-in capital ..................................................... 52,386 45,961 Treasury stock; 192,088 shares at December 31, 2005 and 2004 ................... (327) (327) Accumulated deficit ............................................................ (69,911) (65,565) Accumulated comprehensive loss--Cumulative translation adjustment .............. (68) (59) -------- -------- Total stockholders' equity (deficit) ................................... (10,049) (12,123) -------- -------- Total liabilities and stockholders' equity (deficit) ................... $ 390 $ 529 ======== ======== The accompanying notes are an integral part of these consolidated financial statements. F-2
MOLECULAR DIAGNOSTICS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in thousands, except per share amounts)
Year Ended December 31, -------------------------------- 2005 2004 ------------- ------------- Net Sales ................................................ $ 117 $ 243 Costs and Expenses: Cost of goods sold ................................. 21 24 Research and development ........................... (100) 834 Selling, general and administrative expenses ....... 1,346 4,109 ------------- ------------- Total costs and expenses ........................... 1,267 4,967 ------------- ------------- Operating loss ........................................... (1,150) (4,724) ------------- ------------- Other income (expense): Interest expense--related party .................... (9) (53) Interest expense ................................... (3,167) (1,950) Loss on litigation settlements ..................... -- (6,850) Other, net ......................................... -- 10 ------------- ------------- Total other income (expense) ....................... (3,176) (8,843) ------------- ------------- Loss from continuing operations before income taxes ...... (4,326) (13,567) Income taxes ............................................. -- -- ------------- ------------- Net loss ................................................. $ (4,326) $ (13,567) ============= ============= Preferred stock dividends ................................ (20) (1,034) ------------- ------------- Total dividends .......................................... (20) (1,034) ------------- ------------- Net loss applicable to common stockholders ............... $ (4,346) $ (14,601) ============= ============= Basic and fully diluted net loss per common share ........ $ (.04) $ (.19) ============= ============= Weighted average number of common shares outstanding...... 110,037,893 76,964,553 ============= ============= The accompanying notes are an integral part of these consolidated financial statements. F-3
MOLECULAR DIAGNOSTICS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands)
Year Ended December 31, ----------------------- 2005 2004 -------- -------- Operating Activities: Net loss .......................................................................... $ (4,326) $(13,567) Amortization of debt discount ............................................. 2,673 1,085 Depreciation and amortization ............................................. 117 575 Amortization of fees ...................................................... 80 362 (Gain) Loss on sale of fixed assets ....................................... 3 (99) Return of fixed assets in exchange for relief of indebtedness ............. -- 149 Loss on intangible assets upon legal settlement ........................... -- 6,488 Stock, warrants, and options issued for settlement of debt ................ 421 -- Stock, warrants, and options issued to non-employees for services ......... 58 1,489 Notes issued in payment of expenses ....................................... -- 446 Stock returned for settlement ............................................. (47) -- Changes in assets and liabilities: Accounts receivable ............................................... (8) (4) Inventories .......................................................... 21 47 Due from stockholder ................................................. (1) (16) Prepaid expenses and other current assets ............................ (58) (141) Checks issued in excess of amounts on deposit ........................ 5 (5) Accounts payable ................................................................... (713) (882) Deferred revenue ..................................................... -- (25) Lease obligation ................................................................... (13) (169) Accrued expenses ..................................................... 425 305 -------- -------- Net cash used for operating activities ............................................. (1,363) (3,962) -------- -------- Cash used in investing activities: Expenditures for licenses, patents, and technology ................................. -- (20) Capital purchases .................................................................. (27) (187) -------- -------- Net cash used for investing activities ............................................. (27) (207) -------- -------- Cash flows from financing activities: Proceeds from issuance of convertible notes payable ................................ -- 4,236 Proceeds from issuance of common stock ............................................. 1,483 810 Payments of notes payable .......................................................... (104) (894) Proceeds from sale of fixed assets ................................................. -- 28 -------- -------- Net cash provided by financing activities .......................................... 1,379 4,180 -------- -------- Net increase/(decrease) in cash and cash equivalents ............................... (11) 11 Cash and cash equivalents at beginning of period ................................... 11 0 -------- -------- Cash and cash equivalents at end of period ......................................... $ 0 $ 11 ======== ======== Supplemental disclosure of cash flow information: Cash paid during the period for: Interest ........................................................................... $ 3 $ 135 Non-cash transaction during the period for: Warrants issued for deferred financing costs ....................................... $ -- $ 1,329 Preferred stock and cumulative dividends converted into common stock ............... $ 71 $ 6,451 Convertible promissory notes and accrued interest converted into common stock....... $ 4,494 $ Foreign currency translation adjustment ............................................ $ (9) $ (17) The accompanying notes are an integral part of these consolidated financial statements. F-4
MOLECULAR DIAGNOSTICS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) (Dollars in thousands)
Preferred Stock Common Stock Par Value $0.001 Par Value $0.001 Treasury Stock ---------------------------- --------------------------- ---------------------------- Shares Amount Shares Amount Shares Amount ------------ ------------ ------------ ------------ ------------ ------------ January 1, 2004 ..................... 2,511,108 $ 12,894 45,830,928 $ 46 192,088 $ (327) Comprehensive Loss: Net loss ......................... -- -- -- Foreign currency translation ..... -- -- -- Total net comprehensive Loss ............................. -- -- -- Series B preferred stock and cumulative dividends converted to common stock ........ (434,750) (1,739) 2,280,798 2 -- Series C preferred stock and cumulative dividends converted to common stock ........ (930,000) (2,790) 5,703,816 6 -- Series E preferred stock and cumulative dividends converted to common stock ........ (27,166) (598) 935,483 -- -- Bridge I conversions ................ -- 9,985,182 10 -- Bridge II conversions ............... -- 17,619,242 18 -- Sales of common stock ............... -- 10,988,096 11 -- Common stock issued for services ......................... -- 3,024,333 3 -- Common stock issued in lieu of debt ..................... -- 2,647,748 3 -- Common stock issued to employees ........................ -- 216,666 -- -- Common stock issued for financing fees ................... -- 560,000 1 -- Beneficial conversion feature on convertible notes ............. -- -- -- -- Warrants issued with debt ........... -- -- -- -- Warrants issued for financing fees ............................. -- -- -- -- Warrants issued for services ........ -- -- -- -- Warrants issued in settlement of debt .......................... -- -- -- -- ------------ ------------ ------------ ------------ ------------ ------------ December 31, 2004 ................... 1,119,192 $ 7,767 99,792,292 $ 100 192,088 $ (327) ============ ============ ============ ============ ============ ============ The accompanying notes are an integral part of these consolidated financial statements. F-5
MOLECULAR DIAGNOSTICS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) (Dollars in thousands)
Total Additional Other Stockholders' Paid-In Accumulated Comprehensive Equity Capital Deficit Loss (Deficit) ------------ ------------ ------------ ------------ January 1, 2004 ..................... $ 29,553 $ (50,673) $ (42) $ (8,549) Comprehensive Loss: Net loss ......................... -- (13,567) -- (13,567) Foreign currency translation ..... -- -- (17) (17) ------------ Total net comprehensive Loss ............................. -- -- -- (13,584) Series B preferred stock and cumulative dividends converted to common stock ........ 2,279 (542) -- -- Series C preferred stock and cumulative dividends converted to common stock ........ 3,417 (633) -- -- Series E preferred stock and cumulative dividends converted to common stock ........ 748 (150) -- -- Bridge I conversions ................ 1487 -- -- 1,497 Bridge II conversions ............... 2,377 -- -- 2,395 Sales of common stock ............... 799 -- -- 810 Common stock issued for services ......................... 284 -- -- 287 Common stock issued in lieu of debt ..................... 266 -- -- 269 Common stock issued to employees ........................ 14 -- -- 14 Common stock issued for financing fees ................... 47 -- -- 48 Beneficial conversion feature on convertible notes ............. 3,394 -- -- 3,394 Warrants issued with debt ........... 619 -- -- 619 Warrants issued for financing fees ............................. 529 -- -- 529 Warrants issued for services ........ 84 -- -- 84 Warrants issued in settlement of debt .......................... 64 -- -- 64 ------------ ------------ ------------ ------------ December 31, 2004 ................... $ 45,961 $ (65,565) $ (59) $ (12,123) ============ ============ ============ ============ The accompanying notes are an integral part of these consolidated financial statements. F-6
MOLECULAR DIAGNOSTICS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) (Dollars in thousands)
Preferred Stock Common Stock Par Value $0.001 Par Value $0.001 Treasury Stock ---------------------------- --------------------------- ---------------------------- Shares Amount Shares Amount Shares Amount ------------ ------------ ------------ ------------ ------------ ------------ January 1, 2005 ..................... 1,119,192 $ 7,767 99,792,292 $ 100 192,088 $ (327) Comprehensive Loss: Net loss ......................... -- -- -- Foreign currency translation...... -- -- -- Total net comprehensive Loss ............................. -- -- -- Series C preferred stock and cumulative dividends converted to common stock ........ (17,000) (51) 118,260 -- -- Bridge I conversions ................ -- 2,008,962 2 -- Bridge III conversions .............. -- 15,282,236 15 -- Bridge IV conversions ............... -- 25,605,000 26 -- Sales of common stock ............... -- 11,858,334 12 -- Common stock subscribed for services ......................... -- -- -- -- Common stock returned for settlement ....................... -- -- -- -- Warrants issued for services ........ -- -- -- 42 Warrants issued in settlement of debt .......................... -- -- -- -- ------------ ------------ ------------ ------------ ------------ ------------ December 31, 2005 ................... 1,102,192 $ 7,716 154,665,084 $ 155 192,088 $ (327) ============ ============ ============ ============ ============ ============ The accompanying notes are an integral part of these consolidated financial statements. F-7
MOLECULAR DIAGNOSTICS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) (Dollars in thousands)
Total Additional Other Stockholders' Paid-In Accumulated Comprehensive Equity Capital Deficit Loss (Deficit) ------------ ------------ ------------ ------------ January 1, 2005 ..................... $ 45,961 $ (65,565) $ (59) $ (12,123) Comprehensive Loss: Net loss ......................... -- (4,326) -- (4,326) Foreign currency translationxxxxxx -- -- (9) (9) ------------ Total net comprehensive Loss ............................. -- -- -- (4,335) Series C preferred stock and cumulative dividends converted to common stock ........ 71 (20) -- -- Bridge I conversions ................ 292 -- -- 294 Bridge III conversions .............. 1,560 -- -- 1,575 Bridge IV conversions ............... 2,599 -- -- 2,625 Sales of common stock ............... 1,471 -- -- 1,483 Common stock subscribed for services ......................... 16 -- -- 16 Common stock returned for settlement ....................... (47) -- -- (47) Warrants issued for services ........ 42 -- -- 42 Warrants issued in settlement of debt .......................... 421 -- -- 421 ------------ ------------ ------------ ------------ December 31, 2005 ................... $ 52,386 $ (69,911) $ (68) $ (10,049) ============ ============ ============ ============ The accompanying notes are an integral part of these consolidated financial statements. F-8
MOLECULAR DIAGNOSTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2005 and 2004 Note 1. The Company and Basis of Presentation Molecular Diagnostics, Inc. ("MDI" or the "Company") was incorporated as Ampersand Medical Corporation in Delaware in December 1998 as the successor to Bell National Corporation ("Bell National"). Bell National was incorporated in California in 1958, and was the continuing legal entity following its acquisition of InPath, LLC, a development-stage company engaged in the design and development of medical instruments and related tests, in December 1998. Bell National then merged into the Company, which was then operating under the Ampersand name, in 1999. On September 25, 2001, following the Company's acquisition of AccuMed International, Inc. ("AccuMed") via the merger of AccuMed into a wholly-owned subsidiary of MDI, the Company changed its corporate name to Molecular Diagnostics, Inc. in order to better represent its operations and products. The name change was effected through a merger with a separate wholly-owned subsidiary. MDI retained its Certificate of Incorporation in the merger, except as amended to reflect its new name, bylaws and capitalization. MDI is a biomolecular diagnostics company engaged in the design, development and commercialization of cost-effective screening systems to assist in the early detection of cancer. MDI is currently focused on the design, development and marketing of its InPath(TM) System and related image analysis systems. The InPath System and related products are intended to detect cancer and cancer-related diseases, and may be used in a laboratory, clinic, or doctor's office. The Company has incurred significant operating losses since its inception. Management expects that significant on-going operating expenditures will be necessary to successfully implement MDI's business plan and develop, manufacture and market its products. These circumstances raise substantial doubt about MDI's ability to continue as a going concern. Implementation of its plans and its ability to continue as a going concern depend upon its securing substantial additional financing. Management's plans include efforts to obtain additional capital. If the Company is unable to obtain adequate additional financing or generate profitable sales revenues, it may be unable to resume its product development and other activities and may be forced to cease operations. Note 2. Summary of Significant Accounting Policies Principles of Consolidation. The consolidated financial statements include the Company and its wholly-owned subsidiaries. All significant inter-company balances and transactions have been eliminated in consolidation. Use of Estimates. The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Revenue Recognition MDI recognizes revenue upon shipment of product to customers and invoicing, and no remaining Company obligations or contingencies exist. Revenue from ongoing client maintenance is recognized ratably over the post-contract support term, which is generally 12 months. Revenue from training services and professional services is recognized when the service is completed. Revenue from implementation and installation services is recognized using the percentage of completion method. Revenue from prepayments under licenses is recognized over the license period. F-9 Cash and Cash Equivalents The Company considers all highly liquid investments with a maturity of three months or less at the time of purchase to be cash equivalents. Inventory of Instruments, Component Parts and Labor Inventory of instruments and component parts consisted of AcCell instruments and component parts necessary to manufacture AcCell instruments as of December 31, 2005 and 2004. The manufacturing process is carried out in the facilities of a third-party contractor. Inventory is stated at the lower of cost or market; cost is determined by the first-in first-out method. Property and Equipment Property and equipment are stated at cost and are depreciated using the straight-line method over the assets' estimated useful lives. Principal useful lives are as follows: Furniture and fixtures.................... 5 years Laboratory equipment...................... 5 years Computer and communications equipment..... 3 years Design and tooling........................ 5 years Leasehold improvements.................... Useful life or term of lease, whichever is shorter Normal maintenance and repairs for property and equipment are charged to expense as incurred, while significant improvements are capitalized. Licenses, Patents, and Technology Licenses, patents, and purchased technology are recorded at their acquisition cost. Costs to prepare patent filings are expensed when incurred. Costs related to abandoned patents are written off at the time of abandonment. Amortization is begun as of the date of acquisition or upon the grant of the final patent. Costs are amortized over the asset's useful life, which ranges from two to 17 years. The Company assesses licenses, patents, and technology periodically for impairment. Research and Development Costs Research and development costs are charged to operations as incurred. MDI conducts a portion of its research activities under contractual arrangements with scientists, researchers, universities, and other independent third parties. Foreign Currency Translation The functional currency of the Company's foreign operations is the local currency. Accordingly, all assets and liabilities are translated into U.S. dollars using year-end exchange rates, and all revenues and expenses are translated using average exchange rates during the year. Other Comprehensive Income (Loss) Translation adjustments related to the Company's foreign operations are included in other comprehensive loss and reported separately in stockholders' equity (deficit). Net Loss Per Share F-10 Basic loss per share is calculated based on the weighted-average number of outstanding common shares. Diluted loss per share is calculated based on the weighted-average number of outstanding common shares plus the effect of dilutive potential common shares. MDI's calculation of diluted net loss per share excludes potential common shares as the effect would be anti-dilutive. Cumulative and deemed dividends on convertible preferred shares totaled approximately $4,453,000 and $3,569,000 at December 31, 2005 and 2004, respectively. Loss per share applicable to common stockholders was $0.04 and $0.19 for the years then ended December 31, 2005 and 2004, respectively. Potential common shares include stock underlying convertible notes and convertible preferred stock, accrued interest on convertible notes payable in common stock, cumulative dividends on preferred stock payable in common stock, and stock issuable upon exercise of stock options and warrants. The weighted-average number of options and warrants to purchase common stock using the treasury stock method for 2005 and 2004 was 7,294,319 and 867,818 shares, respectively. Income Taxes MDI follows the liability method in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting carrying amounts and the respective tax bases of assets and liabilities, and are measured using tax rates and laws that are expected to be in effect when the differences are expected to be recovered or settled. Valuation allowances are provided against deferred tax assets if it is more likely than not that the deferred tax assets will not be realized. Recent Accounting Pronouncements Accounting for Stock-Based Compensation-Transition and Disclosure In December 2003, the FASB issued Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure" (SFAS 148). This Statement, which is effective for years ended after December 15, 2003 amends SFAS No. 123, "Accounting for Stock-Based Compensation," and provides alternative methods of transition for a voluntary change to the fair value-based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 regardless of the accounting method used to account for stock-based compensation. The Company has chosen to continue to account for stock-based compensation of employees using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations. The enhanced disclosure provisions as defined by SFAS 148 are included in Note 11 of this report. Share-Based Payment In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123(R), "Share-Based Payment." SFAS No. 123(R) establishes accounting standards for transactions in which a company exchanges its equity instruments for goods or services. In particular, this Statement will require companies to record compensation expense for all share-based payments, such as employee stock options, at fair market value. This statement is effective as of the beginning of the first interim or annual reporting period that begins after December 15, 2005. Adoption of this financial statement is not expected to have a material impact on the Company's consolidated financial position or results of operations. Exchanges of Nonmonetary Assets In December 2004, FASB issued Statement of Financial Accounting Standards No. 153, "Exchanges of Nonmonetary Assets-an amendment to APB Opinion No. 29." This statement amends APB 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. Adoption of this statement did not have a material impact on the Company's consolidated financial position or results of operations. Inventory Costs F-11 In November 2004, FASB issued Statement of Financial Accounting Standards No. 151, "Inventory Costs-an amendment of ARB No. 43, Chapter 4." This statement amends the guidance in ARB No. 43, Chapter 4, "Inventory Pricing," to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Adoption of this statement did not have a material impact on the Company's consolidated financial position or results of operations. Impairment or Disposal of Long-Lived Assets At each balance sheet date or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, management of the Company evaluates recoverability of such assets. An impairment loss is recognized if the amount of undiscounted cash flows is less than the carrying amount of the asset, in which case the asset is written down to fair value. The fair value of the asset is measured by either quoted market prices or the present value of estimated expected future cash flows using a discount rate commensurate with the risks involved. Consolidation of Variable Interest Entities The Financial Accounting Standards Board (FASB) has issued Interpretation No. 46 (FIN-46R) (Revised December 2003), "Consolidation of Variable Interest Entities: an Interpretation of Accounting Research Bulletin No. 51" (FIN 46). FIN 46 addresses consolidation by business enterprises of entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Variable interest entities are required to be consolidated by their primary beneficiaries if they do not effectively disperse risks among parties involved. The primary beneficiary of a variable interest entity is the party that absorbs a majority of its expected residual returns. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2004 and apply to existing entities in the first fiscal year or interim period beginning after June 15, 2004. The adoption of FIN 46 did not have a material effect on the Company's financial statements and related disclosures because it does not have any variable interest entity relationships. Effect of Contingently Convertible Instruments on Diluted Earnings per Share In October 2004, the FASB ratified the consensus reached in Emerging Issue Task Force (EITF) Issue No. 04-8, "The Effect of Contingently Convertible Instruments on Diluted Earnings per Share." The EITF reached a consensus that contingently convertible instruments, such as contingently convertible debt, contingently convertible preferred stock, and other such securities should be included in diluted earnings per share (if dilutive) regardless of whether the market price trigger has been met. The consensus became effective for reporting periods ending after December 15, 2004. The adoption of this pronouncement did not have a material effect on the Company's financial statements. Impairment and Application to Certain Investments On November 3, 2005, the FASB issued FASB Staff Position (FSP) FAS 115-1 and FAS 124-1, "The Meaning of Other-Than Temporary Impairment and its Application to Certain Investments", FSP FAS 115-1 and FAS 124-1 address the determination as to when an investment is considered impaired, whether that impairment is other-than-temporary and the measurement of loss. It also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. FSP FAS 115-1 and FAS 124-1 are effective for reporting periods beginning after December 15, 2005. The Company anticipates the impact of FSP FAS 115-1 and FAS 124-1 on the Company's consolidated results of operations and financial condition will not be material. Accounting Changes and Error Corrections In May 2005, the FASB issued SFAS 154 "Accounting Changes and Error Corrections" (SFAS 154). This statement replaces APB Opinion No. 20, "Accounting Changes" and SFAS No. 3, "Reporting Accounting Changes in Interim Financial Statements", and changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company does not anticipate SFAS 154 will materially impact its Consolidated Financial Statement upon its adoption on January 1, 2006. F-12 Note 3. Fixed Assets Fixed assets consist of the following at December 31 (in thousands): 2005 2004 ------ ------ Furniture and fixtures............................ $ 116 $ 116 Laboratory equipment.............................. 595 595 Computer and communications equipment............. 320 320 Design and tooling................................ 170 160 Leasehold improvements............................ 28 28 ------ ------ 1,229 1,219 Less accumulated depreciation and amortization.... (996) (893) ------ ------ Total..................................... $ 233 $ 326 ====== ====== Aggregate Depreciation Expense For the years ended December 31, 2005 and 2004, aggregate depreciation expense for fixed assets was $117,000 and $156,000, respectively. Note 4. Licenses, Patents, and Technology Licenses, patents, and technology include the following at December 31 (in thousands): 2005 2004 ------ ------ Licenses....................................... $ 20 $ 20 Patent costs................................... 133 133 LabCorp. Technology Agreement.................. 260 260 ------ ------ Subtotal....................................... 413 413 Less accumulated amortization.................. (393) (393) ------ ------ Total.................................. $ 20 $ 20 ====== ====== In 2004, MDI was party to a legal settlement with MonoGen, Inc. involving technology owned by MDI's subsidiary, AccuMed. The dispute was resolved, resulting in the transfer to MonoGen of all MDI ownership and rights to AccuMed intellectual property. The transferred technology is not used in the Company's InPath(TM) cervical screening system. The settlement resulted in a net $5,919,000 loss reflected in adjustments to the MDI Technology Agreement and accumulated amortization balances. In 2004, MDI was also party to a legal settlement with Invirion, Inc. and Dr. Bruce Patterson over the validity of a technology license. Pursuant to the settlement agreement, MDI agreed to the cancellation of the license, which resulted in a net $569,000 loss reflected in adjustments to the licenses and accumulated amortization balances. During 2005 and 2004, the Company recorded all costs related to the prosecution of patents as legal expenses. Aggregate Amortization Expense For the years ended December 31, 2005 and 2004, aggregate amortization expense for licenses, patents and technology was zero and $419,000, respectively. F-13 Note 5. Accrued Expenses Accrued expenses include the following at December 31 (in thousands): 2005 2004 ------- ------- Accrued interest.................................. $ 898 $ 994 Accrued interest--related party................... 34 25 Accrued settlement costs.......................... 438 438 Accrued taxes..................................... 589 476 Other accrued expenses............................ 333 11 ------- ------- Total..................................... $ 2,292 $ 1,944 ======= ======= MDI was delinquent in paying a portion of federal and state employee and employer payroll taxes for 2005, 2003, 2002 and 2001. The delinquent federal payroll taxes relating to 2003 and 2002 were paid in full in April 2004. The delinquent federal payroll taxes relating to 2001 were paid in full in January 2005. Federal and state employee and employer payroll taxes for the fourth quarter of fiscal 2005 remain unpaid at December 31, 2005. The Company owed $57,000 and $97,000 as of December 31, 2005 and 2004, respectively, for federal payroll taxes, which were included in accrued payroll costs in the accompanying balance sheet. MDI is also delinquent in filing certain federal and state income tax returns for 2004, 2003 and 2002 and is working to complete and file the returns. The delinquent federal and state income tax returns for 2001 were filed in March 2005. Note 6. Notes Payable--Related Parties Notes payable to related parties at December 31 (in thousands, except for descriptions) consist of:
2005 2004 ----- ----- Northlea Partners, Ltd., $25,000 Promissory Note issued August 6, 2001; interest rate 15% per annum........................ $ 25 $ 25 Northlea Partners, Ltd., $15,000 Promissory Note issued September 20, 2001; interest rate 9% per annum..................... 15 15 Northlea Partners, Ltd., $15,000 Bridge II convertible promissory note issued May 1, 2003; interest rate 12% per annum (see description under Bridge II notes in Note 7-Notes Payable for other terms and conditions)........................................................ 15 15 Robert Shaw, $25,000 Promissory Note issued September 20, 2001; interest rate 9% per annum..................... 15 15 ----- ----- $ 70 $ 70 ===== =====
Suzanne Gombrich Note. On April 2, 2004, the Company repaid the $1,000,000 Convertible Promissory Note due Suzanne M. Gombrich in full and her first priority security interest in all the Company's assets was released. The Company paid $936,114 in cash towards principal and accrued interest of $126,114 on the note. In addition, Mrs. Gombrich agreed to convert the remaining $190,000 into 1,900,000 shares of common stock of the Company upon stockholder approval of an increase in the number of authorized shares of common stock of the Company. On July 29, 2004, the Company's stockholders approved such increase and the 1,900,000 shares were issued to Mrs. Gombrich on August 31, 2004 in satisfaction of her remaining debt. F-14 Peter Gombrich Bridge II Note and Other Amounts Due. On March 5, 2004, the Bridge II Convertible Promissory Note (and accrued interest thereon) issued to Peter Gombrich in December 2003 was converted into 2,113,987 common shares. Further, Peter Gombrich was owed $37,299 and $52,953 at December 31, 2005 and 2004, respectively, for previous unsecured non-interest bearing advances to the Company, which are classified as a liability -Due To Stockholder.. Carrying Amounts. Management believes it is not practicable to estimate the fair value of the notes payable-related parties due to the uncertainty regarding repayment or possible conversion and the Company's current financial condition. Note 7. Notes Payable Notes payable to unrelated parties at December 31 (in thousands, except for descriptions) consist of: 2005 2004 ------ ------ Bridge I Convertible Promissory Notes; due December 31, 2002; interest rate 7% per annum; convertible into common stock at 75% of the market price on date of conversion; beneficial conversion feature valued at $1,042,000 at June 30, 2002; warrants at an exercise price of $0.25 per share; additional warrants at an exercise price equal to 150% of note conversion price.....................................................$ 500 $ 750 Bridge II Convertible Promissory Notes; due July 31, 2004; interest rate 12% or 15% per annum; convertible into common stock at $0.10 or $0.15 per share; beneficial conversion feature valued at $1,777,000 and $330,000 at December 31, 2003 and 2002, respectively; warrants at an exercise price of $0.15 or $0.20 per share..................................................... 1,285 1,285 Bridge III Convertible Promissory Notes; due December 31, 2008; interest rate 10% per annum; convertible into common stock at $0.10 per share; beneficial conversion feature valued at $1,604,000 at June 30, 2004; warrants at an exercise price of $0.15 per share..................................................... 130 268 Bridge IV Convertible Promissory Notes; due December 31, 2008; interest rate 10% per annum; convertible into common stock at $0.10 per share; beneficial conversion feature valued at $1,791,000 at June 30, 2004; warrants at an exercise price of $0.15 per share - converted in 2005...................................................... -- 1,085 Monsun, AS, $500,000 Promissory Note issued November 1, 2000; due July 31, 2002; interest rate 20% per annum, compounded into principal amount; beneficial conversion feature valued at $125,000 at November 1, 2000...................................................... 953 782 O.P., LLC, $29,390 Promissory Note issued May 12, 2003; interest at 7% per annum; monthly principal payments of $1,316 plus interest commencing June 1, 2003; paid September, 2005...................................................... -- 6 MonoGen, Inc., $305,000 Promissory Note issued October 14, 2004; interest at 14% per annum; first installment of $25,000 due November 1, 2004 with monthly principal and interest installments of $10,000 thereafter; due January 1, 2007........................................... 305 305 Xillix Technologies Corporation, $361,000 Promissory Note issued June 26, 1998; interest rate Canadian Prime plus 6% per annum; represents a debt of AccuMed................................................... 34 34 Ungaretti & Harris LLP, $211,368 Secured Promissory Note issued May 8, 2003; interest at 12% per annum; due September 30, 2003...................................................... 51 149 Ernst & Young LLP, $30,800 Promissory Note issued July 17, 2003; interest at 12% per annum commencing January 1, 2003; due December 31, 2003...................................................... 31 31 Western Economic Diversification, $221,000 Promissory Note issued June 1989; no interest; represents a debt of Oncometrics............................................... 247 239 Ventana Medical Systems, Inc., $62,946 Promissory Note issued November 30, 2003; due December 31, 2003; interest at 8% per annum payable after December 31, 2003 ..................................................... 21 21 ------ ------ $3,557 $4,955 F-15 Bridge I. In 2002, MDI issued an aggregate $3,185,000 in Bridge I Convertible Promissory Notes to accredited investors. The notes bear interest at the rate of 7% per annum and are convertible at any time into the common stock of MDI at a conversion price equal to 75% of the market price of the Company's common stock on the date of conversion. In addition, MDI issued to each holder a warrant that entitled each such holder to purchase one share of common stock at an exercise price of $0.25 per share for each dollar of principal. MDI calculated a fair value of $99,950 for these warrants using the fair value interest rate method and recorded this amount as additional interest expense during 2002. In addition, at the time of conversion of the note, each holder is entitled to receive a warrant to purchase one share of common stock for each four shares of common stock into which the note converts at an exercise price equal to 150% of the conversion price of the note. This offer continued to remain outstanding as of December 31, 2005. MDI has not determined a value for these warrants as of December 31, 2004 and 2005. Since the conversion price of the note is at a 25% discount to the market price of the common stock of MDI, the holder is considered to have a beneficial conversion feature. Management extended a written offer, dated October 10, 2003, to the Bridge I noteholders to convert their notes and accrued interest into common shares at a conversion rate of $0.15 per share. In addition, the Bridge I holders were offered warrants to purchase one new share for every four shares acquired by the noteholder upon exercise of such holder's conversion rights under the notes. This offer continued to remain outstanding as of December 31, 2005. During the twelve months ended December 31, 2004, holders of $1,325,000 principal amount of Bridge I convertible promissory notes elected to convert their notes and related accrued interest of approximately $173,000 into 9,985,182 shares of unregistered common stock. The remaining $750,000 in principal Bridge I notes remained unconverted and outstanding at December 31, 2004. During the twelve months ended December 31, 2005, holders of Bridge I Convertible Promissory Notes elected to convert an aggregate $301,000 note principal and accrued interest into 2,008,962 of unregistered common stock. The remaining $500,000 in principal Bridge I notes remained unconverted and outstanding at December 31, 2005. Bridge II. Beginning in October 2002, MDI began an issue of up to $4,000,000 in Bridge II Convertible Promissory Notes to accredited investors. MDI issued $550,000 in Bridge II notes as of December 31, 2002. From January 1, 2003 through the closing of the offering on December 5, 2003, MDI issued Bridge II notes in the principal amount of: $1,980,200 in exchange for cash, $1,060,000 as a conversion of a Bridge I Convertible Promissory Note (see discussion above) and $305,667 in exchange for a note payable to Peter P. Gombrich, the Company's then-Chairman, for a total issuance during fiscal year 2003 of $3,345,867. The notes bear interest at a rate of 12% per annum payable at the maturity date in kind in the form of shares of common stock of MDI. The Company granted the holders a junior security position in all of its assets. The notes are convertible at any time into the common stock of MDI. The note conversion price and the value of common shares paid in kind as interest for the first $1,000,000 in principal amount of cash subscriptions, determined on a "first come - first served basis," is $0.10 per share. The note conversion price and the value of common shares paid in kind as interest for the remaining $3,000,000 of principal amount of notes in the series is $0.15 per share. The conversion prices of the notes issued during 2002 and 2003 were less than the market price of the common stock when the notes were issued; therefore, the holders are considered to have a beneficial conversion feature. MDI determined the value of the beneficial conversion feature to be $1,777,200 and $330,000 at December 31, 2003 and 2002, respectively. The value was recorded as a reduction of the debt and will be amortized as additional interest over the life of the notes. MDI recorded additional interest expense of zero and $334,909 to reflect amortization of the discount during the twelve months ended December 31, 2005 and 2004, respectively. At the time MDI completes significant additional funding plans, as outlined in the subscription agreement for the Bridge II notes, each holder of Bridge II notes is entitled to receive a warrant to purchase one share of the common stock of the Company for each four shares of common stock into which the note is convertible at an exercise price of $0.15 per share for notes in the class pertaining to the first $1,000,000 in subscriptions and $0.20 for the remaining $3,000,000 in note principal subscriptions. In September 2003, an amendment to the Bridge II convertible promissory notes was sent to holders requesting an extension of the notes to July 31, 2004. As additional consideration for the extension, holders were offered an increase in the interest rate from 12% to 15%. In addition, an amendment to the indenture also offered an increase in the warrant coverage ratio from 25% to 33%. The Bridge II offering was closed as of December 5, 2003. F-16 For the 12 months ended December 31, 2004, holders of $2,146,000 principal amount of Bridge II convertible promissory notes elected to convert their notes and related accrued interest of approximately $251,000 into 17,619,242 shares of unregistered common stock. Included in the above conversion amounts are amounts due Peter P. Gombrich, the Company's then Chairman, of $305,667 in Bridge II principal and $11,431 in accrued interest thereon, which were converted into an aggregate 2,113,987 shares of unregistered common stock. The remaining $1,300,000 in principal Bridge II notes remained unconverted and outstanding at December 31, 2004 and 2005, respectively. Bathgate Capital Partners, LLC - Bridge III. Beginning in January 2004, Bathgate Capital Partners, LLC began an offering of a maximum of $4,000,000 and a minimum of $1,500,000 in Bridge III Convertible Promissory Notes to accredited investors on behalf of the Company. The notes bear interest at 10% per annum payable, on a semi-annual basis, in kind in the form of shares of common stock for the first two years and then in cash for the remaining three years until due December 31, 2008. The note conversion price and the value of common shares paid in kind as interest is $0.10 per share. The notes are convertible at any time into the common stock of MDI, although the notes will automatically convert if the last sales price of the stock is $0.30 or higher for twenty consecutive trading days, the daily average trading volume is at least 250,000 shares, and the underlying shares are registered for sale. The holders were also granted a security interest in all of the Company's assets. MDI granted each note holder the right to receive 25% warrant coverage on all money invested; therefore, for every $100,000 invested, an investor will receive warrants to purchase 25,000 shares of common stock at an exercise price of $0.15 per share. The warrants expire on December 31, 2008. The Bridge III offering documents provided that funds raised would not be released from escrow until the following requirements were met: o A minimum investment of $1,500,000 had been reached; o The $190,000 Convertible Promissory Note held by Suzanne Gombrich was converted into common shares; o A portion of the Bridge II Convertible Promissory Note holders converted their notes into common shares; and o Peter P. Gombrich, MDI's then-current Chairman and CEO, would resign his position as CEO of the Company. With the exception of the conversion of Suzanne Gombrich's note, which was converted following stockholder approval of an increase in the number of authorized shares of common stock of the Company in July 2004, these requirements were satisfied on April 2, 2004 and the Company issued $1,500,000 in convertible promissory notes in exchange for cash. The funds were used for repayment of the Suzanne Gombrich note, payment of taxes, and working capital. On May 21, 2004, the Company issued an additional $162,500 in Bridge III notes in exchange for cash. The conversion prices of the notes issued during 2004 were less than the market price of the common stock when the notes were issued; therefore, the holders are considered to have a beneficial conversion feature. MDI determined the value of the beneficial conversion feature to be $1,604,000 at June 30, 2004. The value was recorded as a reduction of the debt and will be amortized as additional interest over the life of the notes. MDI recorded additional interest expense of $266,014 and $208,595 to reflect amortization of the discount during the 12 months ended December 31, 2005 and 2004, respectively. Through December 31, 2005, the Company had issued $1,662,500 in principal amount of Bridge III convertible promissory notes in exchange for cash. For the twelve months ended December 31, 2005, holders of Bridge III Convertible Promissory Notes elected to convert an aggregate $1,568,459 note principal and accrued interest into 15,282,236 unregistered common shares. As a result of the Bridge III notes conversion, the Company recorded interest expense of $918,176 for the remaining unamortized beneficial conversion feature discount on the note principal. The remaining $302,500 in principal Bridge III notes remained unconverted and outstanding at December 31, 2005. F-17 Bridge IV. Beginning in February 2004, MDI began a separate offering of Bridge IV Convertible Promissory Notes to accredited investors. The notes bear interest at 10% per annum payable, on a semi-annual basis, in kind in the form of shares of common stock for the first two years and then in cash for the remaining three years until the December 31, 2008 maturity date. The note conversion price and the value of common shares paid in kind as interest is $0.10 per share. The conversion price of the notes issued to date has been less than the market price of the common stock when the notes were issued; therefore, the holders are considered to have a beneficial conversion feature. MDI determined the value of the beneficial conversion feature to be $499,000 and $1,292,000 at June 30, 2004 and March 31, 2004, respectively. The value was recorded as a reduction of the debt and will be amortized as additional interest over the life of the notes. MDI recorded additional interest expense of $278,636 and $302,288 to reflect amortization of the discount during the 12 months ended December 31, 2005 and 2004, respectively. The notes are convertible at any time into the common stock of MDI, although the notes will automatically convert if the last sales price of the stock is $0.30 or higher for twenty consecutive trading days, the daily average trading volume is at least 250,000 shares, and the underlying shares are registered for sale. The holders were also granted a security interest in all of the Company's assets. MDI granted each note holder the right to receive 25% warrant coverage on all money invested; therefore, for every $100,000 invested, an investor will receive warrants to purchase 25,000 shares of common stock at an exercise price of $0.15 per share. The warrants expire on December 31, 2008. Through December 31, 2005, the Company had issued $2,573,500 in principal amount of Bridge IV convertible promissory notes in exchange for cash. As of December 31, 2005, all holders of Bridge IV Convertible Promissory Notes elected to convert an aggregate $2,624,266 note principal and accrued interest into 25,605,000 unregistered common shares. As of December 31, 2005, the Bridge IV note holders representing over 85% of the total principal note amounts also elected to waive $332,455 accrued interest resulting in a one-time interest forgiveness expense reduction for the year then ended. As a result of the Bridge IV notes conversion, the Company recorded interest expense of $1,209,975 for the remaining unamortized beneficial conversion feature discount on the note principal. There are no Bridge IV Convertible Promissory Notes outstanding as of December 31, 2005. Monsun. On November 1, 2000, MDI issued a convertible promissory note to Monsun, AS ("Monsun") in exchange for $500,000 in cash. The note bears interest at the rate of 20% per year and was originally due 12 months from the date of issue. The note is convertible into common stock, any time after the expiration of the first 180 days of the loan term, at a conversion price of $1.00 per share. On October 31, 2001, Monsun and MDI agreed to the first extension of the maturity date of the note until January 31, 2002. As consideration for the first extension agreement, MDI issued a three-year warrant to Monsun, entitling the holder to purchase 100,000 shares of common stock of MDI at an exercise price of $0.60 per share. On January 31, 2002, Monsun and MDI agreed to the second extension of the maturity date of the note until June 30, 2002. As consideration for the second extension agreement, MDI issued a three-year warrant to Monsun, entitling the holder to purchase 200,000 shares of common stock of MDI at an exercise price of $0.30 per share. A fair value of $4,110 for the warrant was calculated using the fair value interest rate method and was recorded as additional interest expense during 2002. On April 1, 2002, Monsun and MDI agreed to the third an final extension of the maturity date until July 31, 2002. As consideration for the third extension agreement, MDI issued a five-year warrant to Monsun, entitling the holder to purchase 200,000 shares of common stock of MDI at an exercise price of $0.70 per share. A fair value of $8,287 for the warrant was calculated using the fair value interest rate method and was recorded as additional interest expense during 2002. In November 2002, MDI issued 200,000 shares of common stock of MDI as a default penalty on the note. A fair value of $42,000 for the shares was calculated using the market price of the common stock on the date the shares were issued and recorded as financing expenses during 2002. MDI made payments against the principal of the note amounting to $117,266 and recorded interest expense, in addition to the amounts mentioned above, of $80,200 during 2002. In January 2003, Monsun initiated a legal action against Peter Gombrich, MDI's then-Chairman, as a personal guarantor on the note, in an attempt to collect the unpaid principal balance of the note. Monsun was successful in obtaining a legal judgment of approximately $675,000 related to the note balance and accrued interest against Mr. Gombrich as personal guarantor. In addition, Monsun was granted an award of approximately $438,000 for attorneys' fees against Peter Gombrich as the personal guarantor. The award for legal fees has been recorded as an accrued expense. (See Note 5 - Accrued Expense) The Company continues to negotiate the terms of a settlement of the outstanding balance due. F-18 MonoGen, Inc. In October 2004, MDI entered into a settlement agreement with MonoGen, Inc. relating to a arbitration proceeding brought against AccuMed and Oncometrics for alleged breaches in connection with certain license and related agreements among the parties. MDI issued a promissory note to MonoGen in the amount of $305,000, payable in an initial installment of $25,000 on November 1, 2004 and monthly installments thereafter of $10,000 until the note is paid in full, and agreed to transfer to MonoGen certain assets. Inasmuch as the assets were not timely transferred, and because the initial $25,000 payment to be made under the note was not paid by its due date, MonoGen delivered a notice of default to the Company and AccuMed in November 2004. Ungaretti & Harris LLP. In March 2005, MDI entered into a settlement agreement, related to a lawsuit filed by Ungaretti & Harris for unpaid legal fees, for $150,000 payable in installments of $25,000 commencing March 22, 2005 with subsequent payments due in ninety day increments until the balance is paid in full. The parties have since modified the settlement agreement and MDI has two final payments to make which will conclude in June 2006. See Note 13 - Legal Proceedings for a description of the legal proceedings regarding or giving rise to the above notes. Defaults. Specific events of default have occurred on a significant majority of the outstanding notes payable issued by MDI, including the Bridge I and Bridge II convertible promissory notes, ranging from failure to make principal payments when due to breach of certain warranties and representations. The notes payable require the holder to notify MDI in writing of a declaration of default at which time a cure period, as specified in each individual note, would commence. There is no guarantee that MDI would be able to cure any event of default if, or when, the holder provides the required written notice. Other than the Monsun convertible promissory note and the MonoGen note payable, MDI has not received any written declarations of default from holders of its outstanding notes payable. Carrying Amounts. Management believes it is not practicable to estimate the fair value of the notes payable due to the uncertainty regarding repayment or possible conversion and the Company's current financial condition. Note 8. Stockholders' Equity Sale of Equity A summary of the Company's preferred stock capital table as of December 31, 2005 is as follows:
Shares Issued & Offering Shares Authorized Outstanding -------- ----------------- --------------- Series A convertible...................... 590,197 82,655 Series B convertible, 10% cumulative...... 1,500,000 365,106 Series C convertible, 10% cumulative...... 1,666,666 245,833 Series D convertible, 10% cumulative...... 300,000 175,000 Series E convertible, 10% cumulative...... 800,000 233,598 Undesignated Preferred Series............. 5,143,137 -- ----------- ----------- Total Preferred Stock..................... 10,000,000 1,102,192 =========== ===========
Convertible Cumulative Preferred Stock Conversions: During the third quarter of 2005, a holder of Series C Convertible Cumulative Preferred Stock elected to convert 17,000 shares and cumulative dividends into 118,260 unregistered shares of the Company's common stock. During the first six months of 2004, several holders converted 930,000 shares of Series C convertible preferred stock, including cumulative dividends due thereon, into 5,703,816 shares of common stock. In April 2004, holders of Series B Convertible Preferred Stock elected to convert 422,250 of preferred shares and accrued dividends into 2,211,401 shares of unregistered common stock. In December 2004, a holder of Series B Convertible Preferred Stock elected to convert 12,500 of preferred shares and accrued dividends into 69,397 shares of unregistered common stock. In June 2004, holders of Series E Convertible Preferred Stock elected to convert 25,939 of preferred shares and accrued dividends into 892,154 shares of unregistered common stock. During the third and fourth quarters of 2004, holders of Series E Convertible Preferred Stock elected to convert 1,227 preferred shares and accrued dividends into 43,329 shares of unregistered common stock. F-19
Summary of Preferred Stock Terms Series A Convertible Preferred Stock Liquidation Value: $4.50 per share Conversion Price: $10.3034 per share Conversion Rate: 0.4367--Liquidation Value divided by Conversion Price ($4.50/$10.3034) Voting Rights: None Dividends: None Conversion Period: Any time Series B Convertible Preferred Stock Liquidation Value: $4.00 per share Conversion Price: $1.00 per share Conversion Rate: 4.00--Liquidation Value divided by Conversion Price ($4.00/$1.00) Voting Rights: None Dividends: 10%--Quarterly--Commencing June 30, 2001 Conversion Period: Any time Cumulative dividends in arrears at December 31, 2005 were $719,383 Series C Convertible Preferred Stock Liquidation Value: $3.00 per share Conversion Price: $0.60 per share Conversion Rate: 5.00--Liquidation Value divided by Conversion Price ($3.00/$0.60) Voting Rights: None Dividends: 10%--Quarterly--Commencing June 30, 2002 Conversion Period: Any time Cumulative dividends in arrears at December 31, 2005 were $307,123 Series D Convertible Preferred Stock Liquidation Value: $10.00 per share Conversion Price: $1.00 per share Conversion Rate: 10.00--Liquidation Value divided by Conversion Price ($10.00/$1.00) Voting Rights: None Dividends: 10%--Quarterly--Commencing April 30, 2002 Conversion Period: Any time Cumulative dividends in arrears at December 31, 2005 were $729,726 Series E Convertible Preferred Stock Liquidation Value: $22.00 per share Conversion Price: $0.80 per share Conversion Rate: 27.50--Liquidation Value divided by Conversion Price ($22.00/$0.80) Voting Rights: Equal in all respects to holders of common shares Dividends: 10%--Quarterly--Commencing May 31, 2002 Conversion Period: Any time Cumulative dividends in arrears at December 31, 2005 were $2,062,875
F-20 Issuance of Common Shares for Cash 2005 Beginning in December 2004, MDI began an offering of common stock to accredited investors in exchange for cash. As part of the offering, MDI granted each investor a warrant to purchase common stock at an exercise price of $0.10 per share, with the first $250,000 of investment to receive 50% warrant coverage and subsequent investments in excess of $250,000 to receive 25% coverage. In the first quarter of 2005, the Company had received net aggregate proceeds of $505,000 and issued an aggregate 9,608,334 shares of restricted common stock, as well as warrants to purchase 2,402,084 shares of common stock. MDI valued the warrants at $183,775 using the Black-Scholes valuation model and recorded the amount to additional paid-in-capital - warrants for the quarter ended March 31, 2005. In the second quarter of 2005, the Company received net aggregate proceeds of $96,000 and issued an aggregate 2,250,000 shares of restricted common stock, as well as warrants to purchase 562,500 shares of common stock, in connection with the offering begun in December 2004. MDI valued the warrants at $23,671 using the Black-Scholes valuation model and recorded the amount to additional paid-in-capital - warrants for the quarter ended June 30, 2005. In the third quarter of 2005, the Company received net aggregate proceeds of $579,700 and issued an aggregate 29,660,000 shares of unregistered subscribed common stock at $0.025 per share with no warrant coverage and are reflected in Additional Paid-In Capital until such time as such shares are actually issued by the Company's transfer agent and will then be reflected in our Common Stock register and account. In the fourth quarter of 2005, the Company received net aggregate proceeds of $302,000 and issued an aggregate 12,850,496 shares of unregistered subscribed common stock at prices per share ranging from $0.025 to $0.04 with no warrant coverage and are reflected in Additional Paid-In Capital until such time as such shares are actually issued by the Company's transfer agent and will then be reflected in our Common Stock register and account. 2004 In August and October 2004, MDI offered common stock to accredited investors in exchange for cash. Through December 31, 2004, the Company had received an aggregate $560,000 and had issued an aggregate 6,821,429 shares of restricted common stock. Also in October 2004, MDI entered into a stock purchase agreement with Seaside Investments PLC, a private investment company, for the purchase by Seaside of 11,000,000 shares of MDI's restricted common stock in exchange for registered shares of the investment company. The transaction was never consummated. Beginning in December 2004, MDI began an offering of common stock to accredited investors in exchange for cash. MDI also granted each investor a warrant to purchase common stock at an exercise price of $0.10 per share, with the first $250,000 of investment to receive 50% warrant coverage and subsequent investors to receive 25% coverage. Through December 31, 2004, the Company had received an aggregate $250,000 and issued an aggregate 4,166,667 shares of restricted common stock and warrants to purchase 2,083,334 shares of common stock. MDI valued the warrants at $208,333 using the Black-Scholes valuation model and recorded the amount as an administrative expense for the 2004 fiscal year. Issuance of Common Stock for Services 2005 In the fourth quarter of 2005, MDI issued 650,496 shares of common stock at $0.025 per share in exchange for services to a non-employee professional services firm for $16,262 services due in full satisfaction of the vendor's accounts payable balance due as of December 31, 2005. F-21 2004 In August 2004, MDI issued 924,333 shares of common stock in exchange for services to a non-employee professional services firm for past services. MDI calculated a fair value of $92,433 for these shares based on the value of the shares on the date of issuance and recorded the amount as satisfaction of the vendor's accounts payable balance as of September 30, 2004. In August 2004, MDI issued 1,200,000 shares of common stock in exchange for services to a non-employee financial consultant for future services. MDI calculated a fair value of $120,000 for these shares based on the value of the shares on the date of issuance and is amortizing the amount over the remainder of the service contract. In September 2004, MDI issued 572,748 shares of common stock to a non-employee service vendor in lieu of payment for unpaid invoices. MDI calculated a fair value of $57,275 for these shares based on the market value of the shares on the date of issuance and recorded the amount as satisfaction of the vendor's accounts payable balance as of September 30, 2004 based on a settlement agreement. In September 2004, MDI issued 275,000 shares of common stock to a non-employee financial consultant for past financial services. MDI calculated a fair value of $27,500 for these shares based on the value of the shares on the date of issuance and recorded the amount as an administrative expense as of September 30, 2004. In September 2004, MDI issued 250,000 shares of common stock to a non-employee professional services firm for past investor relations services. MDI calculated a fair value of $25,000 for these shares based on the value of the shares on the date of issuance and recorded the amount as an administrative expense as of September 30, 2004. In October 2004, MDI issued 485,000 shares of common stock to a non-employee financial consultant for past financial services. MDI calculated a fair value of $33,950 for these shares based on the value of the shares on the date of issuance and recorded the amount as an administrative expense as of December 31, 2004. In November 2004, MDI issued 450,000 shares of common stock to a non-employee professional services firm for past investor relations services. MDI calculated a fair value of $36,000 for these shares based on the value of the shares on the date of issuance and recorded the amount as an administrative expense as of December 31, 2004. In December 2004, MDI issued 175,000 shares of common stock to a non-employee service vendor in lieu of payment for unpaid invoices. MDI calculated a fair value of $21,000 for these shares based on the market value of the shares on the date of issuance and recorded the amount as satisfaction of the vendor's accounts payable balance as of December 31, 2004 based on a settlement agreement. In December 2004, MDI issued 16,666 shares of common stock to a former-employee as part of a settlement. MDI calculated a fair value of $1,333 for these shares based on the market value of the shares on the date of issuance and recorded the amount as satisfaction of the accrued wage balance as of December 31, 2004 based on a settlement agreement. Issuance of Warrants for Services 2005 In February 2005, MDI issued warrants to purchase 200,000 shares of common stock with an exercise price of $0.10 per share to a non-employee financial consultant for past financial services. MDI valued the warrants at $16,260 using the Black-Scholes valuation model and recorded the amount as a current quarter administrative expense. In May 2005, MDI issued warrants to purchase 556,500 shares of common stock with an exercise price of $0.06 per share to a non-employee financial consultant for past financial services. MDI valued the warrants at $25,265 using the Black-Scholes valuation model and recorded the amount to additional paid-in capital - warrants for the quarter ended June 30, 2005. 2004 F-22 Between January 2004 and March 2004, MDI issued an aggregate 2,252,581 warrants with an exercise price of $0.20 per share to Bridge I investors upon conversion of their notes per the indenture agreement. MDI valued the warrants at $369,066 using the Black-Scholes valuation model and recorded the amount as an administrative expense for the first quarter of fiscal 2004. In March 2004, MDI issued warrants to purchase 67,000 shares of common stock of the Company with an exercise price of $0.17 per share to a non-employee financial consultant for past financial services. MDI valued the warrants at $13,400 using the Black-Scholes valuation model and recorded the amount as an administrative expense for the first quarter of fiscal 2004. In March 2004, MDI issued warrants to purchase 500,000 shares of common stock of the Company with an exercise price of $0.17 per share to a non-employee financial consultant for past financial services. MDI valued the warrants at $95,000 using the Black-Scholes valuation model and recorded the amount as an administrative expense for the first quarter of fiscal 2004. In April 2004, MDI issued 47,230 warrants with an exercise price of $0.20 per share to Bridge I investors upon conversion of their notes per the indenture agreement. MDI valued the warrants at $9,474 using the Black-Scholes valuation model and recorded the amount as an administrative expense for the 2004 fiscal year. In May 2004, MDI issued warrants to purchase an aggregate 119,042 shares of common stock of the Company with exercise prices ranging from $0.15 to $0.16 per share to non-employee service vendors in lieu of payment for unpaid service invoices. MDI valued the warrants at $18,181 using the Black-Scholes valuation model and recorded the amount as a reduction of the outstanding amount due. In May 2004, MDI issued warrants to purchase 500,000 shares of common stock of the Company with an exercise price of $0.17 per share to a non-employee financial consultant for past financial services. MDI valued the warrants at $76,200 using the Black-Scholes valuation model and recorded the amount as an administrative expense for the second quarter of fiscal 2004. In June 2004, MDI issued warrants to purchase an aggregate 364,942 shares of common stock of the Company with exercise prices ranging from $0.16 to $0.17 per share to non-employee service vendors in lieu of payment for unpaid service invoices. MDI valued the warrants at $42,368 using the Black-Scholes valuation model and recorded the amount as a reduction of the outstanding amount due. In June 2004, MDI issued warrants to purchase 780,000 shares of common stock of the Company with an exercise price of $0.17 per share to a non-employee financial consultant for past financial services. MDI valued the warrants at $73,320 using the Black-Scholes valuation model and recorded the amount as an administrative expense for the second quarter of fiscal 2004. In June 2004, MDI issued warrants to purchase 681,625 shares of common stock of the Company with an exercise price of $0.18 per share to a non-employee broker-dealer for past financial services. MDI valued the warrants at $62,914 using the Black-Scholes valuation model and recorded the amount as an administrative expense for the second quarter of 2004. In August 2004, MDI issued warrants to purchase 500,000 shares of common stock of the Company with an exercise price of $0.17 per share to a non-employee consultant for past services. MDI valued the warrants at $45,000 using the Black-Scholes valuation model and recorded the amount as an administrative expense for the third quarter of fiscal 2004. In September 2004, MDI issued warrants to purchase 200,000 shares of common stock of the Company with an exercise price of $0.10 per share to a non-employee professional services firm for past investor relations services. MDI valued the warrants at $18,400 using the Black-Scholes valuation model and recorded the amount as an administrative expense for the third quarter of fiscal 2004. F-23 In September 2004, MDI issued warrants to purchase 20,000 shares of common stock of the Company with an exercise price of $0.20 per share to a non-employee consultant for past services. MDI valued the warrants at $1,780 using the Black-Scholes valuation model and recorded the amount as an administrative expense for the third quarter of fiscal 2004. In September 2004, MDI issued warrants to purchase 25,000 shares of common stock of the Company with an exercise price of $0.20 per share to a non-employee service vendor in lieu of payment for unpaid services. MDI valued the warrants at $2,225 using the Black-Scholes valuation model and recorded the amount as a reduction of the outstanding amount due. In November 2004, MDI issued warrants to purchase 300,000 shares of common stock of the Company with an exercise price of $0.20 per share to a professional services firm for past investor relations services. MDI valued the warrants at $18,000 using the Black-Scholes valuation model and recorded the amount as an administrative expense for the fourth quarter of fiscal 2004. In December 2004, MDI issued 196,489 warrants with an exercise price of $0.20 per share to Bridge I investors upon conversion of their notes per the indenture agreement. MDI valued the warrants at $19,649 using the Black-Scholes valuation model and recorded the amount as an administrative expense for the fourth quarter of fiscal 2004. Issuance of Warrants for Debt On July 18, 2003, Mr. Milley, a director of MDI, Azimuth Corporation (of which Mr. Milley is President and Chairman of the Board) and Cadmus Corporation (of which Mr. Milley is President), agreed to cancel seven warrants held by Azimuth and one warrant held by Cadmus, which warrants entitled the holders to purchase a total of 3,125,000 shares of MDI common stock at various exercise prices between $0.01 and $1.25 per share. The warrants, issued between December 1999 and August 2001, contained anti-dilution clauses which required MDI to increase the number of shares of common stock the holders were entitled to purchase under the warrants by approximately 1,500,000 shares as of the date of the agreement, with commensurate adjustments in individual exercise prices so that gross proceeds to the Company from exercise of the warrants remained the same. These anti-dilution provisions could have required the Company to make additional adjustments in shares and exercise prices in the future based on the Company's issuance of debt or equity instruments at prices below the adjusted exercise prices of these warrants. In consideration for the parties' agreement to cancel these warrants, including their individual anti-dilution clauses, and the forgiveness of approximately $100,000 owed to Azimuth and Cadmus, in February 2005, MDI issued warrants to purchase 2,875,000 and 3,625,000 shares to Azimuth and Cadmus, respectively, at an exercise price of $0.30 per share. MDI had also agreed to issue a 120-day warrant entitling the holders to purchase 500,000 shares of common stock at an exercise price of $0.30, which warrant expired on November 19, 2003. MDI valued the warrants at $420,551 using the Black-Scholes valuation model and recorded the amount as a current quarter administrative expense. Exchange of certain Bridge I, III, IV Convertible Promissory Notes for Common Shares As described in more detail in Note 7, during the third quarter of fiscal 2005, noteholders of certain Bridge I, III and IV Convertible Promissory Notes elected to exchange an aggregate $4,494,000 principal and accrued interest for 42,896,198 unregistered shares of the Company's common stock Application of Black-Scholes Valuation Model In applying the Black-Scholes valuation model for the years 2005 and 2004, the Company has used an expected dividend yield of zero, a risk-free interest rate of 4.61% and 4.85% for the 2005 and 2004 periods, respectively, volatility factors of 277% and 131%, respectively, and a fair value of the underlying common shares equal to the closing market price on the date of the grant for both periods. The expected life equaled the term of the warrants, options, or restricted shares. F-24 Warrants At December 31, 2005, the Company had the following outstanding warrants to purchase shares of Common Stock: Weighted Average Total Shares Exercisable Exercise Price Expiration Date ------------ ----------- -------------- --------------- 39,834 39,834 $15.060 Perpetual 180,000 180,000 $0.720 January 8, 2006 25,000 25,000 $0.010 February 1, 2006 1,000,000 1,000,000 $0.250 February 7, 2006 599,942 599,942 $1.200 February 28, 2006 1,100,000 1,100,000 $0.200 July 2, 2006 150,000 150,000 $1.200 July 10, 2006 750,000 750,000 $1.000 July 26, 2006 312,500 312,500 $1.000 August 6, 2006 150,000 150,000 $0.500 October 1, 2006 172,120 172,120 $0.820 October 11, 2006 597,750 597,750 $1.000 November 30, 2006 200,000 200,000 $0.700 March 31, 2007 51,493 51,493 $0.010 May 31, 2007 3,185,000 3,185,000 $0.250 July 31, 2007 200,000 200,000 $0.160 November 1, 2007 1,000,000 1,000,000 $0.100 April 2, 2008 500,000 500,000 $0.170 September 2, 2008 400,000 400,000 $0.170 September 16, 2008 935,000 935,000 $0.170 September 16, 2008 415,625 415,625 $0.100 December 31, 2008 643,375 643,375 $0.100 December 31, 2008 2,130,984 2,130,984 $0.170 June 7, 2009 681,625 681,625 $0.180 June 15, 2009 700,000 700,000 $0.170 August 26, 2009 200,000 200,000 $0.100 September 15, 2009 345,000 345,000 $0.200 September 15, 2009 2,083,334 2,083,334 $0.100 December 9, 2009 2,588,445 2,588,445 $0.200 December 1, 2009 250,000 250,000 $0.330 July 14, 2009 375,000 375,000 $0.100 January 2, 2010 291,667 291,667 $0.100 January 24, 2010 454,167 454,167 $0.100 January 25, 2010 6,500,000 6,500,000 $0.300 February 8, 2010 200,000 200,000 $0.100 February 15, 2010 239,583 239,583 $0.100 February 16, 2010 500,000 500,000 $0.100 March 17, 2010 41,667 41,667 $0.100 March 20, 2010 500,000 500,000 $0.100 March 23, 2010 541,667 541,667 $0.100 April 6, 2010 556,500 556,500 $0.060 May 2, 2010 20,833 20,833 $0.100 May 17, 2010 750,000 750,000 $0.001 February 12, 2012 ----------- ---------- ------ 32,558,111 32,558,111 $0.650 =========== ========== ====== F-25 The Company is obligated under the terms of subscription agreements for the Bridge I and Bridge II convertible promissory notes to issue additional warrants to the note holders based on certain events. If and when the holder of a Bridge I note elects to convert the principal of the note into shares of MDI common stock, the holder is entitled to receive a warrant to purchase one share of MDI common stock for each four shares of MDI common stock into which the note is converted at an exercise price equal to $0.20, based on the written offer dated October 10, 2003. Since the Bridge I convertible promissory note holders have not all accepted the offer to convert their convertible promissory notes and accrued interest into common shares at $0.15 per share, the number of warrants to be issued cannot be determined until such time as the notes are actually converted into the common stock of MDI. If and when the Company completes additional financing plans as outlined in the subscription agreements for the Bridge II notes, the holder of a Bridge II note will be entitled to receive a warrant to purchase one share of stock for each three shares into which the note is convertible. The exercise price of the warrants is $0.15 per share for Bridge II notes that fall into the class of the first $1,000,000 in cash subscriptions and $0.20 for the holders of the remaining Bridge II notes. Certain warrants in the above table entitling the holders, Azimuth Corporation and Cadmus Corporation, to purchase a total of 3,125,000 shares of common stock include anti-dilution provisions over and above the standard anti-dilution provisions triggered by dilution resulting from common stock dividends and stock splits or reverse stock splits. These additional provisions consider other items as dilutive events, including but not limited to the issuance of convertible debt or equity securities, options, and warrants. A calculation of the dilutive effect of a convertible security is required at the time the security is issued rather than if and when actual conversion takes place. The Company calculated that at December 31, 2002, these warrants were required to be adjusted to reflect that the holders were entitled to purchase an additional 519,000 shares of common stock. The exercise prices of the warrants would be adjusted so that the total proceeds to the Company from an exercise of these warrants would remain the same. The Company also calculated that as of the beginning of July 2003, additional adjustments were required to reflect that holders were entitled to purchase a further 897,000 additional shares with commensurate adjustments in per share exercise prices. On July 18, 2003, the Company negotiated an agreement with the holders of these warrants, whereby the holders agreed to cancel the warrants and forgive approximately $100,000 owing to the holders by MDI as of that date. The Company agreed to issue new warrants to the holders entitling them to purchase an aggregate 6,500,000 shares of common stock at an exercise price of $0.30 per share. The Company also agreed to issue a 120-day warrant entitling the holders to purchase 500,000 shares of common stock at $0.30 per share, which warrant expired November 19, 2003. The new warrants contain only standard anti-dilution provisions. The final agreement was signed and the warrants issued in the first quarter of 2005. Shares of Common Stock The shareholders approved at the Company's Annual Meeting of Stockholders the amendment to the Company's Certificate of Incorporation (as amended to date) to increase the number of authorized shares of common stock from 300,000,000 shares to 375,000,000 shares in anticipation of raising capital through the issuance of Company securities. Note 9. Leases As of December 31, 2005, the Company leased approximately 2,540 square feet of space for its Chicago, Illinois corporate headquarters and research laboratory and offices under an operating lease expiring in 2008. Total rental expense related to the Company's headquarters location during the years ended December 31, 2005 and 2004 was $68,000 and $119,000, respectively. MDI had another lease obligation relating to the pre-merger office space of AccuMed. During 2002, AccuMed's landlord brought suit against AccuMed for unpaid rent and obtained a judgment in the amount of approximately $157,000. In the first quarter of 2004, a preliminary settlement was reached on the outstanding judgment and four payments totaling $54,896 were paid. As of December 31, 2005, a balance of one monthly payment totaling $13,724 remains due. MDI also agreed to issue 823,466 shares of its common stock as part of the final settlement. Future minimum annual lease payments under these leases as of December 31, 2005 are (in thousands): F-26
AccuMed Operating Lease Year Leases Obligation ---- ------ ---------- 2006.......................................................... $ 70 $ 115 2007.......................................................... $ 72 2008.......................................................... $ 62 ----- ---------- Total lease payments.......................................... $ 204 $ 115 ===== ========== Amount of interest included in the minimum lease payments..... $ (19) ---------- Carrying value of lease obligation............................ $ 96 ========== F-27
Note 10. Income Taxes Significant components of deferred income taxes consist of the following at December 31 (in thousands): 2005 2004 -------- -------- Deferred tax assets related to: Net operating loss carryforwards.......... $ 24,271 $ 22,497 Writedown of intangibles................ 16 18 Accrued liabilities.................. 231 -- Accrued expenses.................... 122 113 -------- -------- 24,640 22,628 Less valuation reserve......... 24,640 22,628 -------- -------- Net deferred tax asset........... $ -- $ -- ======== ======== At December 31, 2005, the Company had domestic net operating loss carryforwards aggregating approximately $61,000,000. For financial reporting purposes, the entire amount of deferred tax assets related principally to the net operating loss carryforwards has been offset by a valuation allowance due to uncertainty regarding the realization of the assets. The valuation allowance increased by approximately $2,012,000 and $2,714,000 for the years ended December 31, 2005 and 2004, respectively. The net operating loss carryforwards and research and development credit carryforwards may not be available to offset future taxable income of MDI due to statutory limitations based on changes of ownership and other statutory restrictions. The net operating loss carryforwards begin to expire in 2006. The research and development credit carryforwards expire from 2005 to 2014. Note 11. Equity Incentive Plan and Employee Stock Purchase Plan On May 25, 1999, MDI stockholders approved the establishment of the 1999 Equity Incentive Plan effective as of June 1, 1999 (the "Plan"). The Plan provides that the Board may grant various forms of equity incentives to directors, employees, and consultants, including but not limited to Incentive Stock Options, Non-Qualified Stock Options, Stock Appreciation Rights, and Restricted Stock Awards. Grants under the Plan are exercisable at fair market value determined as of the date of grant in accordance with the terms of the Plan. Grants vest to recipients immediately or ratably over periods ranging from two to five years, and expire five to 10 years from the date of grant. On May 23, 2000, stockholders approved amendment No. 1 to the Plan, which increased the number of shares of common stock allocated for use in the Plan from 2,000,000 shares to 3,000,000 shares. On June 21, 2002, stockholders approved a second amendment to the Plan, which increased the number of shares allocated for use in the Plan from 3,000,000 shares to 5,500,000 shares. On July 29, 2004 stockholders approved a third amendment to the Plan, which increased the number of shares for use in the Plan from 5,500,000 to 20,000,000 shares. The Board of Directors has also granted options to purchase common stock of MDI that are not covered by the terms of the Plan. MDI applies APB No. 25 and related interpretations in accounting for options granted to employees under the Plan. No compensation cost was recorded during 2005 or 2004 for options granted to employees, as the exercise price approximated the fair value of the underlying common stock on the date of the grant. Had stock options been accounted for under the fair value method recommended by FAS 123, the Company's net loss allocated to common stockholders would have been changed to the pro forma amounts indicated below: F-28
For the Year Ended December 31, 2005 2004 ---------- ---------- (in thousands except for per share amounts) Net loss applicable to common shareholders as reported............. $ (4,326) $ (14,601) Deduct: Total stock-based compensation expense determined under the fair value based method for all awards and forfeitures, net of related taxes................................ (9) (139) ---------- ---------- Pro forma net loss applicable to common shareholders............... $ (4,335) $ (14,740) ========== ========== Basic loss and diluted per share applicable to common shareholders - as reported........................................ $ (.04) $ (.19) ========= ========== Basic and diluted loss per share applicable to common shareholders - pro forma.......................................... $ (.04) $ (.19) ========= ==========
The fair value for these options was estimated at the date of the grant using a Black-Scholes option pricing model with the following weighted average assumptions: risk-free interest rates of 4.61% and 4.85% for the 2005 and 2004 periods, respectively; dividend yields of zero; volatility factors of the expected market price of the Company's common stock of 277% and 131% for each year and a weighted average expected life of the options of 2.5 to 5 years. A summary of the Company's stock option activity and related information follows:
Weighted Average Exercise Options Price --------- -------- Outstanding at December 31, 2003 ........................... 3,494,648 Granted .................................................... 2,500,000 $ 0.1540 Exercised .................................................. -- Forfeited .................................................. (1,046,921) $ 1.0276 ---------- Outstanding at December 31, 2004 ........................... 4,947,727 Granted .................................................... -- Forfeited .................................................. (943,736) $ 1.9032 ---------- Outstanding at December 31, 2005 ........................... 4,003,991 ========== Exercisable at December 31, 2005 ........................... 3,290,658 $ 0.4412 ========== Weighted average fair value of options granted in 2004...... $ 0.1540
No options were granted in fiscal 2005. At the Annual Meeting of Stockholders on May 25, 1999, MDI stockholders also approved the 1999 Employee Stock Purchase Plan (the "Purchase Plan"). The Purchase Plan offers employees the opportunity to purchase shares of common stock of MDI through a payroll deduction plan at 85% of the fair market value of such shares at specified enrollment measurement dates. The aggregate number of shares available for purchase under the Plan is 200,000. Note 12. Commitments and Contingencies On October 11, 2001, MDI obtained a 30% ownership interest in Cell Solutions, LLC, a Virginia limited liability company. MDI determined the fair value of the investment to be impaired at December 31, 2001. The investment was written down to zero as a result of the uncertainty of any future benefit or revenue stream. In February 2004, MDI surrendered any and all ownership in Cell Solutions, LLC. F-29 Note 13. Legal Proceedings Settled in 2005 The Cleveland Clinic Foundation. In March 2003, The Cleveland Clinic Foundation filed suit against MDI (U.S. District Court for the Northern District of Ohio, Eastern Division (Case No. 1:03CV056)) seeking approximately $315,000 for certain clinical trial work conducted by the Foundation in the Peoples Republic of China on behalf of MDI. In June 2005, the parties executed a settlement agreement and in September 2005, MDI made final payment of $85,000 in full satisfaction of the settlement agreement and requested that the Foundation take all steps necessary to file a satisfaction of judgment. MDI has no further monetary obligations under this settlement. Daniel Kussworm, Jennifer Kawaguchi, and Susan Keesee. In February 2004, former MDI employees Daniel Kussworm, Jennifer Kawaguchi, and Susan Keesee filed suit against MDI and former Chairman Peter Gombrich, in the Circuit Court of Cook County, Illinois (04 L 1941) to recover wages and other compensation allegedly due them. These claims were settled and fully satisfied in January 2005, and the lawsuit has been dismissed. Ungaretti & Harris. In May 2004, the law firm Ungaretti & Harris LLP filed an amended complaint against MDI in the Circuit Court of Cook County, Illinois (04 L 1101), to collect fees for services rendered prior to December 31, 2003. In January 2005, the court entered summary judgment in favor of Ungaretti & Harris and against MDI in the amount of $195,500, plus costs of suit. The parties subsequently entered into a settlement agreement to satisfy the judgment. MDI has one final payment to make in June of 2006. The Lash Group, Inc. In June 2004, The Lash Group, Inc., a healthcare consulting firm, filed a lawsuit against the Company in the General Court of Justice, Superior Court Division, in Mecklenburg County, North Carolina (04 CVS 10367). The Lash Group sought approximately $94,000, plus interest, attorney fees, and court costs, for the alleged breach of an agreement, with respect to which Peter Gombrich, the former Chairman and Chief Executive Officer, and MDI were sought to be held primarily liable. In October 2005, MDI entered into a settlement agreement with The Lash Group, which required The Lash Group to file a voluntary dismissal with prejudice of the lawsuit. In March 2006, MDI made its final payment in full satisfaction of the settlement agreement. MDI has no further monetary obligations under this settlement. Eric Gombrich. In May 2004, former MDI officer Eric Gombrich filed suit against MDI, Denis M. O'Donnell, M.D., Peter Gombrich, Dennis Bergquist, and Michael Brodeur (some of whom are no longer officers or directors of the Company) in the Circuit Court of Cook County, Illinois (04 L 05661). Mr. Gombrich claimed that MDI breached a written employment contract and that it owed him $631,258 (plus interest) and 300,000 shares of MDI stock. In October 2005, MDI entered into a settlement agreement with Mr. Gombrich pursuant to which MDI agreed to pay Mr. Gombrich an aggregate $116,000 in three scheduled payments and issue him a warrant to purchase 300,000 shares of the Company's common stock at an exercise price of $.10 per share exercisable until July 31, 2009. The parties also agreed to a release and covenant not to sue for any and all claims arising out of Mr. Gombrich's employment. Pursuant to the settlement, the case against all defendants was dismissed in November 2005. MDI has made the three scheduled payments and has no further monetary obligations under this settlement. Kanan, Corbin, Schupak & Aronow, Inc. In August 2004, Kanan, Corbin, Schupak & Aronow, Inc. ("KCSA") filed suit against AccuMed International, Inc. f/d/b/a Molecular Diagnostics, Inc., in the Circuit Court of Cook County, Illinois (04 L 9109), seeking $59,678, plus interest and court costs, for services provided. The parties agreed to a settlement in 2005, which was paid in full. MDI has no further monetary obligation under this settlement. Reid Jilek. In October 2004, Reid Jilek filed a lawsuit against MDI in the Circuit Court of Cook County, Illinois (04 CH 17375). Mr. Jilek claimed that MDI had breached a 2003 services agreement and that MDI subsequently breached a 2004 settlement agreement. Mr. Jilek sought $180,000 pursuant to the services agreement or, alternatively, $114,000 pursuant to the settlement agreement. Mr. Jilek also sought a court order that MDI issue him 1,500,000 warrants to purchase MDI stock at $0.17 per share pursuant to the services agreement. MDI previously issued to Mr. Jilek warrants to purchase 500,000 shares of its common stock at $0.17 per share. MDI entered into a settlement agreement with Mr. Jilek in December 2005 pursuant to which MDI paid Mr. Jilek $15,000 for attorney fees, issued him warrants to purchase 1,000,000 shares at $.04 per share (in exchange for the cancellation of the previously issued warrants to purchase 500,000 shares) and has agreed to pay Mr. Jilek $5,000 each month for the next 30 months. The first four payments have been made as scheduled. F-30 Esoterix, Inc. Esoterix, Inc. made a claim against MDI for $19,725 arising from a laboratory services agreement that it maintained MDI breached. In March 2005, Esoterix filed suit against MDI to collect this claim in the Circuit Court of Cook County, Illinois (05 M1 116482). MDI entered into a settlement agreement with Esoterix in October 2005 pursuant to which MDI agreed to pay Esoterix $13,000 in full satisfaction of its claims. The case was dismissed following payment in October 2005. The parties also agreed to a mutual release of all claims. Pending as of December 31, 2005 and Settled in 2006 Arthur Lipper III. In July 2004, Arthur Lipper III filed a lawsuit against MDI in the Circuit Court of Cook County, Illinois (04 L 7671). Mr. Lipper claims that MDI breached a consulting services agreement and sought $60,000, plus interest and court costs. MDI entered into a settlement agreement with Mr. Lipper in February 2006 pursuant to which MDI has agreed to pay Mr. Lipper $60,000 in full satisfaction of his claims. Under the agreement, MDI's payments to Mr. Lipper will conclude in April 2006. The lawsuit has been dismissed. Diamics LLC. In October 2005, the Company filed suit against Diamics LLC and related parties in the U.S. District Court, Northern District of California (C05-4282). Diamics was formed by Peter Gombrich, MDI's former Chairman of the Board and CEO. MDI alleged that Mr. Gombrich and a former employee misappropriated MDI's proprietary information, trade secrets and patented products, and the suit charged Diamics with misappropriation of trade secrets, unfair business practices, conversion, and patent and copyright infringement. MDI's suit against Diamics was in part a response to a suit filed by Diamics against MDI in June 2005 in the U.S. District Court, Northern District of California (C05-02549). The complaint in that suit sought declaratory judgment of no misappropriation, conversion, libel or unjust enrichment, and requested that the court enter judgment as follows: declaration that Diamics has not directly or indirectly misappropriated MDI's trade secrets, confidential and proprietary intellectual property, reputation, or goodwill; declaration that Diamics has not converted MDI's confidential and proprietary intellectual property; declaration that Diamics has not been unjustly enriched; and for an order enjoining MDI and its officers, agents, servants, and employees from asserting that Diamics or its employees engaged in the above mentioned conduct. These cases were settled and MDI has no further monetary obligations under the settlement. Pending as of December 31, 2005 and March 31, 2006 Hill & Barlow LLP. In February 2003, Hill & Barlow LLP, a now defunct law firm, filed a complaint against MDI in the Trial Court of the Commonwealth of Massachusetts (000740), seeking the collection of unpaid legal fees. Judgment was entered against MDI in the amount of $16,842, plus costs and interest. In April 2004, the parties entered into a settlement agreement. The terms of settlement have not been fully satisfied by the parties because a dispute has arisen concerning the return of MDI's files. Given that the law firm has dissolved, management does not expect a final resolution of this matter. Medical College of Georgia Research Institute, Inc. In November 2003, the Medical College of Georgia Research Institute, Inc. filed suit against MDI in the Superior Court of Richmond County, Georgia (Case No. 2003-RCCV-1211) to collect amounts allegedly due pursuant to an agreement to provide a clinical study for MDI. Georgia Research Institute claimed that the principal amount of the obligation due from MDI was approximately $86,700, but sought to collect approximately $315,300 pursuant to an interest provision of 10% per month. In October 2004, the court entered summary judgment in favor of Georgia Research Institute and against MDI in the amount of $68,404. The Regents of the University of California. In May 2004, The Regents of the University of California filed suit against MDI in the Superior Court of California, County of San Francisco (CGC-04-431944). The University of California claims that MDI breached an agreement to sponsor a research project for a period of one year. The complaint seeks compensatory damages in the amount of $57,530 and additional lost opportunity damages in the amount of $75,220. In January 2005, the University of California requested that the court enter a default judgment against MDI in the amount of $132,827, which includes court costs. The parties have been involved in settlement negotiations with respect to this matter. F-31 Peter Gombrich. In April 2005, former MDI officer Peter Gombrich filed suit against MDI and MDI's former Chief Executive Officer Denis M. O'Donnell, M.D. in the Circuit Court of Cook County, Illinois (05 L 4543). Mr. Gombrich claims that MDI breached a written employment contract and that it owes him in excess of $849,500 (plus interest and attorneys' fees). Mr. Gombrich also alleged a claim against MDI for contribution and indemnification regarding agreements he allegedly signed as a personal guarantor for certain alleged MDI obligations. MDI filed a motion to compel the case to arbitration, consistent with Mr. Gombrich's employment agreement. This motion was granted in August 2005. In late 2005, MDI filed its answer and affirmative defenses, and has asserted numerous counterclaims against Mr. Gombrich. The hearing on the parties' counterclaims is currently proceeding before the arbitrator. Miscellaneous Other Creditors; Wage and Related Claims. MDI is a defendant in a few lawsuits brought by current or former unsecured creditors to collect past due amounts for goods and services. MDI has recorded the amounts due in its records and is attempting to settle these suits and unfiled claims. MDI is also currently negotiating the settlement of wage claims brought by a former employee and a former consultant seeking to collect for unpaid wages and severance benefits. MDI has recorded the amounts due in its records and is attempting to settle these claims. MDI does not consider any of these claims to be material. The Lumber Company (formerly Garrett Realty, Inc.). Prior to MDI's acquisition of AccuMed, Garrett Realty, Inc. filed suit against AccuMed for unpaid rent and related expenses under a lease for office space located in Chicago, Illinois (Circuit Court of Cook County, Illinois (Case No. 01 M1 725821)). In July 2002, judgment was entered in favor of Garrett in the amount of approximately $157,000. In December 2002, pursuant to a court order, Garrett seized approximately $12,500 from an MDI bank account as a partial payment against the judgment amount. MDI recorded a $290,000 lease obligation in accounting for the AccuMed merger based on the present value of the future payments, but contested the right of Garrett to pursue collection of the judgment against the assets of MDI. During the first quarter of 2004, MDI reached a preliminary settlement on the outstanding judgment amounting to approximately $157,000 (plus interest) at that time, which required six monthly payments. In 2004, MDI made the first four required monthly payments. MDI also agreed to issue shares of its common stock as part of the final settlement. In March 2005, Garrett assigned its right, title and interest in the judgment to The Lumber Company. In March 2006, MDI and Lumber Co. entered into a formal settlement agreement under the same general terms reflected above. In connection with that March 2006 agreement, MDI paid to Lumber Co. $13,724 and owes one final payment of $13,724. MDI also issued to Lumber Co. 823,466 shares of MDI common stock. Final payment was made in April 2006. MDI has no further monetary obligations under this settlement. Note 14. Subsequent Events Delinquent Tax Liabilities MDI is delinquent in paying federal and state employee and employer payroll taxes for the fourth quarter of fiscal 2005. These remain unpaid at April 13, 2006. MDI is also delinquent in filing certain federal and state income tax returns for 2004, 2003 and 2002 and is working to complete and file such returns. Short-term Liquidity Problems During the first quarter of 2006, MDI continued to experience severe liquidity problems and had insufficient cash on hand to effectively manage the business during such period. From January 1, 2005 through March 31, 2006, the Company raised $2,390,500 from the issuance of common stock to accredited investors. MDI has continued to raise operating cash pursuant to the issuance of additional restricted common stock and management is in the process of negotiating additional financing. F-32 Plan to Restructure Outstanding Liabilities The Company's new management team is working to develop a restructuring proposal to provide unsecured creditors a settlement plan, which is contingent on the Company's ability to raise sufficient new equity to fund operations. Note 15. 2005 Third Quarter 10-QSB Management determined during the year-end audit that the interest expense reported in the consolidated statement of operations for the quarter ended September 30, 2005 was understated by approximately $2,128,000. This interest expense charge represents the unamortized portion of the beneficial conversion feature only for the Bridge III and Bridge IV note holders that converted. This charge was required to be recognized and expensed when the convertible promissory note holders converted their notes and accrued interest into the Company's common stock. Because the year-end results supersede that filing, the Company elected to only reflect the change in these consolidated financial statements. The Company intends to reclassify the 2005 comparable amounts when the 2006 third quarter results are reported for the period ended September 30, 2006. F-33 Schedule IX--Valuation and Qualifying Accounts
Additions Charged Balance Balance at to Costs at End Beginning and Other of Description of Period Expenses Retirements Changes Period ----------- --------- -------- ----------- ------- ------ Reserves and allowances deducted from asset accounts.......... Allowance for uncollectible accounts receivable................... Year ended December 31, 2005............ $ 0 $ 0 $ 0 $ 0 $ 0 Year ended December 31, 2004............ $ 50 $ 0 $ 50 $ 0 $ 0 Reserves and allowances which support balance sheet caption reserves........ Warranty reserves Year ended December 31, 2005............ $ 0 $ 0 $ 0 $ 0 $ 0 Year ended December 31, 2004............ $ 0 $ 0 $ 0 $ 0 $ 0 Inventory reserves Year ended December 31, 2005............ $ 57 $ 21 $ 0 $ 0 $ 78 Year ended December 31, 2004............ $ 0 $ 57 $ 0 $ 0 $ 57
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