-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, DEk1wxV1ZqT3oKC72ebImqHHkvDwi/1dM8qjnjClaGCV371EldINX7+LoaXld9It a15xDTrHL9oXegL6ky9ZdQ== 0000897101-98-000353.txt : 19980401 0000897101-98-000353.hdr.sgml : 19980401 ACCESSION NUMBER: 0000897101-98-000353 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 10 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980331 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: CNS INC /DE/ CENTRAL INDEX KEY: 0000814258 STANDARD INDUSTRIAL CLASSIFICATION: ELECTROMEDICAL & ELECTROTHERAPEUTIC APPARATUS [3845] IRS NUMBER: 411580270 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-16612 FILM NUMBER: 98581202 BUSINESS ADDRESS: STREET 1: PO BOX 39802 CITY: MINNEAPOLIS STATE: MN ZIP: 55439 BUSINESS PHONE: 6128206696 MAIL ADDRESS: STREET 2: PO BOX 39802 CITY: MINNEAPOLIS STATE: MN ZIP: 55439 10-K 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1997 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition period from _________ to __________ COMMISSION FILE NUMBER: 0-16612 CNS, INC. (Exact name of registrant as specified in its charter) DELAWARE 41-1580270 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) P.O. BOX 39802 MINNEAPOLIS, MN 55439 (Address of principal executive offices and zip code) Registrant's telephone number, including area code: (612) 820-6696 Securities registered pursuant to section 12(b) of the Act: None Securities registered pursuant to section 12(g) of the Act: Title of each class Common stock, par value of $.01 per share Preferred stock purchase rights Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES _X_ No___ Indicate by check mark if disclosure of delinquent filers pursuant to Rule 405 of Regulation S-K is not contained herein, and will not 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-K or any amendment to this Form 10-K. [ ] As of March 3, 1998, assuming as market value the price of $6.3125 per share, the closing sale price of the Company's Common Stock on the Nasdaq National Market, the aggregate market value of shares held by non-affiliates was approximately $103,643,000. As of March 3, 1998, the Company had outstanding 18,393,059 shares of Common Stock of $.01 par value per share. Documents Incorporated by Reference: The Company's (i) Annual Report to Stockholders for the year ended December 31, 1997, and (ii) Proxy Statement for its Annual Meeting of Stockholders to be held on April 22, 1998, are incorporated by reference into Parts II and III of this Form 10-K. TABLE OF CONTENTS
PAGE ---- PART I Item 1. Business................................................................................. 3 Item 2. Properties............................................................................... 14 Item 3. Legal Proceedings........................................................................ 15 Item 4. Submission of Matters to a Vote of Security Holders...................................... 15 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.................... 16 Item 6. Selected Financial Data.................................................................. 16 Item 7. Management's Discussion and Analysis of Financial Condition.............................. 16 and Results of Operations Item 7A. Quantitative and Qualitative Disclosures about Market Risk............................... 16 Item 8. Financial Statements and Supplementary Data.............................................. 16 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.................................................................. 16 PART III Item 10. Directors and Executive Officers of the Registrant....................................... 17 Item 11. Executive Compensation................................................................... 17 Item 12. Security Ownership of Certain Beneficial Owners and Management........................... 17 Item 13. Certain Relationships and Related Transactions........................................... 17 PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K................................................................... 18 SIGNATURES ......................................................................................... 19
FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K contains forward-looking statements under the Private Securities Litigation Reform Act of 1995 that are subject to certain risks and uncertainties that could cause actual results to differ materially from those presently anticipated or projected. Such forward-looking statements can be identified by the use of terminology such as "may," "will," "expect," "plan," "intend," "anticipate," "estimate," or "continue" or comparable terminology. Factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to the following factors: (i) the Company's revenue and profitability is currently reliant on sales of a single product, Breath Right nasal strips; (ii) the Company's success will depend, to a large extent, on the enforceability and comprehensiveness of the patents on the Breathe Right(R) nasal strip technology, which have been, and in the future may be, the subject of litigation (see Item 3, Legal Proceedings); (iii) the markets in which the Company competes are highly competitive; (iv) the Company will face challenges in successfully introducing any new products; (v) the fact that the Company is dependant upon contract manufacturers for the production of substantially all of its products; (vi) the fact that the Company is partially dependent upon 3M Company for sale of its products internationally, and (vii) the fact that the Company's products are generally subject to government regulation. PART I ITEM 1. BUSINESS GENERAL CNS, Inc. (the "Company") develops and markets consumer products, including the Breathe Right nasal strip. The Breathe Right strip improves breathing by reducing nasal airflow resistance. It can be effective in eliminating or reducing snoring, for the temporary relief of nasal congestion and for the temporary relief of breathing difficulties due to a deviated nasal septum. The Company recently launched BANISH (TM), a personal smoke deodorizer that removes same-day tobacco smoke odor trapped in clothing and hair. The Company also has entered into or is exploring a number of agreements to market or license other new consumer products, including a chewable dietary fiber tablet. These new products are in various stages of evaluation and testing. PRODUCTS BREATHE RIGHT NASAL STRIPS. The Breathe Right nasal strip is a nonprescription single-use disposable device that improves breathing by reducing nasal airflow resistance. The Company received 510(k) clearances from the United States Food and Drug Administration ("FDA") to market the Breathe Right nasal strip for improvement of nasal breathing (October 1993), reduction or elimination of snoring (November 1995), temporary relief of nasal congestion (February 1996) and temporary relief of breathing difficulties due to a deviated nasal septum (May 1996). The Breathe Right nasal strip comes both in tan and a nearly transparent product, the Breathe Right Near Clear(TM) nasal strip. The Breathe Right nasal strip includes two embedded plastic strips. When folded down onto the sides of the nose, the Breathe Right nasal strip lifts the side walls of the nose outward to open the nasal passages. The product improves nasal breathing upon application and does not include any medication, thereby avoiding any medicinal side effects. The Breathe Right nasal strip is offered in three sizes (junior/small, small/medium and medium/large) to accommodate the range of nose sizes from a child's nose to an adult's nose. The Breathe Right nasal strip is packaged for the consumer market in quantities of 10, 24 or 30 strips per box. The Company believes that the Breathe Right nasal strip is priced comparably to medicinal decongestants on a daily or nightly dosage basis at suggested retail prices of $4.99 for a box of ten and $11.99 for a box of 30. The Company introduced its new Breathe Right Near Clear nasal strips at a suggested retail price of $11.99 for a box of 24. The Company has begun its expansion of the Breathe Right product line with the introduction of Breathe Right Near Clear nasal strips, a nearly transparent product that the Company believes may help reduce the vanity issues associated with daytime use of the Breathe Right product. The Company introduced Breathe Right Near Clear nasal strips in the second half of 1997 and the strips became available in stores in November. The Company also intends to introduce additional non-nasal strip products that carry the Breathe Right name and extend the Breathe Right product line. Potential new products include a saline nasal spray and allergen barrier pillow covers. BANISH PERSONAL SMOKE DEODORIZER. Late in 1997, the Company began introduction of the BANISH personal smoke deodorizer, a water based nontoxic odorless spray that removes same day odor from clothes and hair. This product does not cover up the tobacco smoke odor, it neutralizes it. The product is available in 2 and 3 fl. oz. bottles and a 12 fl. oz. refill bottle. The Company intends to begin national advertising of BANISH in the second quarter of 1998. MARKETS BREATHE RIGHT PRODUCT LINE. The Breathe Right nasal strip is sold primarily in the consumer market, and to a lesser extent in the athletic market and the professional medical market. A substantial number of potential users may be included in more than one market. CONSUMER MARKET. Air impedance in the nose accounts for half of the total airway resistance involved in the respiratory system (i.e., half of the energy required for breathing). If the effort to breathe through the nose during sleep is excessive, the person will resort to mouth breathing, promoting snoring, dry mouth, sore throat and mini-awakenings which disrupt sleep. In addition, nasal breathing difficulties during sleep are often caused by nasal congestion found in people with allergies, sinusitis and the common cold and by nasal obstruction due to a deviated nasal septum. The Company believes that people with deviated septa or other structural problems or chronic conditions such as snoring may be more predisposed to use the Breathe Right nasal strip on a regular or daily basis while seasonal sufferers are likely to use the Breathe Right nasal strip as needed. People with these medical conditions are currently the primary users of the product and are the primary targets of the Company's advertising. In November 1997, the Company began a focused campaign to increase Breathe Right product sales in the consumer market, using a Breathe Right. SLEEP TIGHT (TM). advertising campaign. The new campaign, with its emphasis on better night time breathing and better sleep, provides an umbrella to point out the benefits of Breathe Right strips for a variety of large consumer markets. * Sleep quality can be enhanced by improving nasal breathing at night with a Breath Right strip. Nearly 88% of all households in the United States report nightly sleep disruptions, many of which are related to poor breathing. * Breathe Right nasal strips were effective in reducing snoring loudness or eliminating snoring in 75% of the participants in a clinical study. The Company believes that 78% of all households have at least one snorer, and that approximately 37 million people snore regularly while another 50 million people snore occasionally. * Nasal congestion as a result of allergies affects approximately 35 million Americans while substantially all Americans suffer some nasal congestion annually as a result of the common cold. The Company believes that the Breathe Right nasal strip is often used as either an alternative or adjunct to decongestant drugs (including nasal sprays and oral decongestants). * Approximately 12 million people in the United States suffer from a deviated septum, a bend in the cartilage or bone that divides the nostrils. Breathe Right strips were cleared by the Food and Drug Administration in 1996 to provide temporary relief from breathing difficulties associated with a deviated septum. ATHLETIC MARKET. The Company believes that the product may make nasal breathing more comfortable and may improve endurance during athletic activity, particularly when a mouth guard is used. An exercise physiology study published in peer-reviewed medical literature in 1997 concluded that the Breathe Right nasal strip provided physiologic advantages in ventilation and heart rate during mid-level exercise. Other exercise physiology studies are being conducted and are expected to add to substantiation of the positive effects of the Breathe Right nasal strips during exercise. The Breathe Right nasal strip has been used by professional and collegiate athletes in sports such as football and hockey, by race car drivers and horse racing jockeys and by recreational athletes, including runners and bikers. The Company uses athletes to endorse the Breathe Right nasal strip to increase the visibility of the product, which thereby leads to awareness of the product for not only its athletic applications, but also for snoring, nasal congestion and other applications. PROFESSIONAL MEDICAL MARKET. The Company also sells Breathe Right nasal strips to the professional medical market. Sales into this market have been limited to date and the Company is reevaluating the best way to penetrate this market. BANISH PERSONAL SMOKE DEODORIZER. The Company believes there are approximately 50 million adult smokers in the United States, 16 million of whom are in positions that involve high interaction with others who could be offended by smoke odor. There are also a significant number of additional Americans that do not smoke, but are exposed to smoke in environments such as bars, restaurants, offices, or factories. The Company believes BANISH has potential use both for smokers and non-smokers who wish to eliminate tobacco smoke odor. BUSINESS STRATEGY The Company's business strategy includes increasing sales of its Breathe Right nasal strip, expanding its Breathe Right product line and successfully introducing new products such as BANISH personal smoke deodorizer. INCREASING NEW CONSUMER PRODUCT TRIAL AND INCREASING PRODUCT USAGE. The Company uses a combination of advertising, promotions and celebrity endorsements to increase consumer awareness of the Breathe Right nasal strip and its benefits and to encourage consumer trial of the product. During the fourth quarter of 1997, the Company introduced a new advertising campaign Breathe Right. SLEEP TIGHT., which promotes better sleep through use of Breathe Right nasal strips. The campaign provides an umbrella to point out the benefits of Breathe Right strips for a variety of large consumer markets including sleep, snoring, nasal congestion and a deviated septum. By the end of 1997, household trial of the Breathe Right nasal strip was approximately 13.5%. MARKETING NEW PRODUCTS THAT LEVERAGE DISTRIBUTION CHANNELS. The Company plans to leverage its marketing and distribution strengths by acquiring or licensing the rights to products that it believes have merit and by attempting to bring them to market. In late 1997, the Company introduced BANISH personal smoke deodorizer and plans to begin national advertising in the second quarter of 1998. Among other products currently being evaluated is a unique, chewable dietary fiber tablet. Current plans are to introduce this product later in 1998. There can be no assurance that the Company will ever successfully market any of the Company's new products. EXPANDING COMPANY PRESENCE IN INTERNATIONAL MARKET. The Company sells its Breathe Right nasal strip outside the United States pursuant to an international distribution agreement under which 3M Company agreed to act as exclusive distributor for the Breathe Right nasal strip in all counties outside of the United States and Canada. The Company believes international markets require an increased level of advertising and promotion to reach their potential. Under a new arrangement with 3M, the Company and 3M will jointly undertake a more aggressive advertising and promotional campaign in the United Kingdom early in 1998. A similar approach is anticipated over the next two to three years in a number of other countries where both companies believe the approach could enhance Breathe Right nasal strip sales. This will also allow the Company to build its international marketing and distribution capacity in preparation for other Company products. MARKETING NEW PRODUCTS THAT LEVERAGE THE BREATHE RIGHT BRAND NAME. The Company believes that the Breathe Right brand name is one of its most valuable assets. The Company is in the process of evaluating new products that leverage off the Breathe Right name. Potential products include a saline nasal spray and allergen barrier pillow covers. MARKETING STRATEGY BREATHE RIGHT NASAL STRIPS. The Company began broad consumer marketing of the Breathe Right nasal strip in September 1994. According to data collected by Information Resources, Inc. ("IRI"), the Breathe Right nasal strip became a leading sales volume producer during 1995 in the cough, cold and allergy section of drug, grocery and mass merchant stores nationwide. In September 1995, the Company received two REX (retail excellence) awards from Drug Stores News magazine. The first award named the Breathe Right nasal strip as the best new product in the cough, cold and allergy section in U.S. drug stores. The second award named the product the "market maker of the year," the single most important product which disproportionately increased traffic and profits in U.S. drug stores. In 1997, the Breathe Right brand was the number one ranking brand in annual dollar sales in the nasal products category, with sales exceeding those of familiar brand names such as Afrin(R), Vicks Sinex(R) and Dristan(R). The Company's marketing efforts are primarily directed to the consumer market. The Company's advertising focuses on the snoring and nasal congestion applications for the product using the campaign Breathe Right. SLEEP TIGHT. The campaign, with its emphasis on better night time breathing and better sleep, provides an umbrella for the Company to point out the benefits of Breathe Right nasal strips for a variety of large consumer markets. The Company primarily uses a mix of consumer and trade promotions and magazine, radio and television advertising to market the Breathe Right nasal strip. Marketing communications are generally designed to promote trial of the Breathe Right nasal strip by increasing consumer awareness of the product's benefits. The Company's paid advertising programs have been enhanced by media coverage of use of Breathe Right nasal strips by professional athletes. In addition, a number of radio and television personalties have provided unsolicited endorsements of the product on national radio and television programs. The Company has also entered into endorsement agreements pursuant to which athletes will provide the Company with endorsement services. The Company believes that use by professional athletes increases the visibility of the product, which thereby leads to greater awareness of the product for not only its athletic applications but also for snoring, nasal congestion and other applications, and also makes it more acceptable for consumers to wear the highly visible product. The Company also uses product promotion programs, such as coupons, and public relations activities to encourage product trial and repeat purchases. Typically, coupons for the Breathe Right nasal strip appear three to four times each year in free standing inserts (FSIs) that are included in Sunday newspapers and are often tied to a holiday or special event theme such as Super Bowl, Fathers Day, or the Christmas holidays (stocking stuffer). In 1997, the Company undertook joint promotions with two of the nations best-known brand names KLEENEX (R) tissues, and TYLENOL(R) PM pain reliever. The Company intends to seek additional joint promotion opportunities in the future. To increase consumer product awareness, the Company also uses public relations programs associated with "special events," such as sponsoring marathons, providing product to certain professional athletic teams and sponsoring radio station contests in conjunction with certain holidays. Because the Breathe Right nasal strip is sold as a consumer product, sales of the product will depend in part upon the degree to which the consumer is aware of the product and is satisfied with its use, which also influences repeat usage and word of mouth referrals. The most recent research data collected by a nationally recognized consumer market research firm indicated that approximately 32% of those in the U.S. who had purchased Breathe Right nasal strips have purchased additional product. BANISH PERSONAL SMOKE DEODORIZER. The Company intends to market its BANISH personal smoke deodorizer to the consumer market. Similar to its marketing of Breathe Right nasal strips, the Company intends to use public relations to launch the BANISH personal smoke deodorizer by making consumers aware of the product's benefits. Beginning in the second quarter of 1998 the Company anticipates using a mix of consumer and trade promotions and radio and magazine advertising to market the product. DOMESTIC DISTRIBUTION The Breathe Right nasal strip is sold primarily as a consumer product in drug stores, grocery stores, mass merchant chain stores, warehouse clubs, military base stores and convenience stores in the U.S. The Company sells product to retailers through a network of independent sales representatives referred to in the industry as non-food general merchandise brokers. The Company uses broker groups who call on the chain drug, grocery, mass merchant and warehouse club accounts and the wholesalers who serve primarily the independent drug stores and many of the grocery stores in the U.S. Although the Company's advertising focuses on both the snoring and nasal congestion applications, the Breathe Right nasal strip is typically positioned in the cough, cold and allergy section of the store because Breathe Right nasal strips provide benefits similar to those obtained with decongestant products and there is typically no section in stores for snoring relief products. Many store managers have also placed the product in secondary locations, such as on the pharmacy counter or in special sections located at the end of an aisle reserved for better selling products. The Company's retail customers for the Breathe Right nasal strip include national chains of drug stores, grocery stores and mass merchants such as Eckerd, Walgreens, RiteAid, CVS, Albertson's, Kroger, Wal-Mart and Kmart and warehouse clubs such as Sam's Club and Price Costco, as well as regional and independent stores in the same store categories. In 1997, one retailer accounted for approximately 18% of domestic Breathe Right nasal strip sales. The loss of this customer or any other large retailer would require the Company to replace the lost sales through other retail outlets and could temporarily disrupt distribution of the Breathe Right nasal strip. INTERNATIONAL DISTRIBUTION The Company executed an international distributor agreement with 3M in August 1995 pursuant to which 3M has the exclusive right to distribute the Breathe Right nasal strip outside of the U.S. and Canada. 3M has operations in over 60 foreign countries. The product is marketed internationally under the co-brand of "3M Breathe Right nasal strips" in order to benefit from both 3M's brand name and the publicity that the Breathe Right brand name has received. Under the terms of the agreement, 3M buys product from the Company either in finished form in 3M boxes or in bulk quantities to be packaged by 3M's international subsidiaries. All sales to 3M are denominated in U.S. dollars. 3M is responsible for obtaining all necessary regulatory approvals outside of the U.S. and for all marketing and selling expenses. The agreement contains certain minimum performance objectives and breakup provisions. The product was on retail shelves in over 40 countries by the end of 1997. The Company is in the process of negotiating modifications to certain minimum purchase and pricing provisions of the 3M agreement to enable the Company to take a more active role in sales and marketing in certain countries. In 1995, the Company arranged with LOCIN Industries, a Canadian dental floss company, to establish distribution in the Canadian market. LOCIN distributes the product to drug stores in Canada. During 1996, LOCIN began purchasing product in bulk and packaging it at its facility and assumed responsibility for cooperative advertising programs. BANISH PERSONAL SMOKE DEODORIZER DISTRIBUTION . The BANISH personal smoke deodorizer is being sold as a consumer product with distribution planned initially for drug stores, grocery stores, mass merchant chain stores and convenience stores. The Company sells product to retailers through its network of independent sales representatives. The planned primary location for the product in stores is tobacco accessories. THERAPATCH (TM) EXTERNAL ANALGESIC PATCH. In 1996, the Company began national distribution of the TheraPatch (TM), an external analgesic patch designed for temporary relief of pain from arthritis, simple backaches and muscular aches and strains. The Company is not actively pursuing distribution of the product at the current time and does not expect to do so in the near future. NEW PRODUCTS As a result of the Company's established distribution channels and highly visible success with the Breathe Right nasal strip, the Company is frequently approached by individuals and smaller companies to explore the possibility of partnering with the Company to manufacture and market new product ideas. The Company routinely evaluates the merit of these products, and from time to time may acquire or license the rights to products which it believes could successfully be sold through the Company's established distribution channels. The Company has entered into contractual arrangements for several products which are in various stages of evaluation and testing prior to potential market launch. The Company is currently evaluating a unique, chewable dietary fiber tablet with plans to introduce this product later in 1998. The Company plans to incur costs of approximately $1.5 million relating to evaluation and test marketing of these products in 1998. Most, if not all, of these products are regulated to varying degrees by the FDA and some will require extensive clinical studies and regulatory approvals prior to marketing. There can be no assurance that any required regulatory approvals will be obtained or that the Company will market any of these products. MANUFACTURING AND OPERATIONS The Company currently sub-contracts with multiple manufacturers, known as converters, to produce the Breathe Right nasal strip and does no in-house product production itself. The converters are capable of providing full turnkey service and shipping product to the Company that is completely packaged ready to be sold to retailers or providing semi-finished goods to the Company that require final packaging. To complete these products, the Company has the ability to wrap individual strips in the paper sleeve in-house and subcontracts the final packaging out to qualified packaging subcontractors. Each of these converters builds the product to the Company's specifications using materials specified by the Company and, for the major materials, places orders against a supply agreement negotiated by the Company with the material manufacturer. The converters have all entered into confidentiality agreements with the Company to protect the Company's intellectual property rights. Company quality control and operations personnel periodically visit the converters to observe processes and procedures. Finished goods are inspected at the Company to ensure that they meet quality requirements. The Company inspects its converters on a regular basis and is not aware of any material violation of FDA Good Manufacturing Practice Standards. The Company works closely with its material vendors and converters to reduce scrap and waste, improve efficiency, and improve yields to reduce the manufacturing costs of the product. In 1997, the Company received certification that it has established and maintains a quality system which meets the requirements of ISO 9002/EN 46002. To ensure consistent quality and favorable pricing, the Company has entered into a multi-year material supply agreement with 3M for the major components of the Breathe Right nasal strip. Although similar materials are currently available from other suppliers, the Company believes that 3M's materials are of superior quality. Although the Company believes that this relationship will not be disrupted or terminated, the inability to obtain sufficient quantities of these components or the need to develop alternative sources in a timely and cost effective manner could adversely affect the Company's operations until new sources of these components become available, if at all. In addition, while the Company does not expect 3M to do so, 3M has the right to discontinue its production or sale of these products at any time with 90 days notice to the Company. The Company has contracted with a third party for the production of the BANISH personal smoke deodorizer. COMPETITION The Company believes that the market for decongestant products is highly competitive while there is currently somewhat less competition in the market for products for the reduction or elimination of snoring. In the U.S., the Company's competition in the consumer market for decongestant products and other cold, allergy and sinus relief products consists primarily of pharmaceutical products while competition in the snoring remedies market consist primarily of internal nasal dilators. Although the Company believes that the patents on the Breathe Right nasal strip will somewhat limit the ability of others to introduce competitive external nasal dilator products in the United States, the Company announced in 1997 that it had become aware of a foreign reference to a nasal dilator that will result in narrower protection in the future for the patents licensed by the Company with respect to Breathe Right nasal strips. External nasal dilator products also compete in the consumer markets with decongestant and sinus relief products and snoring remedies in international markets where the Company does not have patent protection on the Breathe Right nasal strip. See "Patents, Trademarks and Proprietary Rights" below. Many of the manufacturers of the pharmaceutical products that compete with the Breathe Right nasal strip have significantly greater financial and operating resources than the Company. In addition, competitors may develop products which are able to circumvent the Company's patents. GOVERNMENT REGULATION As a manufacturer and marketer of medical devices, the Company is subject to regulation by, among other governmental entities, the FDA and the corresponding agencies of the states and foreign countries in which the Company sells its products. The Company must comply with a variety of regulations, including the FDA's Good Manufacturing Practice regulations, and is subject to periodic inspections by the FDA and applicable state and foreign agencies. If the FDA believes that its regulations have not been fulfilled, it may implement extensive enforcement powers, including the ability to ban products from the market, prohibit the operation of manufacturing facilities and effect recalls of products from customer locations. The Company believes that it is currently in compliance with applicable FDA regulations. FDA regulations classify medical devices into three categories that determine the degree of regulatory control to which the manufacturer of the device is subject. In general, Class I devices involve compliance with labeling and record keeping requirements and are subject to other general controls. Class II devices are subject to performance standards in addition to general controls. Class III devices are those devices, usually invasive, for which pre-market approval (as distinct from pre-market notification) is required before commercial marketing to assure the products' safety and effectiveness. The Breathe Right nasal strip has not yet been classified. Before a new medical device can be introduced into the market, the manufacturer generally must obtain FDA clearance through either a 510(k) pre-market notification or a pre-market approval application ("PMA"). A 510(k) clearance will be granted if the submitted data establish that the proposed device is "substantially equivalent" to a legally marketed Class I or II medical device, or to a Class III medical device for which the FDA has not called for PMAs. The PMA process can be expensive, uncertain and lengthy, frequently requiring from one to several years from the date the PMA is accepted. In addition to requiring clearance for new products, FDA rules may require a filing and waiting period prior to marketing modifications of existing products. The Company has received 510(k) approvals to market the Breathe Right nasal strip as a device that can (i) reduce or eliminate snoring, (ii) temporarily relieve the symptoms of nasal congestion and stuffy nose, (iii) improve nasal breathing by reducing nasal airflow resistance and (iv) temporarily relieve breathing difficulties due to a deviated nasal septum. BANISH personal smoke deodorizer is not a medical product and does not fall under the regulatory authority of the FDA. It does, however fall under the purview of the Federal Trade Commission (FTC) as a consumer product. In this context, the claims that are made concerning BANISH (express or implied) must have a reasonable basis before they are disseminated. The Company believes that it has a reasonable basis for all claims it is making with respect to BANISH. The Company's proposed dietary fiber product is considered to be a dietary supplement and is regulated under the Federal Food, Drug, and Cosmetic Act (the Act) as amended by the Dietary Supplement Health and Education Act "DSHEA" of 1994, and under the Fair Packaging and Labeling Act. There is generally no requirement that a firm obtain a license or approval from FDA before marketing dietary supplements in the U.S. The FDA is developing implementing regulations for certain provisions of the DSHEA which will be published as final rules in the Federal Register. In addition to the Company's medical device products, the Company has entered into an agreement to manufacture and market a smoking substitute and appetite suppressant product that the FDA may classify as either a "New Drug" or as a dietary supplement. The FDA must approve safety and effectiveness for each labeled use before a New Drug can be sold. As part of the requirements for obtaining approval of a New Drug, the Company will be required to conduct extensive preclinical studies to determine the safety and efficacy of the drug. Upon completion of these studies, the Company will submit an Investigational New Drug application ("IND") to the FDA, which permits the Company to begin clinical trials. These clinical trials of the products must be conducted and the results submitted to the FDA as part of a New Drug Application ("NDA"). The FDA must approve the NDA before pharmaceutical products may be sold in the U.S. The grant of regulatory approvals often takes a number of years and may involve the expenditure of substantial resources. There is no assurance that NDAs will be approved for the Company's products if any are required. Even after initial FDA approval has been granted, further studies may be conducted to provide additional data on safety or efficacy or to obtain approval for marketing the drug as a treatment for disease indications in addition to those originally approved. In addition, the FDA can revoke its approval even after it has initially been given. Sales of the Company's products outside the U.S. are subject to regulatory requirements governing human clinical trials and marketing approval for drugs, and such requirements vary widely from country to country. Under its current agreement with the Company, which is as noted above under "International Distribution" in the process of being renegotiated, 3M is responsible for obtaining all necessary regulatory approvals outside the U.S. for Breathe Right nasal strips. The Company believes it has provided 3M with the necessary documentation to enable 3M to obtain the "CE" mark, an international symbol of quality and compliance with applicable European medical device directives, and 3M is affixing the CE mark on the Company's products in Europe. No assurance can be given that the FDA or state or foreign regulatory agencies will give on a timely basis, if at all, the requisite approvals or clearances for additional applications for the Breathe Right nasal strip or for any of the Company's products which are under development. Moreover, after clearance is given, the Company is required to advise the FDA and these other regulatory agencies of modifications to its products. These agencies have the power to withdraw the clearance or require the Company to change the device or its manufacturing process or labeling, to supply additional proof of its safety and effectiveness or to recall, repair, replace or refund the cost of the medical device if it is shown to be hazardous or defective. The process of obtaining clearance to market products is costly and time-consuming and can delay the marketing and sale of the Company's products. Furthermore, federal, state and foreign regulations regarding the manufacture and sale of medical devices are subject to future change. The Company cannot predict what impact, if any, such changes might have on its business. The Company is also subject to substantial federal, state and local regulation regarding occupational health and safety, environmental protection, hazardous substance control and waste management and disposal, among others. PATENTS, TRADEMARKS AND PROPRIETARY RIGHTS The Company entered into a license agreement in 1992 (the "License Agreement") pursuant to which the Company acquired from the licensor (the "Licensor") the exclusive rights to manufacture and sell the Breathe Right nasal strip. Specifically, the Company has the exclusive right pursuant to the License Agreement to manufacture, sell and otherwise practice any invention, including the Breathe Right nasal strip, claimed in the Licensor's patent applications related thereto and all patents issued in any country which correspond to those applications. The Company must pay royalties to the Licensor based on sales of the Breathe Right nasal strip including certain minimum royalty amounts to maintain its exclusivity. The Company is also responsible for all costs and expenses incurred in obtaining and maintaining patents related to the Breathe Right nasal strip. The Licensor has filed patent applications with the U.S. Patent and Trademark Office seeking patent protection for different aspects of the Breathe Right nasal strip technology. Six of these patent applications have resulted in issued patents, including one with claims that cover the single-body construction of the Breathe Right nasal strip. The Company has one patent application pending. The Licensor has also obtained patent protection on the Breathe Right nasal strip in three foreign countries and has various applications pending which seek patent protection in a number of additional countries. There can be no assurance that the Licensor's patents on the Breathe Right nasal strip, or any additional patents issued, if any, will effectively foreclose the development of competitive products or that the Company will have sufficient resources to pursue enforcement of any patents issued. See Item 3, Legal Proceedings. The Company intends to aggressively enforce the patents covering the Breathe Right nasal strip. In order to enforce any patents issued covering the Breathe Right nasal strip, the Company may have to engage in litigation, which may result in substantial cost to the Company and counterclaims against the Company. Any adverse outcome of such litigation could have a negative impact on the Company's business. In 1997, the Company became aware of a foreign reference to a nasal dilator that will result in narrower protection than originally expected from the patents being licensed by the Company with respect to Breathe Right nasal strips. In addition, in February 1998, the Company was notified by Acutek Adhesive Specialities, Inc. ("Acutek") that Acutek or one or its affiliates will make or sell nasal dilators in the United States and certain other markets. Acutek and the Company are engaged in patent litigation on which settlement discussions are pending. See Item 3, Legal Proceedings. The Company has registered its Breathe Right trademark in the United States and in several foreign countries and is seeking registration of its other trademarks. The Company believes its trademarks are important as protection for the Company's names and advertising, and intends to take such steps as are necessary to protect these trademarks. There can be no assurance that the Company's technology will not be challenged on the grounds that the Company's products infringe on patents, copyrights or other proprietary information owned or claimed by others or that others will not successfully utilize part or all of the Company's technology without compensation to the Company. In addition to seeking patent protection for its products, the Company intends to also protect its technologies and proprietary information as trade secrets. EMPLOYEES At March 3, 1998, the Company had 50 full-time and two part-time employees, of whom 14 were engaged in operations, 19 in general administration, 17 in marketing and sales and two in product development. There are no unions representing Company employees. Relations with its employees are believed to be positive and there are no pending or threatened labor employment disputes or work interruptions. EXECUTIVE OFFICERS OF THE COMPANY The following table sets forth the names and ages of the Company's Executive Officers together with all positions and offices held with the Company by such Executive Officers. Officers are appointed to serve until the meeting of the Board of Directors following the next Annual Meeting of Shareholders and until their successors have been elected and have qualified. Name and Age Office ------------ ------ Daniel E. Cohen, M.D.(45) Chairman of the Board, Chief Executive Officer, Treasurer and Director Marti Morfitt(40) President, Chief Operating Officer and Director M. W. Anderson, Ph.D.(47) Vice President of Clinical and Regulatory Affairs David J. Byrd(44) Vice President of Finance and Chief Financial Officer William Doubek(42) Vice President of Operations Rihab FitzGerald(46) Vice President of Consumer Sales Kirk P. Hodgdon(38) Vice President of Consumer Marketing Gerhard Tschautscher(41) Vice President of International and Professional Medical Marketing DANIEL E. COHEN, M.D. has served as the Company's Chairman of the Board since 1993, its Chief Executive Officer since 1989 and a director and the Treasurer since 1982. Dr. Cohen was a founder of the Company and is a board-certified neurologist. MARTI MORFITT, has agreed to serve as the Company's President and Chief Operating Officer and a director beginning March 30, 1998. From September 1982 through February 1998, Ms. Morfitt served in a series of positions of increasing responsibility with the Pillsbury Company, a Minneapolis-based manufacturer and distributor of food products, most recently serving from May 1997, to February 1998, as Vice-President, Meals, and from February 1994, to May 1997, as Vice-President, Green Giant Brands. She also serves as a director of Graco, Inc., a Minneapolis-based manufacturer of fluid handling systems. M. W. ANDERSON, PH.D. has served as the Company's Vice President of Clinical and Regulatory Affairs and Vice President of Research and Development since 1990. He has served in various capacities since joining the Company in 1984, including Director of Applications Research and Director of Research and Development. Prior to joining the Company in 1984, Dr. Anderson was an Assistant Professor at the University of Minnesota's College of Pharmacy. DAVID J. BYRD has served as the Company's Vice President of Finance and Chief Financial Officer since February 1996. Prior to joining the Company, Mr. Byrd was Chief Financial Officer and Treasurer of Medisys, Inc., a health care services company, since 1991. From 1975 to 1991, Mr. Byrd was employed by Coopers & Lybrand, where he was a partner from 1986 to 1991. Mr. Byrd is a certified public accountant. WILLIAM DOUBEK has served as the Company's Vice President of Operations since 1990, Director of Operations from 1986 to 1990 and was the Company's Senior Engineer from 1982 to 1986. Prior to joining the Company in 1982, Mr. Doubek served as Senior Project Engineer at Medtronic, Inc., a manufacturer of medical devices, Senior Engineer at Micro Control Company, a manufacturer of computer testing equipment, and Electrical Engineer at Palico Instrument Company, a manufacturer of computer testing equipment. RIHAB FITZGERALD has served as the Company's Vice President of Consumer Sales since August 1993, Vice President of Sales and Marketing from 1990 to August 1993 and Director of Marketing from 1985 to 1990. Prior to joining the Company in 1984, Ms. Fitzgerald was employed in sales and marketing with Nicolet Instrument Corporation, a medical devices manufacturer. KIRK P. HODGDON has been the Company's Vice President of Marketing since February 1994. Prior to joining the Company, Mr. Hodgdon served as: Vice President-Management Supervisor at Gage Marketing Communications, a marketing services company, from 1993 to February 1994; Vice President - Account Supervisor at U.S. Communications, a marketing agency, from 1989 to 1993; and Marketing Manager at Land O'Lakes, Inc., a consumer foods cooperative, from 1988 to 1989. GERHARD TSCHAUTSCHER has served as the Company's Vice President of International and Professional Medical Marketing since January 1994 and as a Company Product Director and as the International Sales Marketing and Sales Director between 1988 and December 1993. ITEM 2. PROPERTIES The Company leases approximately 80,000 square feet of office, manufacturing and warehouse space in Bloomington, Minnesota. The lease expires in December 2000. The Company also leases approximately 32,000 square feet of warehouse space on a month to month basis. ITEM 3. LEGAL PROCEEDINGS Except as otherwise disclosed in this Form 10-K, no material legal proceedings are pending or known to be contemplated to which the Company is a party or to which any of its property is subject, and the Company knows of no material legal proceedings pending or threatened, or judgments against any director or officer of the Company in his or her capacity as such. In January 1997, the Company was sued for patent infringement in the United States District Court for the Central District of California by Acutek Adhesive Specialties, Inc. ("Acutek"). Acutek claims to be an exclusive licensee in the United States Reissue Patent RE. 35,408. The plaintiff seeks compensatory damages, interest, costs and fees. The Company has counterclaimed for a declaration of invalidity of the patents asserted by Acutek and for a declaration that the Company does not infringe the Reissue Patent. Cross-motions for summary judgment with respect to the lawsuit are pending. In February 1998, Acutek was issued a patent entitled "Transparent Nasal Dilator" and commenced an additional patent infringement lawsuit against the Company in the United States District Court for the Central District of California. The Company believes that it does not infringe any valid patent claims and has vigorously defended the lawsuits brought against it by Acutek. The Company is engaged in settlement negotiations, however, that may resolve all pending matters between the parties. The Company is currently unable to determine if these discussions will ultimately result in a settlement. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Information as to the principal market on which the Company's common stock is traded and market price information for the common stock of the Company is incorporated herein by reference from page 20 of the 1997 Annual Report to Shareholders (the "1997 Annual Report"). On March 3, 1998, the last sale price of the Common Stock as reported on the NASDAQ National Market was $6.3125. As of March 3, 1998, there were approximately 850 owners of record of Common Stock. The Company has never paid any dividends on its Common Stock. The Company currently intends to retain any earnings for use in its operations and does not anticipate paying any cash dividends in the foreseeable future. The payment of dividends, if any, in the future will be at the discretion of the Board of Directors and will depend upon, among other things, future earnings, capital requirements, restrictions in future financing agreements, the general financial condition of the Company and general business considerations. ITEM 6. SELECTED FINANCIAL DATA Selected financial information is presented on page 1 of the Company's 1997 Annual Report and is incorporated herein by reference. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations appears on pages 8 through 12 of the Company's 1997 Annual Report and is incorporated herein by reference. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not Applicable. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Balance Sheets of the Company as of December 31, 1996 and 1997, and the related Statements of Income, Stockholders' Equity and Cash Flows for each of the years in the three-year period ended December 31, 1997, the Notes to the Financial Statements and the Report of KPMG Peat Marwick LLP, independent auditors, is contained in the Company's 1997 Annual Report on pages 13 through 20 and is incorporated herein by reference. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Certain information required under this Item with respect to directors is contained in the Section "Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's Proxy Statement for the Annual Meeting of Shareholders to be held on April 22, 1998 (the "1998 Proxy Statement"), a definitive copy of which will be filed with the Commission within 120 days of the close of the last fiscal year, and is incorporated herein by reference. Information concerning executive officers is set forth in the Section entitled "Executive Officers of the Company" in Part I of this Form 10-K pursuant to Instruction 3 to paragraph (b) of Item 401 of Regulation S-K. ITEM 11. EXECUTIVE COMPENSATION Information required under this item is contained in the section entitled "Executive Compensation" in the 1998 Proxy Statement and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required under this item is contained in the section entitled "Security Ownership of Principal Stockholders and Management" in the Company's 1998 Proxy Statement and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Not applicable. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K a. Documents filed as part of this Report: 1. Financial Statements. See Item 8, Financial Statements. 2. Financial Statement Schedules. Not Applicable. 3. Exhibits. See "Exhibit Index" on the page following the Signature Page. b. Reports on Form 8-K. The Company did not file a report on Form 8-K during the fourth quarter ended December 31, 1997. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CNS, INC. ("Registrant") Dated: March 27, 1998 By/s/ Daniel E. Cohen -------------------- Daniel E. Cohen, M.D. Chairman of the Board, Chief Executive Officer, Treasurer and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed by the following persons on March 27, 1998 on behalf of the Registrant in the capacities indicated. (Power of Attorney) Each person whose signature appears below constitutes and appoints DANIEL E. COHEN, M.D. and PATRICK DELANEY as his true and lawful attorneys-in-fact and agents, each acting alone, with the full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any or all amendments to this Annual Report on Form 10-K and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, each acting alone, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all said attorneys-in-fact and agents, each acting alone, or his substitute or substitutes, may lawfully do or cause to be done by virtue thereof. /s/ Daniel E. Cohen, M.D. Daniel E. Cohen, M.D. Chairman of the Board and Chief Executive Officer, Treasurer and Director (Principal Executive Officer) /s/David J. Byrd David J. Byrd Vice President of Finance and Chief Financial Officer (Principal Financial and Accounting Officer) /s/ Patrick Delaney Patrick Delaney Director /s/ R. Hunt Greene R. Hunt Greene Director /s/ Andrew J. Greenshields Andrew J. Greenshields Director /s/ Richard W. Perkins Richard W. Perkins Director CNS, INC. EXHIBIT INDEX Exhibit No. Description - ----------- ----------- 3.1 Company's Certificate of Incorporation as amended to date (incorporated by reference to Exhibit 3.1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995 (the "1995 Form 10-K"). 3.2 Company's Amended By-Laws (incorporated by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991 (the "1991 Form 10-K")). 10.1 * CNS, Inc. 1987 Employee Incentive Stock Option Plan (incorporated by reference to Exhibit 10.1 to the Company's Registration Statement on Form S-18, Commission File No. 33-14052C). 10.2 * CNS, Inc. 1989 Employee Stock Purchase Plan (incorporated by reference to Exhibit 10.9 to the Company's Registration Statement on Form S-8, Commission File No. 33-29454). 10.3 * CNS, Inc. 1990 Stock Plan (incorporated by reference to Exhibit 10.11 to the Company's Annual Report on Form 10-K for the year ended December 31, 1990). 10.4 License Agreement dated January 30, 1992 between the Company and Creative Integration and Design, Inc. (incorporated by reference to Exhibit 10.11 to the 1992 Form S-2). 10.5 * CNS, Inc. 1994 Amended Stock Plan. 10.6 Distribution Agreement dated August 2, 1995 between the Company and Minnesota Mining and Manufacturing Company ("3M") (incorporated by reference to Exhibit 10.11 to the 1995 Form 10-K). 10.7 Supply Agreement dated May 17, 1995 between the Company and Minnesota Mining and Manufacturing Company ("3M") incorporated by reference to Exhibit 10.12 to the 1995 Form 10-K). 10.8 License Agreement dated January 24, 1996 between the Company and Ronald S. Nietupsky (incorporated by reference to Exhibit 10.15 to the 1995 Form 10-K). 10.9 License Agreement dated May 9, 1997 between the Company and Cigone, Enterprises, SmokeBusters of Texas, Inc. and Odor Pros, Inc. (Certain information has been omitted from this Exhibit and filed separately with the SEC pursuant to a request for confidential treatment under Rule 24b-2.) 10.10 * Employment Agreement between the Company and Dr. Daniel E. Cohen dated April 15, 1996, (incorporated by reference to Exhibit 10.15 to 1996 Form 10-K). 10.11 * Employment Agreement dated April 15, 1996 between the Company and Kirk Hodgdon (incorporated by reference to Exhibit 10.17 to 1996 Form 10-K). 10.12 * Employment Agreement dated April 15, 1996 between the Company and David J. Byrd (incorporated by reference to Exhibit 10.18 to 1996 Form 10-K). 11.1 Computation of Net Income Per Share of Common Stock. 13.1 Selected information from 1997 Annual Report to Stockholders 21.1 Subsidiaries of the Company 23.1 Consent of KPMG Peat Marwick LLP. 24.1 Powers of Attorney (included on the signature page hereof). 27.1 Financial Data Schedule. 27.2 Financial Data Schedule. 27.3 Financial Data Schedule. - --------------- * Indicates Compensatory Agreement EX-10.5 2 CNS, INC. 1994 AMENDED STOCK PLAN CNS, INC. 1994 AMENDED STOCK PLAN TABLE OF CONTENTS PAGE ---- SECTION 1. General Purpose of Plan; Definitions..................... 1 SECTION 2. Administration........................................... 3 SECTION 3. Stock Subject to Plan.................................... 4 SECTION 4. Eligibility.............................................. 5 SECTION 5. Stock Options............................................ 5 SECTION 6. Stock Appreciation Rights................................ 9 SECTION 7. Restricted Stock.........................................10 SECTION 8. Deferred Stock Awards....................................11 SECTION 9. Other Awards. ..........................................12 SECTION 10. Transfer, Leave of Absence, etc......................... 13 SECTION 11. Amendments and Termination.............................. 13 SECTION 12. Unfunded Status of Plan................................. 13 SECTION 13. General Provisions...................................... 14 SECTION 14. Effective Date of Plan.................................. 15 CNS, INC. 1994 AMENDED STOCK PLAN SECTION 1. General Purpose of Plan; Definitions. The name of this plan is the CNS, Inc. 1994 Amended Stock Plan (the "Plan"). The purpose of the Plan is to enable CNS, Inc. (the "Company") and its Subsidiaries to retain and attract executives, other key employees and members of the Board of Directors who contribute to the Company's success by their ability, ingenuity and industry, and to enable such individuals to participate in the long-term success and growth of the Company by giving them a proprietary interest in the Company. For purposes of the Plan, the following terms shall be defined as set forth below: a. "Agreement" means an agreement by and between the Company and an optionee or recipient of an award under the Plan setting forth the terms and conditions of the option or award. b. "Board" means the Board of Directors of the Company. c. "Cause" means a felony conviction of a participant or the failure of a participant to contest prosecution for a felony, or a participant's willful misconduct or dishonesty, any of which is directly and materially harmful to the business or reputation of the Company. d. "Code" means the Internal Revenue Code of 1986, as amended from time to time, or any successor statute. e. "Committee" means the Committee referred to in Section 2 of the Plan. If at any time no Committee shall be in office, then the functions of the Committee specified in the Plan shall be exercised by the Board, unless the Plan specifically states otherwise. f. "Company" means CNS, Inc., a corporation organized under the laws of the State of Delaware (or any successor corporation). g. "Deferred Stock" means an award made pursuant to Section 8 below of the right to receive Stock at the end of a specified deferral period. h. "Disability" means total and permanent disability as determined by the Committee. i. "Early Retirement" means retirement, with consent of the Committee at the time of retirement, from active employment with the Company and any Subsidiary or Parent Corporation of the Company. j. "Fair Market Value" of Stock on any given date shall be determined by a Committee as follows: (a) if the Stock is listed for trading on one or more national securities exchanges, or is traded on the Nasdaq Stock Market, the last reported sales price on the principal such exchange or the Nasdaq Stock Market on the date in question, or if such Stock shall not have been traded on such principal exchange on such date, the last reported sales price on such principal exchange or the Nasdaq Stock Market on the first day prior thereto on which such Stock was so traded; or (b) if the Stock is not listed for trading on a national securities exchange or the Nasdaq Stock Market, but is traded in the over-the-counter market, including the Nasdaq Small Cap Market, the closing bid price for such Stock on the date in question, or if there is no such bid price for such Stock on such date, the closing bid price on the first day prior thereto on which such price existed; or (c) if neither (a) nor (b) is applicable, by any means fair and reasonable by the Committee, which determination shall be final and binding on all parties. k. "Incentive Stock Option" means any Stock Option intended to be and designated as an "Incentive Stock Option" within the meaning of Section 422 of the Code. l. "Non-Employee Director" means a "Non-Employee Director" within the meaning of Rule 16b-3 under the Securities Exchange Act of 1934. m. "Non-Qualified Stock Option" means any Stock Option that is not an Incentive Stock Option, and is intended to be and is designated as a "Non-Qualified Stock Option." n. "Normal Retirement" means retirement from active employment with the Company and any Subsidiary or Parent Corporation of the Company on or after age 60. o. "Other Awards" means those awards granted pursuant to Section 9 hereof. p. "Outside Director" means a Director who: (a) is not a current employee of the Company or any member of an affiliated group which includes the Company; (b) is not a former employee of the Company who receives compensation for prior services (other than benefits under a tax-qualified retirement plan) during the taxable year; (c) has not been an officer of the Company; (d) does not receive remuneration from the Company, either directly or indirectly, in any capacity other than as a director, except as otherwise permitted under Code Section 162(m) and regulations thereunder. For this purpose, remuneration includes any payment in exchange for goods or services. This definition shall be further governed by the provisions of Code Section 162(m) and regulations promulgated thereunder. q. "Parent Corporation" means any corporation (other than the Company) in an unbroken chain of corporations ending with the Company if each of the corporations (other than the Company) owns stock possessing 50% or more of the total combined voting power of all classes of stock in one of the other corporations in the chain. r. "Restricted Stock" means an award of shares of Stock that are subject to restrictions under Section 7 below. s. "Retirement" means Normal Retirement or Early Retirement. t. "Stock" means the Common Stock, $.01 par value per share, of the Company. u. "Stock Appreciation Right" means the right pursuant to an award granted under Section 6 below to surrender to the Company all or a portion of a Stock Option in exchange for an amount equal to the difference between (i) the Fair Market Value, as of the date such Stock Option or such portion thereof is surrendered, of the shares of Stock covered by such Stock Option or such portion thereof, and (ii) the aggregate exercise price of such Stock Option or such portion thereof. v. "Stock Option" means any option to purchase shares of Stock granted pursuant to Section 5 below. w. "Subsidiary" means any corporation (other than the Company) in an unbroken chain of corporations beginning with the Company if each of the corporations (other than the last corporation in the unbroken chain) owns stock possessing 50% or more of the total combined voting power of all classes of stock in one of the other corporations in the chain. SECTION 2. Administration. The Plan shall be administered by the Board of Directors or by a Committee appointed by the Board of Directors of the Company consisting of at least two Directors, all of whom shall be Outside Directors and Non-Employee Directors, who shall serve at the pleasure of the Board. The Committee shall have the power and authority to grant to eligible employees and members of the Board, pursuant to the terms of the Plan: (i) Stock Options, (ii) Stock Appreciation Rights, (iii) Restricted Stock, (iv) Deferred Stock awards, or (v) Other Awards. In particular, the Committee shall have the authority: (i) to select the members of the Board, officers and other key employees of the Company and its Subsidiaries and other eligible persons to whom Stock Options, Stock Appreciation Rights, Restricted Stock, Deferred Stock awards and/or Other Awards may from time to time be granted hereunder; (ii) to determine whether and to what extent Incentive Stock Options, NonQualified Stock Options, Stock Appreciation Rights, Restricted Stock, Deferred Stock awards and/or Other Awards, or a combination of the foregoing, are to be granted hereunder; (iii) to determine the number of shares to be covered by each such award granted hereunder; (iv) to determine the terms and conditions, not inconsistent with the terms of the Plan, of any award granted hereunder (including, but not limited to, any restriction on any Stock Option or other award and/or the shares of Stock relating thereto), which authority shall be exclusively vested in the Committee (and not the Board) for purposes of establishing performance criteria used with Restricted Stock and Deferred Stock awards and Other Awards; provided, however, that in the event of a merger or asset sale, the applicable provisions of Sections 5(c) and 7(c) of the Plan shall govern the acceleration of vesting of any Stock Option or awards; and (v) to determine whether, to what extent and under what circumstances Stock and other amounts payable with respect to an award under this Plan shall be deferred either automatically or at the election of the participant. The Committee shall have the authority to adopt, alter and repeal such administrative rules, guidelines and practices governing the Plan as it shall, from time to time, deem advisable; to interpret the terms and provisions of the Plan and any award issued under the Plan (and any agreements relating thereto); and to otherwise supervise the administration of the Plan. The Committee may delegate to executive officers of the Company the authority to exercise the powers specified in (i), (ii), (iii), (iv) and (v) above with respect to persons who are not either the chief executive officer of the Company or the four highest paid officers of the Company other than the chief executive officer. All decisions made by the Committee pursuant to the provisions of the Plan shall be final and binding on all persons, including the Company and Plan participants. SECTION 3. Stock Subject to Plan. The total number of shares of Stock reserved and available for distribution under the Plan shall be 1,750,000. Such shares may consist, in whole or in part, of authorized and unissued shares. Subject to paragraph (b)(iv) of Section 6 below, if any shares that have been optioned ceased to be subject to Stock Options, or if any shares subject to any Restricted Stock or Deferred Stock award or Other Award granted hereunder are forfeited or such award otherwise terminates without a payment being made to the participant, such shares shall again be available for distribution in connection with future awards under the Plan. In the event of any merger, reorganization, consolidation, recapitalization, stock dividend, stock split, other change in corporate structure affecting the Stock, or spin-off or other distribution of assets to shareholders, such substitution or adjustment shall be made in the aggregate number of shares reserved for issuance under the Plan, in the number and option price of shares subject to outstanding options granted under the Plan, and in the number of shares subject to Restricted Stock or Deferred Stock awards granted under the Plan as may be determined to be appropriate by the Committee, in its sole discretion, provided that the number of shares subject to any award shall always be a whole number. Such adjusted option price shall also be used to determine the amount payable by the Company upon the exercise of any Stock Appreciation Right associated with any Option. SECTION 4. Eligibility. Officers, other key employees of the Company and Subsidiaries and members of the Board who are responsible for or contribute to the management, growth and/or profitability of the business of the Company and its Subsidiaries are eligible to be granted Stock Options, Stock Appreciation Rights, Restricted Stock or Deferred Stock awards or Other Awards under the Plan. The optionees and participants under the Plan shall be selected from time to time by the Committee, in its sole discretion, from among those eligible, and the Committee shall determine, in its sole discretion, the number of shares covered by each award. Notwithstanding the foregoing, no person shall receive awards under this Plan which exceed 150,000 shares during any fiscal year of the Company. SECTION 5. Stock Options. Any Stock Option granted under the Plan shall be in such form as the Committee may from time to time approve. The Stock Options granted under the Plan may be of two types: (i) Incentive Stock Options and (ii) Non-Qualified Stock Options. No Incentive Stock Options shall be granted under the Plan after June 17, 2004. The Committee shall have the authority to grant any optionee Incentive Stock Options, NonQualified Stock Options, or both types of options (in each case with or without Stock Appreciation Rights). To the extent that any option does not qualify as an Incentive Stock Option, it shall constitute a separate Non-Qualified Stock Option. Anything in the Plan to the contrary notwithstanding, no term of this Plan relating to Incentive Stock Options shall be interpreted, amended or altered, nor shall any discretion or authority granted under the Plan be so exercised, so as to disqualify either the Plan or any Incentive Stock Option under Section 422 of the Code. The preceding sentence shall not preclude any modification or amendment to an outstanding Incentive Stock Option, whether or not such modification or amendment results in disqualification of such Option as an Incentive Stock Option, provided the optionee consents in writing to the modification or amendment. Options granted under the Plan shall be subject to the following terms and conditions and shall contain such additional terms and conditions, not inconsistent with the terms of the Plan, as the Committee shall deem desirable. (a) Option Price. The option price per share of Stock purchasable under a Stock Option shall be determined by the Committee at the time of grant. In no event shall the option price per share of Stock purchasable under an Incentive Stock Option or a Non-Qualified Stock Option be less than 100% of the Fair Market Value of the Stock on the date of the option is granted. If an employee owns or is deemed to own (by reason of the attribution rules applicable under Section 424(d) of the Code) more than 10% of the combined voting power of all classes of stock of the Company or any Parent Corporation or Subsidiary and an Incentive Stock Option is granted to such employee, the option price shall be no less than 110% of the Fair Market Value of the Stock on the date the option is granted. (b) Option Term. The term of each Stock Option shall be fixed by the Committee, but no Incentive Stock Option shall be exercisable more than ten years after the date the option is granted. If an employee owns or is deemed to own (by reason of the attribution rules of Section 424(d) of the Code) more than 10% of the combined voting power of all classes of stock of the Company or any Parent Corporation or Subsidiary and an Incentive Stock Option is granted to such employee, the term of such option shall be no more than five years from the date of grant. (c) Exercisability. Stock Options shall be exercisable at such time or times as determined by the Committee at or after grant, subject to the restrictions stated in Section 5(b) above. If the Committee provides, in its discretion, that any option is exercisable only in installments, the Committee may waive such installment exercise provisions at any time. Notwithstanding anything contained in the Plan to the contrary, the Committee may, in its discretion extend or vary the term of any Stock Option or any installment thereof, whether or not the optionee is then employed by the Company, if such action is deemed to be in the best interests of the Company; provided, however, that in the event of a merger or sale of assets, the provisions of this Section 5(c) shall govern vesting acceleration. Notwithstanding the foregoing, unless the Stock Option Agreement provides otherwise, any Stock Option granted under this Plan shall be exercisable in full, without regard to any installment exercise provisions, for a period specified by the Committee, but not to exceed sixty (60) days prior to or subsequent to the occurrence of any of the following events: (i) dissolution or liquidation of the Company other than in conjunction with a bankruptcy of the Company or any similar occurrence, (ii) any merger, consolidation, acquisition, separation, reorganization, or similar occurrence, where the Company will not be the surviving entity or (iii) the transfer of substantially all of the assets of the Company or 20% or more of the outstanding Stock of the Company. The grant of an option pursuant to the Plan shall not limit in any way the right or power of the Company to make adjustments, reclassifications, reorganizations or changes of its capital or business structure or to merge, exchange or consolidate or to dissolve, liquidate, sell or transfer all or any part of its business or assets. (d) Method of Exercise. Stock Options may be exercised in whole or in part at any time during the option period by giving written notice of exercise to the Company specifying the number of shares to be purchased. Such notice shall be accompanied by payment in full of the purchase price, either by certified or bank check, or by any other form of legal consideration deemed sufficient by the Committee and consistent with the Plan's purpose and applicable law, including promissory notes or a properly executed exercise notice together with irrevocable instructions to a broker acceptable to the Company to promptly deliver to the Company the amount of sale or loan proceeds to pay the exercise price. As determined by the Committee, in its sole discretion, payment in full or in part may also be made in the form of Stock already owned by the optionee (which in the case of Stock acquired upon exercise of an option have been owned for more than six months on the date of surrender) or, in the case of the exercise of a Non-Qualified Stock Option, Restricted Stock or Deferred Stock subject to an award hereunder (based, in each case, on the Fair Market Value of the Stock on the date immediately preceding the date the option is exercised, as determined by the Committee), provided, however, that, in the case of an Incentive Stock Option, the right to make a payment in the form of already owned shares may be authorized only at the time the option is granted, and provided further that in the event payment is made in the form of shares of Restricted Stock or a Deferred Stock award, the optionee will receive a portion of the option shares in the form of, and in an amount equal to, the Restricted Stock or Deferred Stock award tendered as payment by the optionee. If the terms of an option so permit, an optionee may elect to pay all or part of the option exercise price by having the Company withhold from the shares of Stock that would otherwise be issued upon exercise that number of shares of Stock having a Fair Market Value equal to the aggregate option exercise price for the shares with respect to which such election is made. No shares of Stock shall be issued until full payment therefor has been made. An optionee shall generally have the rights to dividends and other rights of a shareholder with respect to shares subject to the option when the optionee has given written notice of exercise, has paid in full for such shares. (e) Non-transferability of Options. No Stock Option shall be transferable by the optionee otherwise than by will or by the laws of descent and distribution, and all Stock Options shall be exercisable, during the optionee's lifetime, only by the optionee. (f) Termination by Death. If an optionee's employment by the Company and any Subsidiary or Parent Corporation terminates by reason of death, the Stock Option may thereafter be immediately exercised, to the extent then exercisable (or on such accelerated basis as the Committee shall determine at or after grant), by the legal representative of the estate or by the legatee of the optionee under the will of the optionee, for a period of three months (or such shorter period as the Committee shall specify at grant) from the date of such death or until the expiration of the stated term of the option, whichever period is shorter. In the event of termination of employment by reason of death, if any Stock Option is exercised after the expiration of the exercise periods that apply for purposes of Section 422 of the Code, the option will thereafter be treated as a Non-Qualified Stock Option. (g) Termination by Reason of Disability. If an optionee's employment by the Company and any Subsidiary or Parent Corporation terminates by reason of Disability, any Stock Option held by such optionee may thereafter be exercised, to the extent it was exercisable at the time of termination due to Disability (or on such accelerated basis as the Committee shall determine at or after grant), but may not be exercised after one year (or such shorter period as the Committee shall specify at grant) from the date of such termination of employment or the expiration of the stated term of the option, whichever period is the shorter. In the event of termination of employment by reason of Disability, if an Incentive Stock Option is exercised after the expiration of the exercise periods that apply for purposes of Section 422 of the Code, the option will thereafter be treated as a NonQualified Stock Option. (h) Termination by Reason of Retirement. If an optionee's employment by the Company and any Subsidiary or Parent Corporation terminates by reason of Retirement and the terms of the Stock Option so provide, any Stock Option held by such optionee may thereafter be exercised to the extent it was exercisable at the time of such Retirement, but may not be exercised after three months (or such shorter period as the Committee shall specify at grant) from the date of such termination of employment or the expiration of the stated term of the option, whichever period is the shorter. In the event of termination of employment by reason of Retirement, if an Incentive Stock Option is exercised after the expiration of the exercise periods that apply for purposes of Section 422 of the Code, the option will thereafter be treated as a Non-Qualified Stock Option. (i) Other Termination. Unless otherwise determined by the Committee, if an optionee's employment by the Company and any Subsidiary or Parent Corporation terminates for any reason other than death, Disability or Retirement, the Stock Option may be exercised to the extent it was exercisable at such termination for the lesser of three months or the balance of the option's term, except that if the optionee is terminated for Cause by the Company or any Subsidiary or Parent Corporation, the Stock Option shall thereupon terminate immediately. (j) Annual Limit on Incentive Stock Options. The aggregate Fair Market Value (determined as of the time the Option is granted) of the Common Stock with respect to which an Incentive Stock Option under this Plan or any other plan of the Company and any Subsidiary or Parent Corporation is exercisable for the first time by an optionee during any calendar year shall not exceed $100,000. SECTION 6. Stock Appreciation Rights. (a) Grant and Exercise. Stock Appreciation Rights may be granted in conjunction with all or part of any Stock Option granted under the Plan. In the case of a Non-Qualified Stock Option, such rights may be granted either at or after the time of the grant of such Option. In the case of an Incentive Stock Option, such rights may be granted only at the time of the grant of the option. A Stock Appreciation Right or applicable portion thereof granted with respect to a given Stock Option shall terminate and no longer be exercisable upon the termination or exercise of the related Stock Option, except that a Stock Appreciation Right granted with respect to less than the full number of shares covered by a related stock Option shall not be reduced until the exercise or termination of the related Stock Option exceeds the number of shares not covered by the Stock Appreciation Right. A Stock Appreciation Right may be exercised by an optionee, in accordance with paragraph (b) of this Section 6, by surrendering the applicable portion of the related Stock Option. Upon such exercise and surrender, the optionee shall be entitled to receive an amount determined in the manner prescribed in paragraph (b) of this Section 6. Stock Options which have been so surrendered, in whole or in part, shall no longer be exercisable to the extent the related Stock Appreciation Rights have been exercised. (b) Terms and Conditions. Stock Appreciation Rights shall be subject to such terms and conditions, not inconsistent with the provisions of the Plan, as shall be determined from time to time by the Committee, including the following: (i) Stock Appreciation Rights shall be exercisable only at such time or times and to the extent that the Stock Options to which they relate shall be exercisable in accordance with the provisions of Section 5 and this Section 6 of the Plan. (ii) Upon the exercise of a Stock Appreciation Right, an optionee shall be entitled to receive up to, but not more than, an amount in cash or shares of Stock equal in value to the excess of the Fair Market Value of one share of Stock over the option price per share specified in the related option multiplied by the number of shares in respect of which the Stock Appreciation Right shall have been exercised, with the Committee having the right to determine the form of payment; provided the Committee may not require the optionee to receive more than 50% of the aggregate value of such Stock Appreciation Rights in shares of Stock. (iii) Stock Appreciation Rights shall be transferable only when and to the extent that the underlying Stock Option would be transferable under Section 5 of the Plan. (iv) Upon the exercise of a Stock Appreciation Right, the Stock Option or part thereof to which such Stock Appreciation Right is related shall be deemed to have been exercised for the purpose of the limitation set forth in Sections 3 and 4 of the Plan on the total number of shares of Stock to be issued under the Plan and the maximum number of shares to be awarded to any one person in a fiscal year, but only to the extent of the number of shares issued or issuable under the Stock Appreciation Right at the time of exercise based on the value of the Stock Appreciation Right at such time. (v) A Stock Appreciation Right granted in connection with an Incentive Stock Option may be exercised only if and when the market price of the Stock subject to the Incentive Stock Option exceeds the exercise price of such Option. (vi) Each award shall be confirmed by, and subject to the terms of, a Stock Appreciation Rights Agreement executed by the Company and the participant. SECTION 7. Restricted Stock. (a) Administration. Shares of Restricted Stock may be issued either alone or in addition to other awards granted under the Plan. The Committee shall determine the officers and key employees of the Company and Subsidiaries to whom, and the time or times at which, grants of Restricted Stock will be made, the number of shares to be awarded, the time or times within which such awards may be subject to forfeiture, and all other conditions of the awards. The Committee may also condition the grant of Restricted Stock upon the attainment of specified performance goals. The provisions of Restricted Stock awards need not be the same with respect to each recipient. (b) Awards and Certificates. The prospective recipient of an award of shares of Restricted Stock shall not have any rights with respect to such award, unless and until such recipient has executed an Agreement evidencing the award and has delivered a fully executed copy thereof to the Company, and has otherwise complied with the then applicable terms and conditions. (i) Each participant shall be issued a stock certificate in respect of shares of Restricted Stock awarded under the Plan. Such certificate shall be registered in the name of the participant, and shall bear an appropriate legend referring to the terms, conditions, and restrictions applicable to such award, substantially in the following form: "The transferability of this certificate and the shares of stock represented hereby are subject to the terms and conditions (including forfeiture) of the CNS, Inc. 1994 Amended Stock Plan and an Agreement entered into between the registered owner and CNS, Inc. Copies of such Plan and Agreement are on file in the offices of CNS, Inc., P.O. Box 39802, Minneapolis, MN 55439." (ii) The Committee shall require that the stock certificates evidencing such shares be held in custody by the Company until the restrictions thereon shall have lapsed, and that, as a condition of any Restricted Stock award, the participant shall have delivered a stock power, endorsed in blank, relating to the Stock covered by such award. (c) Restrictions and Conditions. The shares of Restricted Stock awarded pursuant to the Plan shall be subject to the following restrictions and conditions: (i) Subject to the provisions of this Plan and the award Agreement, during a period set by the Committee commencing with the date of such award (the "Restriction Period"), the participant shall not be permitted to sell, transfer, pledge or assign shares of Restricted Stock awarded under the Plan. In no event shall the Restriction Period be less than one (1) year. Within these limits, the Committee may provide for the lapse of such restrictions in installments where deemed appropriate. (ii) Except as provided in paragraph (c)(i) of this Section 7, the participant shall have, with respect to the shares of Restricted Stock, all of the rights of a shareholder of the Company, including the right to vote the shares and the right to receive any cash dividends. The Committee, in its sole discretion, may permit or require the payment of cash dividends to be deferred and, if the Committee so determines, reinvested in additional shares of Restricted Stock (to the extent shares are available under Section 3 and subject to paragraph (f) of Section 13). Certificates for shares of unrestricted Stock shall be delivered to the grantee promptly after, and only after, the period of forfeiture shall have expired without forfeiture in respect of such shares of Restricted Stock. (iii) Subject to the provisions of the award Agreement and paragraph (c)(iv) of this Section 7, upon termination of employment for any reason during the Restriction Period, all shares still subject to restriction shall be forfeited by the participant. (iv) In the event of special hardship circumstances of a participant whose employment is terminated (other than for Cause), including death, Disability or Retirement, or in the event of an unforeseeable emergency of a participant still in service, the Committee may, in its sole discretion, when it finds that a waiver would be in the best interest of the Company, waive in whole or in part any or all remaining restrictions with respect to such participant's shares of Restricted Stock. (v) Notwithstanding the foregoing, all restrictions with respect to any participant's shares of Restricted Stock shall lapse on the date determined by the Committee, but in no event more than sixty (60) days prior to or subsequent to the occurrence of any of the following events: (i) dissolution or liquidation of the Company other than in conjunction with a bankruptcy of the Company or any similar occurrence, (ii) any merger, consolidation, acquisition, separation, reorganization, or similar occurrence, where the Company will not be the surviving entity or (iii) the transfer of substantially all of the assets of the Company or 20% or more of the outstanding Stock of the Company. SECTION 8. Deferred Stock Awards. (a) Administration. Deferred Stock may be awarded either alone or in addition to other awards granted under the Plan. The Committee shall determine the officers and key employees of the Company and Subsidiaries to whom and the time or times at which Deferred Stock shall be awarded, the number of Shares of Deferred Stock to be awarded to any participant or group of participants, the duration of the period (the "Deferral Period") during which, and the conditions under which, receipt of the Stock will be deferred, and the terms and conditions of the award in addition to those contained in paragraph (b) of this Section 8. The Committee may also condition the grant of Deferred Stock upon the attainment of specified performance goals. The provisions of Deferred Stock awards need not be the same with respect to each recipient. (b) Terms and Conditions. (i) Subject to the provisions of this Plan and the award agreement, Deferred Stock awards may not be sold, assigned, transferred, pledged or otherwise encumbered during the Deferral Period. In no event shall the Deferral Period be less than one (1) year. At the expiration of the Deferral Period (or Elective Deferral Period, where applicable), share certificates shall be delivered to the participant, or his legal representative, in a number equal to the shares covered by the Deferred Stock award. (ii) Amounts equal to any dividends declared during the Deferral Period with respect to the number of shares covered by a Deferred Stock award will be paid to the participant currently or deferred and deemed to be reinvested in additional Deferred Stock or otherwise reinvested, all as determined at the time of the award by the Committee, in its sole discretion. (iii) Subject to the provisions of the award Agreement and paragraph (b)(iv) of this Section 8, upon termination of employment for any reason during the Deferral Period for a given award, the Deferred Stock in question shall be forfeited by the participant. (iv) In the event of special hardship circumstances of a participant whose employment is terminated (other than for Cause) including death, Disability or Retirement, or in the event of an unforeseeable emergency of a participant still in service, the Committee may, in its sole discretion, when it finds that a waiver would be in the best interest of the Company, waive in whole or in part any or all of the remaining deferral limitations imposed hereunder with respect to any or all of the participant's Deferred Stock. (v) A participant may elect to further defer receipt of the award for a specified period or until a specified event (the "Elective Deferral Period"), subject in each case to the Committee's approval and to such terms as are determined by the Committee, all in its sole discretion. Subject to any exceptions adopted by the Committee, such election must generally be made prior to completion of one half of the Deferral Period for a Deferred Stock award (or for an installment of such an award). (vi) Each award shall be confirmed by, and subject to the terms of, a Deferred Stock Agreement executed by the Company and the participant. SECTION 9. Other Awards. The Committee may from time to time grant Stock, other Stock based and non-Stock based awards under this Plan including without limitations those awards pursuant to which shares of Stock are or in the future may be acquired, awards denominated in Stock units, securities convertible into Stock, phantom securities and dividend equivalents. The Committee shall determine the terms and conditions of such Stock, Stock based and non-Stock based awards provided that such awards shall not be inconsistent with the terms of this Plan. SECTION 10. Transfer, Leave of Absence, etc. For purposes of the Plan, the following events shall not be deemed a termination of employment: (a) a transfer of an employee from the Company to a Parent Corporation or Subsidiary, or from a Parent Corporation or Subsidiary to the Company, or from one Subsidiary to another; (b) a leave of absence, approved in writing by the Committee, for military service or sickness, or for any other purpose approved by the Company if the period of such leave does not exceed ninety (90) days (or such longer period as the Committee may approve, in its sole discretion); and (c) a leave of absence in excess of ninety (90) days, approved in writing by the Committee, but only if the employee's right to reemployment is guaranteed either by a statute or by contract, and provided that, in the case of any leave of absence, the employee returns to work within 30 days after the end of such leave. SECTION 11. Amendments and Termination. The Board may amend, alter, or discontinue the Plan, but no amendment, alteration, or discontinuation shall be made (i) which would impair the rights of an optionee or participant under a Stock Option, Stock Appreciation Right, Restricted Stock, Deferred Stock or other Stock-based award theretofore granted, without the optionee's or participant's consent, or (ii) which without the approval of the stockholders of the Company would cause the Plan to no longer comply with Rule 16b-3 under the Securities Exchange Act of 1934, Section 422 of the Code or any other regulatory requirements. The Committee may amend the terms of any award or option theretofore granted, prospectively or retroactively to the extent such amendment is consistent with the terms of this Plan, but no such amendment shall impair the rights of any holder without his or her consent except to the extent authorized under the Plan. The Committee may also substitute new Stock Options for previously granted options, including previously granted options having higher option prices. SECTION 12. Unfunded Status of Plan. The Plan is intended to constitute an "unfunded" plan for incentive and deferred compensation. With respect to any payments not yet made to a participant or optionee by the Company, nothing contained herein shall give any such participant or optionee any rights that are greater than those of a general creditor of the Company. In its sole discretion, the Committee may authorize the creation of trusts or other arrangements to meet the obligations created under the Plan to deliver Stock or payments in lieu of or with respect to awards hereunder, provided, however, that the existence of such trusts or other arrangements is consistent with the unfunded status of the Plan. SECTION 13. General Provisions. (a) All certificates for shares of Stock delivered under the Plan pursuant to any Restricted Stock, Deferred Stock or other Stock-based awards shall be subject to such stock-transfer orders and other restrictions as the Committee may deem advisable under the rules, regulations, and other requirements of the Securities and Exchange Commission, any stock exchange upon which the Stock is then listed, and any applicable Federal or state securities laws, and the Committee may cause a legend or legends to be put on any such certificates to make appropriate reference to such restrictions. (b) Subject to paragraph (d) below, recipients of Restricted Stock, Deferred Stock and other Stock-based awards under the Plan (other than Stock Options) are not required to make any payment or provide consideration other than the rendering of services. (c) Nothing contained in this Plan shall prevent the Board of Directors from adopting other or additional compensation arrangements, subject to stockholder approval if such approval is required; and such arrangements may be either generally applicable or applicable only in specific cases. The adoption of the Plan shall not confer upon any employee of the Company or any Subsidiary any right to continued employment with the Company or a Subsidiary, as the case may be, nor shall it interfere in any way with the right of the Company or a Subsidiary to terminate the employment of any of its employees at any time. (d) Each participant shall, no later than the date as of which any part of the value of an award first becomes includible as compensation in the gross income of the participant for Federal income tax purposes, pay to the Company, or make arrangements satisfactory to the Committee regarding payment of, any Federal, state, or local taxes of any kind required by law to be withheld with respect to the award. The obligations of the Company under the Plan shall be conditional on such payment or arrangements and the Company and Subsidiaries shall, to the extent permitted by law, have the right to deduct any such taxes from any payment of any kind otherwise due to the participant. With respect to any award under the Plan, if the terms of such award so permit, a participant may elect by written notice to the Company to satisfy part or all of the withholding tax requirements associated with the award by (i) authorizing the Company to retain from the number of shares of Stock that would otherwise be deliverable to the participant, or (ii) delivering to the Company from shares of Stock already owned by the participant, that number of shares having an aggregate Fair Market Value equal to part or all of the tax payable by the participant under this Section 13(d). Any such election shall be in accordance with, and subject to, applicable tax and securities laws, regulations and rulings. (e) At the time of grant, the Committee may provide in connection with any grant made under this Plan that the shares of Stock received as a result of such grant shall be subject to a repurchase right in favor of the Company pursuant to which any participant shall be required to offer to the Company upon termination of employment for any reason any shares that the participant acquired under the Plan, with the price being the then Fair Market Value of the Stock or, in the case of a termination for Cause, an amount equal to the cash consideration paid for the Stock, subject to such other terms and conditions as the Committee may specify at the time of grant. The Committee may, at the time of grant of an award under the Plan, provide the Company with the right to repurchase, or require forfeiture of, shares of Stock acquired pursuant to the Plan by any participant who, at any time within one year after termination of employment with the Company, directly or indirectly, competes with, or is employed by a competitor of, the Company. (f) The reinvestment of dividends in additional Restricted Stock (or in Deferred Stock or other types of Plan awards) at the time of any dividend payment shall only be permissible if the Committee (or the Company's chief financial officer) certifies in writing that under Section 3 sufficient shares are available for such reinvestment (taking into account then outstanding Stock Options and other Plan awards). SECTION 14. Effective Date of Plan. The Plan is expressly made subject to the approval by the shareholders of the Company. If the Plan is not so approved by the shareholders on or before one year after this Plan's adoption by the Board of Directors, this Plan shall not come into effect. The offering of the shares hereunder shall be also subject to the effecting by the Company of any registration or qualification of the shares under any federal or state law or the obtaining of the consent or approval of any governmental regulatory body which the Company shall determine, in its sole discretion, is necessary or desirable as a condition to or in connection with, the offering or the issue or purchase of the shares covered thereby. The Company shall make every reasonable effort to effect such registration or qualification or to obtain such consent or approval. - -------------------------- Adopted by the Board of Directors: June 17, 1994. Ratified and Approved by the Shareholders: May 11, 1995. Amended by the Board of Directors: February 10, 1997. Amendment Ratified and Approved by the Shareholders: April 23, 1997. EX-10.9 3 LICENSE AGREEMENT (Certain information has been omitted from this exhibit and filed separately with the SEC pursuant to a request for confidential treatment under Rule 24b-2) LICENSE AGREEMENT THIS AGREEMENT is made and effective as of May 9, 1997 by and between CNS, Inc., a Delaware corporation ("Licensee"), Cigone Enterprises, Inc., a Texas corporation ("Licensor"), and SmokeBusters of Texas, Inc. and Odor Pros, Inc., each a Texas corporation (the "Affiliates"). RECITALS WHEREAS, Licensor is now and has been engaged in developing certain Products (as defined in Subsection 1.1) for use in removing the odor of smoke from, among other things, hair and clothing; WHEREAS, the Products embody inventions and designs owned exclusively by Licensor and Licensor has available certain Know-how relating to the manufacture of the Products; WHEREAS, Licensor owns or controls, or may hereafter own or control, certain Know-how, patents or patent applications relating to the Products; WHEREAS, Licensor desires to license to Licensee and Licensee desires to license from Licensor certain Know-how and patent applications of Licensor relating to the manufacture and use of the Products for removing the odor of smoke. NOW, THEREFORE, in consideration of the premises, the mutual covenants and agreements hereinafter set forth and other good consideration, the receipt and sufficiency of which are hereby acknowledged, the parties agree as follows: 1. GENERAL DEFINITIONS. As used herein, the following terms shall be defined in the manner set forth below: 1.1 Products. The term "Products" shall mean products containing [confidential treatment requested] and water mixtures for removing the odor of smoke and components or ingredients therefor and related thereto, all improvements thereto, and any other products similar in function and purpose developed by Licensor or any of its employees, consultants, agents or representatives during the term of this Agreement using any Licensed Patents or Know-how; provided, however, that for any such improvement or enhancement or similar product developed by Licensor to be included within the license herein granted, Licensee shall at its option make an election for such inclusion by providing prior written notice of such election to Licensor within 30 days after Licensee learns of such improvement, enhancement or similar product. 1.2 Know-how. The term "Know-how" shall mean any and all tangible and intangible information, technology, documents and materials in the possession and control of Licensor, necessary in order to enable Licensee to utilize fully the rights granted by Licensor to Licensee hereunder and shall include, without limiting the foregoing, the ideas, concepts, confidential information, trade secrets and techniques, as well as all the materials, documents, manuals, schematics, blueprints, specifications, patterns, art work, bills of materials and technical specifications and other information of Licensor relating to the Products. 1.3 Licensed Patents. The term "Licensed Patents" shall mean the following: (i) all future United States patent applications related to the Products and any patents arising therefrom; (ii) the rights, patents and patent applications, if any, in any country or jurisdiction in the world corresponding to the United States patent applications; and (iii) any division, continuation, continuation-in-part, divisional, re-examined, reissued or extended letters patent, applications and petty patents, utility models, utility model conversions, inventor's certificates relating to the inventions claimed in any of the foregoing United States patents and patents pending and foreign patent rights, which may be developed, acquired or controlled by Licensor during the term of this Agreement and with respect to which Licensor shall have the right to grant the license hereinafter provided. 1.4. Contract Year and Quarter. The term "Contract Year" shall mean each period of twelve consecutive months commencing on January 1 of the year designated in Subsection 4.3. The term "Contract Quarter" shall mean each period of three consecutive months commencing January 1, March 1, July 1 and October 1. 1.5. Gross Revenues. The term "Gross Revenues" shall mean the gross amounts collected by Licensee from any end-user, sublicensee, assignee or other person or entity relating to or arising from the sale of Products after the deduction of (i) any amounts repaid or credited by reason of rejections or returns, and (ii) trade and quantity discounts actually allowed and taken. 1.6. Earned Royalty. The term "Earned Royalty" shall mean the royalty payable to Licensor on Products. 2. GRANT OF LICENSES. 2.1 Patent and Know-how License. Except as otherwise set forth in Section 2.5 below, Licensor hereby grants to Licensee an exclusive, worldwide, transferable right and license to manufacture and have manufactured the Products and an exclusive, worldwide, transferable license to use, sell and otherwise practice the Products and all Know-how of Licensor and any invention disclosed or claimed in any of the Licensed Patents for distribution as a product to consumers, retailers, wholesalers or otherwise. Licensor and Affiliates agree that they will (i) not manufacture or use Products except as set forth in Section 2.5 below, (ii) not sell Products directly or indirectly to any third party other than as set forth in Section 2.5 below, (iii) not enter into any license or distribution arrangement with any person or entity other than Licensee to manufacture or sell Products and (iv) enter into and take such steps as are necessary to enforce agreements with purchasers of the Product which prohibit such purchasers from selling or distributing Products. 2.2 Sublicenses and Assignments. Licensee may sublicense and/or assign to any third party, including affiliates of Licensee, any and all rights granted hereunder. In the event of an assignment, Licensee shall enter into a written agreement with the assignee pursuant to which the assignee shall assume all of the obligations of Licensee under this Agreement and this Agreement shall be binding upon and inure to the benefit of such assignee. In the event of a sub-license, Licensee shall enter into a written agreement with sub-licensee (i) with a term no greater than the term of this Agreement, (ii) with rights granted to sub-licensee which are no greater than the terms of this Agreement, and (iii) pursuant to which Licensee shall use reasonable business efforts to impose upon sub-licensees similar obligations as Licensor has imposed upon Licensee under this Agreement. 2.3 Patent Procurement and Costs. Licensee shall be responsible for and pay all patent costs and expenses (including reasonable attorneys' fees) to be incurred in obtaining, prosecuting, owning and maintaining any of the Licensed Patents issued or to be issued under the law of any jurisdiction, including filing, prosecution, working and maintenance costs and taxes. Notwithstanding the above, Licensor shall direct and control the procurement of the Licensed Patents and shall select patent counsel for such procurement (which counsel is subject to the reasonable consent of Licensee), provided, however, that Licensee shall have the right to terminate such patent counsel if Licensee has a reasonable basis for not being satisfied with such counsel's efforts or results, and in such event Licensor shall select a new patent counsel (which counsel is subject to the reasonable consent of Licensee). 2.4 Exploitation. Except as set forth in Section 8, Licensee shall not be under any obligation to use, exploit, develop or market any license under this Agreement. Licensee shall be entitled to use its sole business judgment in deciding the manner and extent, if any, of any exploitation of any licenses granted hereunder and in deciding whether to use any other products, devices, techniques or technology competing therewith in any field of use. 2.5 Reservation; Manufacture and Sale by Licensor. All rights not explicitly granted to Licensee in this Agreement are expressly reserved to Licensor. Notwithstanding any other provision in this Agreement, Licensor specifically retains all rights in and to the Products, Licensed Patents, and Know-how as such rights relate to Licensor's (i) manufacture and use (but not sale) of the Products in its business and (ii) manufacture of Products for, and the sale of the Products to, commercial end-users that agree not to sell the Products, and Licensee acknowledges and agrees that Licensor may license the Products to Affiliates for such limited purposes. Licensor and Affiliates shall notify Licensee within five business days of any purchase orders of a third party that exceed 40 gallons of concentrated Products in the aggregate in a calendar month and, in such event, Licensee shall have the right to assume the responsibility of manufacturing and distributing Products to such third party purchaser on behalf of Licensee or Affiliates, provided that Licensee shall have the right to terminate such sales upon a reasonable belief that such third party purchaser is reselling the Products. The price for such Products to Licensor or Affiliates for such third party purchasers shall be Licensee's actual and direct cost to manufacture and ship such Products. 3. REPRESENTATIONS AND WARRANTIES. 3.1 Licensor and Affiliates each hereby warrant and represent to Licensee as follows: (a) Each of Licensor and Affiliates is a corporation duly organized, validly existing and in good standing under the laws of the State of Texas. (b) This Agreement has been duly authorized, executed and delivered by each of Licensor and Affiliates and constitutes a valid and binding obligation of Licensor and Affiliates, enforceable in accordance with its terms, except as rights to indemnification thereunder may be limited by applicable law and except as the enforcement thereof may be limited by bankruptcy, insolvency, reorganization, moratorium or other similar laws relating to or affecting creditors' rights generally or by general equitable principles. The execution, delivery and performance of this Agreement by Licensor and Affiliates and the consummation of the transactions contemplated hereby do not and will not conflict with or result in any material breach of any of the provisions of, or constitute a material default under, or result in a material violation of, or require any authorization, consent or approval, under the provisions of such party's Articles of Incorporation or Bylaws or any other agreement or instrument to which such party is bound or affected, or any law, statute, rule, regulation, judgment order or decree to which such party is subject. (c) Licensor owns all the rights of Sherrie Thomas and all other employees, agents, consultants or representatives of Licensor with respect to the Products, Licensed Patents and Know-how. (d) To Licensor's knowledge, there is no reason that enforceable patents will not issue in the United States or in any other jurisdiction where corresponding rights are sought. (e) To Licensor's knowledge, the Products, Licensed Patents and Know-how do not infringe on any patent, copyright or other intellectual property right of any third party. (f) Licensor has not received notice of any claims, actions, suits or proceedings pending or threatened effecting Licensor, the Licensed Patents or Know-how, which, if adversely determined, would have a material adverse effect upon Licensee's ability to manufacture, have manufactured, use or sell the Products or otherwise practice the rights and technology licensed to Licensee by Licensor under this Agreement and, to Licensor's knowledge, there is no reasonable basis for anyone to bring such claims, actions, suits or proceedings. (g) Licensor has not received any claim from any third-party proceedings relating to the Licensed Patents, Know-how, or the Products which are based upon infringement of any patent or misappropriation or misuse of trade secrets. 3.2 Licensee hereby warrants and represents to Licensor as follows: (a) Licensee is a corporation duly organized, validly existing and in good standing under the laws of the State of Delaware. (b) This Agreement has been duly authorized, executed and delivered by Licensee and constitutes a valid and binding obligation of Licensee, enforceable in accordance with its terms, except as rights to indemnification thereunder may be limited by applicable law and except as the enforcement thereof may be limited by bankruptcy, insolvency, reorganization, moratorium or other similar laws relating to or affecting creditors' rights generally or by general equitable principles. The execution, delivery and performance of this Agreement by Licensee and the consummation of the transactions contemplated hereby do not and will not conflict with or result in any material breach of any of the provisions of, or constitute a material default under, or result in a material violation of, or require any authorization, consent or approval, under the provisions of Licensee's Certificate of Incorporation or Bylaws. 4. CONSIDERATION AND REPORTS. 4.1 Royalties. Licensee agrees to pay to Licensor royalties as follows based on the Gross Revenues from the sale of Products: (a) [Confidential treatment requested] of Gross Revenues until royalties have been paid on an aggregate total of [Confidential treatment requested] of Gross Revenues, then (b) [Confidential treatment requested] of Gross Revenues until royalties have been paid on an aggregate total of [Confidential treatment requested] of Gross Revenues, and then (c) [Confidential treatment requested]% of all Gross Revenues in excess of an aggregate total of [Confidential treatment requested]. The royalty provided for in this Section 4.1 shall be reduced to [Confidential treatment requested] of Gross Revenues, if and when (i) a third party through patent proceedings negates the functional exclusionary utility of the Licensed Patents issued in the United States taken as a whole or (ii) a third party is marketing a competing product using the same key ingredient contained in the Licensed Products and no patents are pending in the United States Patent and Trademark Office with regard to the Products. In the event the royalty is reduced pursuant to item (i) above and, as the result of a successful appeal or otherwise, the functional exclusionary utility of the Licensed Patents is later reinstated, then the royalty rate shall also be reinstated to its original levels and Licensee shall pay Licensor an amount equal to the royalties which Licensee would have been required to pay under the original royalty rates during the period that the royalty was reduced, less the amount of royalties actually paid during such period using the reduced royalty rate. 4.2 Quarterly Payments. All royalties due Licensor from Licensee hereunder shall be payable on a Contract Quarterly basis. Within forty-five (45) days after the end of each Contract Quarter during the term of this Agreement, Licensee shall pay to Licensor the royalty due Licensor under Subsection 4.1 through the end of the preceding Contract Quarter and shall furnish Licensor with a written statement setting forth the number of Products sold and the Gross Revenues received during such Contract Quarter, and the resulting amount of the royalty due Licensor under Subsection 4.1. 4.3 Minimum Royalties. To maintain its rights hereunder, Licensee shall pay to Licensor minimum royalties as follows: Minimum Royalty Payment Minimum Royalty Payment Contract Year Per Contract Year Per Contract Quarter ------------- ----------------- -------------------- 1998 [Confidential treatment requested] 1999 [Confidential treatment requested] 2000 [Confidential treatment requested] 2001 [Confidential treatment requested] 4.4 Minimum Royalty Payment. Licensee shall pay Licensor within forty-five (45) days after the end of each Contract Quarter, an amount equal to (i) the minimum royalties payable pursuant to the terms of Subsection 4.3 for the Contract Quarter then ended, less (ii): (a) the aggregate amount of Earned Royalties actually paid to Licensor pursuant to the terms of Subsections 4.1 and 4.2 for the Contract Quarter then ended; (b) any patent costs, as described in Subsection 2.4, paid by Licensee, including any patent cost carry forwards, provided this deduction shall not reduce the payment to Licensor lower than the minimum guaranteed payment in Section 4.3, but will be carried forward and deducted in later periods; and (c) any Earned Royalties paid to Licensor during the prior Contract Quarters in the current Contract Year that exceed the amount of cumulative minimum royalties payable for those Contract Quarters. Licensee's failure to pay any and all amounts payable under the preceding sentence within thirty (30) days after receipt of written notice from Licensor that such amounts have not been timely paid shall render the licenses granted hereunder void and thereupon, Licensee shall have no further rights or interests of any kind or nature with respect to the Products, Know-how, License or Patents and Licensee shall take any and all action that Licensor may request to further document the provisions hereof. In the event that any law, statute, regulation, rule, guideline, ruling or decision prevents Licensee from marketing or offering Products for sale, the minimum royalty payment will be suspended until such time that Licensee is no longer prevented from marketing or offering Products for sale. 4.5 Late Payment. Licensee shall have five (5) days to make any late payments hereunder, without interest. Thereafter, Licensee shall pay a late payment fee to Licensor calculated at a variable rate of 2% over the prime per annum interest rate as set from time to time by Norwest Bank Minneapolis, N.A. , Minneapolis, Minnesota (the "Interest Rate"), on any and all amounts that are at any time overdue and payable to Licensor under this Agreement, such interest being calculated on each such overdue amount from the date when such amount became due to the date of actual payment thereof. Such late payment fee shall be in addition to and not in lieu of any and all other rights or remedies that Licensor may have under this Agreement or law relating to a default by Licensee under this Agreement. 4.6 Records. During the term of this Agreement and for three (3) years after termination of this Agreement, Licensee shall at all times maintain accurate and up-to-date records containing complete data from which amounts due to Licensor under this Agreement may be readily calculated. Further, Licensee shall preserve and permit examination of such records by Licensor's representatives at reasonable intervals and under reasonable conditions during the term of this Agreement and for three (3) years thereafter and, upon request, shall supply to Licensor's representatives all information useful in making a proper audit and verification of Licensee's performance of its obligations under this Agreement. 4.7 Underpayment. If Licensor determines by audit and inspection of Licensee's books and records that Licensee has failed to pay all royalties due under Subsection 4.1, Licensee shall pay Licensor 105% of such additional royalties as may be due. If the amount of underpayment exceeds 5% of the royalties due under Subsection 4.1, then Licensor shall, in addition to any other remedies available to it, recover from Licensee the reasonable costs incurred in making any such audit and inspection pursuant to Section 4.6 hereof which revealed such shortfall. 4.8 Buy-Out of License Rights. At any time on or after January 1, 2002, Licensee may purchase any and all rights to the Products, Know-how and Licensed Patents, as such rights are set forth in Section 2.1 above, by giving Licensor written notification of its election to exercise this buy-out option and by making the following payments (collectively referred to herein as the "Buy-Out Payments") to Licensor: (i) an amount equal to three (3) times the total Earned Royalty paid or payable with respect to the most recent four (4) consecutive Contract Quarters (the "Evaluation Period"), and (ii) quarterly payments in the amount of [confidential treatment requested] per Contract Quarter ending on the earlier of the twelfth Contract Quarter after the buy-out option is exercised or the Contract Quarter ending on December 31, 2006; provided that Licensee shall not be entitled to make such election and consummate such purchase unless a competing product is being offered and Gross Revenues during the Evaluation Period do not exceed Gross Revenues from the four (4) consecutive Contract Quarters preceding the Evaluation Period. 5. INDEMNIFICATION. 5.1 Indemnification by Licensor. Licensor shall indemnify and hold Licensee harmless from and against any and all claims, damages, costs (including reasonable attorneys' fees), judgments and liabilities of any kind or nature arising out of the breach by Licensor of any of its warranties, representations and covenants under this Agreement or by any misuse by Licensor of the patent process or fraud by Licensor on the patent office or notice by Licensor before the date hereof of a claim by any party of a prior or superseding right to practice the art of and commercialize the Products. 5.2 Indemnification by Licensee. Licensee shall indemnify and hold Licensor harmless from and against any and all claims, damages, costs (including reasonable attorneys' fees), judgments and liabilities of any kind or nature: (a) arising out of the breach by Licensee of any of its covenants under this Agreement; or (b) arising out of any actual or alleged defect in a Product. 6. PROTECTION AGAINST INFRINGEMENT. In the event that Licensee becomes aware of activity on the part of any third party which may constitute infringement of the Licensed Patents, or any other intellectual property rights with respect to which Licensee is granted a license hereunder, Licensee shall give Licensor written notice thereof. Upon reasonable request by Licensor, Licensee shall, at its sole expense, initiate and thereafter diligently maintain reasonable efforts to prevent and abate such infringement, including the initiation of an appropriate civil action for infringement and the taking of such other action as may be necessary or appropriate, to enforce the Licensed Patents or other intellectual property rights with respect to which Licensee is granted a license hereunder. In such event, (i) Licensor will permit the use of its name in, and as a party to, all such suits and execute all pleadings, documents and other papers necessary or appropriate in conjunction therewith and (ii) Licensee shall receive the full benefits of any action it takes pursuant to this subsection, including retaining all sums recovered in any such suit or in settlement thereof after paying Licensor the Earned Royalties which shall be calculated from the amount of Gross Revenues, if any, asserted by Licensee to support any award of compensatory damages (as opposed to punitive or any other damages). Licensor may, at its option and its cost and expense, participate in meetings with Licensee and/or its counsel and receive all pleadings, documents and other related papers useful for the purpose of keeping Licensor informed of the status of any proceedings commenced by Licensee pursuant to this Section 6. 7. TERM AND TERMINATION. 7.1 Term. This Agreement shall commence on the effective date hereof and shall expire, unless earlier terminated pursuant to Sections 4.8, 7.2 or 7.3 of this Agreement, upon the expiration of the last of the Licensed Patents to expire or, at the sole discretion of Licensee, ten (10) years from the date hereof if no patent has issued. If a pending patent issues after ten (10) years from the date hereof and after the expiration of the Agreement, the Agreement shall be reinstated in full and shall expire, unless terminated pursuant to the terms of this Agreement, upon the expiration of the last of the Licensed Patents. 7.2 Termination by Licensor. If Licensee defaults in any of its obligations under this Agreement, Licensor shall have the right to terminate this Agreement by giving thirty (30) days' written notice of termination specifying the reason for termination, provided that such notice will be of no effect and termination will not occur if the specified default is cured prior to the expiration of said thirty (30) day notice period. 7.3 Termination by Licensee. (a) This Agreement may be terminated by Licensee at any time at will, with or without cause, by the giving of at least thirty (30) days' written notice to Licensor by Licensee in which event such license shall terminate upon the effective date stated in any such notice. In the event of the termination of any such license, neither Licensor nor Licensee shall have any further obligation to the other party hereunder except as expressly provided in Subsection 7.4 below. (b) Upon the termination of any license granted under this Agreement, Licensee may, after the effective date of such termination, sell any of its (i) completed Products, (ii) Products then in the process of manufacture and (iii) Products with respect to which manufacture has been committed at the time of termination by reason of either (x) any contracts for the purchase of materials to be used in the manufacture of such Products or (y) any contract for the sale of such Products. All such sales and uses shall be subject to the royalty provisions of Section 4 of this Agreement as though the termination of this Agreement had not occurred. (c) Except as expressly provided in Subsection 7.3(b), after termination of this Agreement, Licensee may not use develop, market or sell the Products, Know-how, or Licensed Patents in any way or manner that would violate any rights of Licensor and Licensee shall take any and all steps reasonably requested by Licensor to fully document the complete vesting of all rights licensed hereunder to Licensee by Licensor upon any such termination. 7.4 Continued Obligations. Termination shall not relieve or release either party from its obligations to make any payment which may be owing to the other under the terms of this Agreement or from any other liability which either party may have to the other arising out of the terms of this Agreement. Additionally, notwithstanding anything contained herein to the contrary, Sections 3, 4 (including Subsection 4.8 to the extent then exercised) and 5 shall survive termination of this Agreement and remain in full force and effect; provided, that Licensor and Licensee hereby acknowledge that they may not bring claims against one another based upon the representations and warranties contained in Section 3, except to the extent such representations and warranties are not accurate as of the date hereof. 8. LICENSEE'S UNDERTAKINGS. 8.1 Licensing Fee and Payment. On the date hereof, Licensee will pay to Licensor the sum of $20,000 as a license fee. 8.2 Manufacturing. Licensee will develop systems, or have systems developed for, and will begin the manufacture of salable Products by October 1, 1997, provided no law, statute, regulation, rule, ruling, guideline, order or decision prevent Licensee from marking or offering Products for sale. 8.3 Marketing. No later than January 1, 1998, Licensee will prepare promotional materials and sample packages of Products for promotional distribution. Licensee will also attend relevant trade shows and train its direct sales force and independent sales representative groups under contract to begin selling the Products. 8.4 Marking. Licensee shall apply the patent notices to the Products and Product advertising and packaging that are reasonably required by Licensor. 8.5 Confidentiality. Licensee shall maintain the confidentiality of Licensor's confidential information, both during and after the term of this Agreement. After this Agreement is terminated, Licensee shall not use any of Licensor's confidential information for any purpose that is not specifically provided for in Section 7.3(b) of this Agreement. 9. MISCELLANEOUS. 9.1 Force majeure. Neither party shall be responsible for any delay or failure in the performance of any obligation hereunder due to strikes, lockouts, fires, floods, acts of God, embargoes, wars, riots, or act or order of any government or governmental agency; provided, however, nothing set forth in this Subsection 9.1 shall be construed to relieve Licensee of the requirement that it pay minimum royalties pursuant to Subsections 4.3 and 4.4 hereof. 9.2 Waiver. The waiver or failure of either party to enforce the terms of this Agreement in one instance shall not constitute a waiver of said party's right under this Agreement with respect to other violations. 9.3 Remedies. The election by either party of any particular right or remedy shall not be deemed to exclude any other right or remedy and all rights and remedies of either party shall be cumulative. The parties agree that, in addition to any other relief afforded under the terms of this Agreement or by law, each party shall have the right to enforce this Agreement by injunctive or mandatory relief to be issued against the other party, it being understood that both damages and specific performance shall be proper modes of relief and are not to be considered as alternative remedies. 9.4 Notices. All notices and replies thereto required hereunder shall be in writing, signed by the party giving notice, placed in an envelope and either delivered by hand or sent by facsimile or registered mail, postage prepaid, return receipt requested, and properly addressed to the other party. Notices sent by mail shall be deemed received on the date of receipt indicated by the receipt verification provided by the United States Postal Service. Notices sent by facsimile shall be deemed received on the date indicated on the sender's confirmation report. Notice shall be given, mailed or sent to the other party at the following addresses or at such other address as may be given by proper notice: If to Licensor or Affiliates: Cigone Enterprises, Inc. [confidential treatment requested] Attn: Sherrie Thomas With a copy to: Kuperman, Orr, Mouer & Albers 100 Congress Avenue Suite 1400 Austin, TX 78701 Attn: Vince Mouer Fax No.: 512-322-8143 If to Licensee: CNS, Inc. 4400 West 78th Street Minneapolis, MN 55435 Attn: Daniel E. Cohen, M.D. Fax No.: 612-820-6697 With a copy to: Lindquist & Vennum P.L.L.P. 4200 IDS Center 80 South 8th Street Minneapolis, MN 55402-2205 Attn: Patrick Delaney Fax No.: 612-317-3207 Either party hereto may designate any other address for notices given hereunder by written notice to the other party given at least ten (10) days prior to the effective date of such change. 9.5 Entire Agreement. Agreement represents the entire agreement between the parties with respect to the subject matter hereof; there are no oral promises, representations or warranties. No modification of this Agreement or waiver of any of its terms shall be binding upon the parties unless said modification or waiver is in writing, signed by both parties, and states that it is an amendment to this Agreement. 9.6 Parties in Interest. This Agreement shall inure to the benefit of, be binding upon, and be enforceable against the parties hereto, their respective successors and assigns. 9.7 Governing Law. This Agreement shall be governed by, construed and enforced under the internal laws (and not the laws of conflicts) of the State of Minnesota. 9.8 Severability. If any portion of this Agreement is held invalid by the final judgment of any court of competent jurisdiction, such portion shall be deemed revised or "blue lined" so that it is enforceable to the fullest extent possible under applicable law and the remaining provisions shall remain in full force and effect as if such invalid provision had not been included herein. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the day and year first above written. CNS, INC. By: Daniel E. Cohen, M.D. Its: President CIGONE ENTERPRISES By: Sherrie Thomas Its: President SMOKEBUSTERS OF TEXAS, INC. By: Sherrie Thomas Its: President ODOR PROS, INC. By: Sherrie Thomas Its: President EX-11 4 COMP OF NET INCOME PER SHARE OF COMMON STOCK Exhibit 11 CNS, INC. Computation of Net Income per Share of Common Stock
Year ended December 31, ----------------------------------------- 1997 1996 1995 ----------- ----------- ----------- NET INCOME Income from continuing operations $ 8,770,316 $15,522,484 $13,310,505 Income from discontinued operations 0 0 765,989 ----------- ----------- ----------- Net income $ 8,770,316 $15,522,484 $14,076,494 =========== =========== =========== BASIC NET INCOME PER SHARE Weighted average number of common shares outstanding 19,119,000 18,704,000 17,221,000 =========== =========== =========== From continuing operations $ .46 $ .83 $ .77 From discontinued operations .00 .00 .05 ----------- ----------- ----------- Basic net income per share $ .46 $ .83 $ .82 =========== =========== =========== DILUTED NET INCOME PER SHARE Weiighted average number of common and assumed conversion shares outstanding: Weighted average number of common shares outstanding 19,119,000 18,704,000 17,221,000 Incentive stock options 422,000 636,000 680,000 Non qualified stock options 260,000 392,000 403,000 Warrants 1,000 75,000 72,000 ----------- ----------- ----------- 19,802,000 19,807,000 18,376,000 =========== =========== =========== From continuing operations $ .44 $ .78 $ .72 From discontinued operations .00 .00 .04 ----------- ----------- ----------- Diluted net income per share $ .44 $ .78 $ .76 =========== =========== ===========
EX-13 5 1997 ANNUAL REPORT FINANCIAL HIGHLIGHTS
YEARS ENDED DECEMBER 31, 1997 1996 1995 1994 1993 - ---------------------------------------------------------------------------------------------------------------------------- Results of Operations(1)(2): Net sales: Domestic net sales ................... $ 60,601,757 $ 60,098,235 $ 47,196,414 $ 2,798,174 $ 93,352 International net sales .............. 6,355,377 25,768,290 1,435,441 0 0 ----------------------------------------------------------------------------- Total net sales .................... 66,957,134 85,866,525 48,631,855 2,798,174 93,352 ----------------------------------------------------------------------------- Gross profit ........................... 45,664,139 52,519,647 31,077,442 1,008,629 44,840 Operating income (loss) ................ 9,644,195 21,742,602 12,398,086 (2,757,636) (395,554) Income (loss) from continuing operations before income taxes .................. 12,620,316 24,022,484 12,969,505 (2,558,101) (298,753) Income (loss) from continuing operations 8,770,316 15,522,484 13,310,505 (2,558,101) (298,753) Net income (loss) ...................... 8,770,316 15,522,484 14,076,494 (2,867,415) (1,430,773) Diluted net income (loss) per share: From continuing operations ........... $ .44 $ .78 $ .72 $ (.16) $ (.02) From discontinued operations ......... .00 .00 .04 (.02) (.09) ----------------------------------------------------------------------------- Diluted net income (loss) per share $ .44 $ .78 $ .76 $ (.18) $ (.11) ============================================================================== Weighted average number of common and assumed conversion shares outstanding 19,802,000 19,807,000 18,376,000 15,755,000 13,145,000 DECEMBER 31, 1997 1996 1995 1994 1993 - ---------------------------------------------------------------------------------------------------------------------------- Financial Position(1): Working capital ........................ $ 76,919,076 $ 78,402,795 $ 25,855,456 $ 10,790,457 $ 3,716,040 Total assets ........................... 88,494,973 89,409,067 32,340,535 11,612,871 3,871,506 Stockholders' equity ................... 80,644,501 79,774,907 26,885,342 11,206,535 3,871,506
(1) Until June 1995, the Company manufactured and marketed diagnostic devices for sleep disorders. This line of business was sold in June 1995 and is reported as discontinued operations. (2) Results of operations prior to 1996 included no income tax expense due to net operating loss and credit carryforwards. 1 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of the financial condition and results of operations should be read in conjunction with the Company's audited financial statements and notes thereto appearing elsewhere in this Annual Report. In the opinion of the Company's management, the quarterly unaudited information set forth below has been prepared on the same basis as the audited financial information, and includes all adjustments (consisting only of normal, recurring adjustments) necessary to present this information fairly when read in conjunction with the Company's financial statements and notes thereto. OVERVIEW The Company was founded in 1982. From 1987 until 1995, the Company designed, manufactured and marketed computer-based diagnostic devices for sleep disorders. Beginning in 1995, the Company focused on the Breathe Right(R) nasal strip and divested itself of the assets related to its sleep disorders business. Unless otherwise noted, the following discussion of financial condition and results of operations relate only to continuing operations of the Company. The Company's revenues are derived primarily from the manufacture and sale of the Breathe Right nasal strip. Revenue from sales is recognized when earned, at the time products are shipped. The Company obtained the license to manufacture and sell the Breathe Right nasal strip in 1992 and received FDA clearance in October 1993 to market the Breathe Right nasal strip as a product that improves nasal breathing. In September 1994, the Company launched its consumer marketing program which was enhanced by broad media coverage of the use of Breathe Right nasal strips by professional football players. At the same time, a number of radio and television personalities provided unsolicited endorsements of the product on national radio and television. During 1995, the Company continued its marketing efforts and also focused on expanding its distribution network both domestically and internationally. In the first quarter of 1995, a rapid increase in domestic demand for the product resulted in the Company being unable to secure delivery of sufficient raw materials to avoid large back orders and out of stock situations at the retail level. The Company eliminated the back orders and began building inventory by the end of the second quarter of 1995. In August 1995, the Company signed an exclusive international distribution agreement with 3M to market Breathe Right nasal strips outside the U.S. and Canada. At the end of 1995, Breathe Right nasal strips were available in most domestic drug stores, mass merchants and warehouse clubs and a majority of grocery stores. In November 1995, the Company received FDA clearance to market the Breathe Right nasal strip for the reduction or elimination of snoring and began marketing programs emphasizing the snoring benefits of the product. In February 1996, the Company received FDA clearance to market the Breathe Right nasal strip for the temporary relief of nasal congestion and thereafter launched a media program to increase consumer awareness of the benefits of the product for this application. In June 1996, the Company received FDA clearance to market the Breathe Right nasal strip for the temporary relief of breathing difficulties due to a deviated nasal septum. In July 1996, U.S. Utility Patents were issued covering the basic invention of the Breathe Right nasal strip and additional elements incorporated in the product. By the end of 1996, the Company's international distributor, 3M, had introduced the Breathe Right nasal strip in more than 30 foreign countries. During 1997, the Company increased the level of domestic marketing expenditures, primarily through national television advertising, in order to increase the level of new trial and repeat usage of Breathe Right nasal strips. While usage of the product increased, the overall results of the increased level of marketing, especially in the first quarter of 1997, did not meet expectations. In order to improve the effectiveness of advertising and promotion programs, the Company hired a new advertising agency on April 1, 1997. The new advertising campaign developed for the fourth quarter of 1997 focused on the benefits of improved sleep resulting from better nasal breathing, with the slogan "Breathe Right. Sleep Tight.(TM)" As discussed in more detail below, the Company's international sales decreased during 1997. The Company believes that a higher level of advertising and promotion is needed in international markets and is working with 3M to amend the distribution agreement to permit the Company to take a more active role in advertising and promoting the product in certain countries in the future. In January 1997, the Company was sued for patent infringement. The Company believes it has good and sufficient defenses to the claim of patent infringement. Cross motions for summary judgment with respect to the lawsuit are pending. In February 1998, the company that brought the patent infringement suit against the Company was issued a patent entitled "Transparent Nasal Dilator" and commenced another patent infringement lawsuit against the Company. The Company intends to defend this action vigorously. Also, during 1997 the Company became aware of a foreign reference to a nasal dilator, not commercially available, that will result in narrower protection in the future from the patents licensed for Breathe Right nasal strips. 8 OPERATING RESULTS The tables below set forth certain selected financial information of the Company and the percentage of net sales represented by certain items included in the Company's statements of income for the periods indicated.
THREE MONTHS ENDED (UNAUDITED) YEAR - ----------------------------------------------------------------------------- ENDED MAR 31, JUN 30, SEP 30, DEC 31, DEC 31, 1997 1997 1997 1997 1997 - --------------------------------------------------------------------------------------- (In thousands) Domestic net sales ............. $16,909 $12,623 $12,352 $18,718 $60,602 International net sales ........ 2,486 970 291 2,608 6,355 --------------------------------------------------- Net sales .................... 19,395 13,593 12,643 21,326 66,957 Cost of goods sold ............. 6,245 4,456 3,897 6,695 21,293 --------------------------------------------------- Gross profit ................. 13,150 9,137 8,746 14,631 45,664 --------------------------------------------------- Operating expenses: Marketing and selling ........ 11,124 4,900 4,582 11,033 31,639 General and administrative ... 762 812 933 768 3,275 Product development .......... 202 289 246 369 1,106 --------------------------------------------------- Total operating expenses .... 12,088 6,001 5,761 12,170 36,020 --------------------------------------------------- Operating income ............ 1,062 3,136 2,985 2,461 9,644 Interest income ................ 710 777 773 716 2,976 --------------------------------------------------- Income from continuing operations before income taxes $ 1,772 $ 3,913 $ 3,758 $ 3,177 $12,620 =================================================== THREE MONTHS ENDED (UNAUDITED) YEAR - ----------------------------------------------------------------------------- ENDED MAR 31, JUN 30, SEP 30, DEC 31, DEC 31, 1996 1996 1996 1996 1996 - --------------------------------------------------------------------------------------- (In thousands) Domestic net sales ............. $17,986 $12,611 $11,582 $17,919 $60,098 International net sales ........ 2,835 8,508 7,793 6,632 25,768 --------------------------------------------------- Net sales .................... 20,821 21,119 19,375 24,551 85,866 Cost of goods sold ............. 7,652 9,147 8,000 8,548 33,347 --------------------------------------------------- Gross profit ................. 13,169 11,972 11,375 16,003 52,520 --------------------------------------------------- Operating expenses: Marketing and selling ........ 7,430 6,917 4,862 7,589 26,798 General and administrative ... 738 645 760 727 2,870 Product development .......... 157 340 336 275 1,109 --------------------------------------------------- Total operating expenses .... 8,325 7,902 5,958 8,591 30,777 --------------------------------------------------- Operating income ............ 4,844 4,070 5,417 7,412 21,743 Interest income ................ 155 685 696 743 2,279 --------------------------------------------------- Income from continuing operations before income taxes $ 4,999 $ 4,755 $ 6,113 $ 8,155 $24,022 =================================================== THREE MONTHS ENDED (UNAUDITED) YEAR - --------------------------------------------------------------------------- ENDED MAR 31, JUN 30, SEP 30, DEC 31, DEC 31, 1995 1995 1995 1995 1995 - -------------------------------------------------------------------------------------- (In thousands) Domestic net sales ............. $7,151 $18,540 $10,180 $11,324 $47,196 International net sales ........ 308 278 108 742 1,436 -------------------------------------------------- Net sales .................... 7,459 18,818 10,288 12,066 48,632 Cost of goods sold ............. 2,850 7,072 3,513 4,119 17,555 -------------------------------------------------- Gross profit ................. 4,609 11,746 6,775 7,947 31,077 -------------------------------------------------- Operating expenses: Marketing and selling ........ 2,140 3,788 4,836 5,931 16,695 General and administrative ... 254 377 639 657 1,927 Product development .......... 46 7 3 0 57 -------------------------------------------------- Total operating expenses .... 2,440 4,172 5,478 6,588 18,679 -------------------------------------------------- Operating income ............ 2,169 7,574 1,297 1,359 12,398 Interest income ................ 84 124 214 149 572 -------------------------------------------------- Income from continuing operations before income taxes $2,253 $ 7,698 $ 1,511 $ 1,508 $12,970 ================================================== THREE MONTHS ENDED (UNAUDITED) YEAR - ----------------------------------------------------------------------------- ENDED MAR 31, JUN 30, SEP 30, DEC 31, DEC 31, 1997 1997 1997 1997 1997 - --------------------------------------------------------------------------------------- Net sales ...................... 100.0% 100.0% 100.0% 100.0% 100.0% Cost of goods sold ............. 32.2 32.8 30.8 31.4 31.8 --------------------------------------------------- Gross profit ................. 67.8 67.2 69.2 68.6 68.2 --------------------------------------------------- Operating expenses: Marketing and selling ........ 57.4 36.0 36.2 51.8 47.3 General and administrative ... 3.9 6.0 7.4 3.6 4.9 Product development .......... 1.0 2.1 2.0 1.7 1.6 --------------------------------------------------- Total operating expenses .... 62.3 44.1 45.6 57.1 53.8 --------------------------------------------------- Operating income ............ 5.5 23.1 23.6 11.5 14.4 Interest income ................ 3.6 5.7 6.1 3.4 4.4 --------------------------------------------------- Income from continuing operations before income taxes 9.1% 28.8% 29.7% 14.9% 18.8% =================================================== THREE MONTHS ENDED (UNAUDITED) YEAR - ---------------------------------------------------------------------------- ENDED MAR 31, JUN 30, SEP 30, DEC 31, DEC 31, 1996 1996 1996 1996 1996 - --------------------------------------------------------------------------------------- Net sales ...................... 100.0% 100.0% 100.0% 100.0% 100.0% Cost of goods sold ............. 36.7 43.3 41.3 34.8 38.8 --------------------------------------------------- Gross profit ................. 63.3 56.7 58.7 65.2 61.2 --------------------------------------------------- Operating expenses: Marketing and selling ........ 35.7 32.8 25.1 30.9 31.2 General and administrative ... 3.5 3.0 3.9 3.0 3.3 Product development .......... .8 1.6 1.7 1.1 1.3 --------------------------------------------------- Total operating expenses .... 40.0 37.4 30.7 35.0 35.8 --------------------------------------------------- Operating income ............ 23.3 19.3 28.0 30.2 25.3 Interest income ................ .7 3.2 3.6 3.0 2.7 --------------------------------------------------- Income from continuing operations before income taxes 24.0% 22.5% 31.6% 33.2% 28.0% =================================================== THREE MONTHS ENDED (UNAUDITED) YEAR - ----------------------------------------------------------------------------- ENDED MAR 31, JUN 30, SEP 30, DEC 31, DEC 31, 1995 1995 1995 1995 1995 - --------------------------------------------------------------------------------------- Net sales ...................... 100.0% 100.0% 100.0% 100.0% 100.0% Cost of goods sold ............. 38.2 37.6 34.2 34.1 36.1 --------------------------------------------------- Gross profit ................. 61.8 62.4 65.8 65.9 63.9 --------------------------------------------------- Operating expenses: Marketing and selling ........ 28.7 20.1 47.0 49.2 34.3 General and administrative ... 3.4 2.0 6.2 5.4 4.0 Product development .......... .6 .1 .0 .0 .1 --------------------------------------------------- Total operating expenses .... 32.7 22.2 53.2 54.6 38.4 --------------------------------------------------- Operating income ............ 29.1 40.2 12.6 11.3 25.5 Interest income ................ 1.1 .7 2.1 1.2 1.2 --------------------------------------------------- Income from continuing operations before income taxes 30.2% 40.9% 14.7% 12.5% 26.7% ===================================================
9 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 1997 COMPARED TO 1996 NET SALES. Net sales were $67.0 million for 1997 compared to $85.9 million for 1996. Breathe Right nasal strip sales decreased in 1997 as a result of a decrease in international sales. The Company has experienced in the past, and expects that it will continue to experience in the future, quarterly fluctuations in both domestic and international sales and earnings. These fluctuations are due in part to seasonality of sales as described below, as well as increases and decreases in purchases by distributors and retailers in anticipation of future demand by consumers. For the year 1997, domestic sales increased to $60.6 million from $60.1 million for 1996. While our domestic sales dollars were relatively flat in 1997 compared to 1996, both retail sell-through and our strip sales, measured in units, increased by approximately ten percent. This is primarily due to a higher percentage of sales in 30 and 24 count boxes compared to ten count boxes. International sales decreased to $6.4 million for 1997 from $25.8 million for 1996. International sales in 1996 represented primarily initial inventory purchases by 3M, the Company's international distributor, and initial stocking of inventory at international retail outlets in certain countries. The lower level of international sales in 1997 reflects continued high inventory levels at 3M. As a result, the quarterly international sales patterns for 1997 are not comparable to the quarters of 1996 and may not be comparable to the quarters of 1998. The Company believes a higher level of advertising and promotion is needed in international markets and is working with 3M to amend the distribution agreement to permit the Company to take a more active role in advertising and promoting the product in certain countries in the future. GROSS PROFIT. Gross profit was $45.7 million for 1997 compared to $52.5 million for 1996. Gross profit as a percentage of net sales was 68.2% for 1997 compared to 61.2% for 1996. The higher gross profit as a percentage of net sales in 1997 was due to the lower level of international sales. The Company obtains lower gross profit margins on international sales because the Company sells product to 3M at a price lower than its sales price in domestic markets. In connection with these international sales, 3M is responsible for substantially all of the operating expenses and a portion of the packaging costs. Domestic gross profit as a percentage of domestic net sales for 1997 was approximately 1.5 percentage points higher than 1996, due to a combination of lower manufacturing costs obtained from sub contractors, an increase in the selling price of certain products and changes in the mix of products sold. The Company is continuing efforts to reduce the manufacturing costs of the product and improve gross profit margins on sales. MARKETING AND SELLING EXPENSES. Marketing and selling expenses were $31.6 million for 1997 compared to $26.8 million for 1996. This increase resulted primarily from heavier levels of advertising primarily associated with domestic national television advertising. Marketing and selling expenses as a percentage of net sales increased to 47.3% in 1997 from 31.2% in 1996 as a result of the increase in expenses and lower level of international sales. GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses were $3.3 million for 1997 compared to $2.9 million for 1996. This increase resulted primarily from expenses associated with patent litigation. General and administrative expenses as a percentage of net sales increased to 4.9% in 1997 from 3.3% in 1996 primarily as a result of the lower level of international sales. PRODUCT DEVELOPMENT EXPENSES. Product development expenses were $1.1 million for 1997 and 1996. Product development expenses as a percentage of net sales increased to 1.6% in 1997 from 1.3% in 1996 primarily as a result of the lower level of international sales. INTEREST INCOME. Interest income was $3.0 million for 1997 compared to $2.3 million for 1996. This increase resulted primarily from investment of net proceeds from the public offering of common stock completed in the second quarter of 1996. INCOME TAX EXPENSE. Income tax expense for 1997 was $3.9 million or 30.5% of income before income taxes compared to $8.5 million or 35.4% for 1996. The lower effective income tax rate was due primarily to the higher level of tax exempt interest income as a percentage of income before income taxes. 1996 COMPARED TO 1995 NET SALES. Net sales increased to $85.9 million for 1996 from $48.6 million for 1995. Breathe Right nasal strip sales increased in 1996 in part as a result of increased consumer advertising, particularly national television and radio, and the commencement of international sales. Unlike domestic sales in the first nine months of 1995, which reflected an increase in inventory levels at existing and new retail outlets, domestic sales during 1996 approximated off the shelf movement at retail due to increased consumer demand for the product. As a result, the quarterly domestic sales patterns for the first three quarters of 1996 are not directly comparable to the first three quarters of 1995. During the fourth quarter of 1996, domestic retail 10 sell-through of Breathe Right nasal strips was estimated to be approximately 50 percent higher than the fourth quarter of 1995. For the year 1996, domestic retail sell-through approximately doubled from the 1995 level. International sales increased to $25.8 million for 1996 from $1.4 million for 1995. International sales in 1996 represented primarily initial inventory purchases by 3M, the Company's international distributor, and initial stocking of inventory at international retail outlets in certain countries. GROSS PROFIT. Gross profit was $52.5 million for 1996 compared to $31.1 million for 1995. Gross profit as a percentage of net sales was 61.2% for 1996 compared to 63.9% for 1995. The lower gross profit in 1996 was due to the higher level of international sales. Domestic gross profit as a percentage of domestic net sales for 1996 was approximately 4 percentage points higher than 1995, primarily due to lower manufacturing costs resulting from the Company bringing a portion of the packaging operation in-house and increased production levels. MARKETING AND SELLING EXPENSES. Marketing and selling expenses were $26.8 million for 1996 compared to $16.7 million for 1995. This increase resulted primarily from expenses associated with national television and radio advertising. Marketing and selling expenses as a percentage of net sales decreased to 31.2% in 1996 from 34.3% in 1995 as a result of the higher level of sales. GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses were $2.9 million for 1996 compared to $1.9 million for 1995. This increase resulted from the additional personnel and systems required to support growth of the Breathe Right nasal strip business. General and administrative expenses as a percentage of net sales decreased to 3.3% in 1996 from 4.0% in 1995 as a result of the higher level of sales. PRODUCT DEVELOPMENT EXPENSES. Product development expenses were $1.1 million for 1996 compared to $57,000 for 1995. This increase resulted from expenses associated with the development of potential new products and enhancements to the Breathe Right nasal strip. Product development expenses as a percentage of net sales increased to 1.3% in 1996 from .1% in 1995 primarily as a result of increased expenditures. INTEREST INCOME. Interest income was $2.3 million for 1996 compared to $572,000 for 1995. This increase resulted primarily from investment of net proceeds from the public offering of common stock completed in the second quarter of 1996. INCOME TAX BENEFIT (EXPENSE). Income tax expense for 1996 was $8.5 million or 35.4% of income before income taxes. The income tax benefit for 1995 of $341,000 resulted from the recognition of the benefit of net operating losses and credit carry forwards from prior years by the elimination of the valuation allowance on deferred tax assets due to the Company's expected future taxable income. There were no net operating loss carry forwards available for 1996 or future years. SEASONALITY The Company believes that approximately 50% of Breathe Right nasal strip users currently use the product for the temporary relief of nasal congestion and congestion-related snoring. Sales of nasal congestion remedies are higher during the fall and winter seasons because of increased use during the cold season. For this reason the Company's domestic net sales were relatively higher in the first and fourth quarters. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1997, the Company had cash, cash equivalents and marketable securities of $59.7 million and working capital of $76.9 million. OPERATING ACTIVITIES. The Company generated cash from operations of approximately $8.0 million for 1997 compared to $16.4 million for 1996. The reduced cash flow was primarily due to a decrease in net income. INVESTING ACTIVITIES. The Company purchased, net of sales and maturities, marketable securities of $9.1 million in 1997 compared to $42.4 million in 1996 which included net proceeds from the 1996 public offering of common stock. Marketable securities purchased consisted of cash equivalents, commercial paper, corporate bonds, U.S. Government obligations and municipal bonds. The Company purchased $1.2 million of property and equipment in 1997, primarily associated with the upgrade of management information systems, compared to $465,000 in 1996. Capitalized product rights were $1.6 million in 1997 compared to $141,000 in 1996. The Company currently expects to spend up to an aggregate of $7.0 million on capital expenditures in 1998 and 1999 in order to among other things supplement its in-house manufacturing capability and to complete the expansion and upgrade of management information systems. The actual amount of the expenditures as well as the timing of the expenditures may be subject to change. The Company has reviewed the ability of its computer systems to process transactions relating to the year 2000 and beyond and believes that all significant systems are compliant. FINANCING ACTIVITIES. In 1997, the Company's Board of Directors authorized and the Company purchased one million shares of its common stock for 11 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS $8.3 million. These treasury shares are to be used to meet the Company's obligations under its employee stock ownership plan and stock option plans, and for possible future acquisitions. The Company received $362,000 in 1997 from the exercise of stock options. In April 1996, the Company completed a public offering of 1,725,000 shares of common stock. Of these shares, 1,525,000 shares were sold by the Company and 200,000 shares by selling shareholders. Net proceeds to the Company were $35.5 million. The Company also received $686,000 in 1996 from the exercise of stock options. In June 1995, the Company sold all the assets of its sleep disorder diagnostic products business. Proceeds from the sale included $5.0 million cash and a note receivable of $596,000 that was collected later in 1995. The Company also received $1.1 million in 1995 from the exercise of stock options and warrants. The Company believes that its existing funds and funds generated from operations will be sufficient to support its planned operations for the foreseeable future, including capital expenditures noted above and possible future acquisitions of products that would complement existing operations. RECENT ACCOUNTING PRONOUNCEMENTS In 1997, the Financial Accounting Standards Board ("FASB") issued Statement No. 128, Earnings Per Share. The Company adopted the provisions of this Statement in 1997. The FASB also issued Statement No. 130, Reporting Comprehensive Income and Statement No. 131, Disclosures about Segments of an Enterprise and Related Information. The Company intends to adopt these standards in 1998 by making the required disclosures. Therefore, the adoption of these standards is not expected to have an effect on the Company's financial position or results of operations. FORWARD LOOKING STATEMENTS This Annual Report contains forward-looking statements under the Private Securities Litigation Reform Act of 1995 that are subject to certain risks and uncertainties that could cause actual results to differ materially from those presently anticipated or projected. Such forward-looking statements can be identified by the use of terminology such as "may," "will," "expect," "plan," "intend," "anticipate," "estimate," or "continue" or comparable terminology. Factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to: (i) the Company's revenue and profitability is currently reliant on sales of a single product; (ii) the Company's success will depend, to a large extent, on the enforceability and comprehensiveness of the patents on the Breathe Right nasal strip technology, and the Company has been sued for patent infringement (see Item 3, Legal Proceedings in the Company's Form 10-K for the year ended December 31, 1997); (iii) the markets in which the Company competes are highly competitive; and (iv) the risk factors included in the Company's Prospectus dated March 29, 1996. 12 STATEMENTS OF INCOME CNS, Inc.
YEARS ENDED DECEMBER 31, 1997 1996 1995 - ------------------------------------------------------------------------------------------------------------- Net sales ................................................. $ 66,957,134 $ 85,866,525 $ 48,631,855 Cost of goods sold ........................................ 21,292,995 33,346,878 17,554,413 ---------------------------------------------- Gross profit ............................................ 45,664,139 52,519,647 31,077,442 ---------------------------------------------- Operating expenses: Marketing and selling ................................... 31,638,518 26,798,820 16,695,428 General and administrative .............................. 3,275,636 2,869,163 1,926,988 Product development ..................................... 1,105,790 1,109,062 56,940 ---------------------------------------------- Total operating expenses ............................... 36,019,944 30,777,045 18,679,356 ---------------------------------------------- Operating income ....................................... 9,644,195 21,742,602 12,398,086 Interest income ........................................... 2,976,121 2,279,882 571,419 ---------------------------------------------- Income from continuing operations before income taxes .. 12,620,316 24,022,484 12,969,505 Income tax benefit (expense) .............................. (3,850,000) (8,500,000) 341,000 ---------------------------------------------- Income from continuing operations ...................... 8,770,316 15,522,484 13,310,505 Loss from operations of discontinued sleep division (less applicable income tax benefit of $259,000 in 1995) 0 0 (459,901) Gain on sale of sleep division (less applicable income taxes of $690,000 in 1995) ....................... 0 0 1,225,890 ---------------------------------------------- Net income ............................................. $ 8,770,316 $ 15,522,484 $ 14,076,494 ============================================== Basic net income per share: From continuing operations .............................. $ .46 $ .83 $ .77 From discontinued operations ............................ .00 .00 .05 ---------------------------------------------- Basic net income per share ............................. $ .46 $ .83 $ .82 ---------------------------------------------- Weighted average number of common shares outstanding ...... 19,119,000 18,704,000 17,221,000 ============================================== Diluted net income per share: From continuing operations .............................. $ .44 $ .78 $ .72 From discontinued operations ............................ .00 .00 .04 ---------------------------------------------- Diluted net income per share ........................... $ .44 $ .78 $ .76 ============================================== Weighted average number of common and assumed conversion shares outstanding ................... 19,802,000 19,807,000 18,376,000 ==============================================
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE FINANCIAL STATEMENTS. 13 BALANCE SHEETS CNS, Inc.
December 31, 1997 1996 - ---------------------------------------------------------------------------------------------- ASSETS Current assets: Cash and cash equivalents .................................. $ 229,647 $12,109,150 Marketable securities ...................................... 59,458,236 50,339,193 Accounts receivable, net of allowance for doubtful accounts of $210,000 in 1997 and 1996 .............................. 11,392,001 14,665,731 Inventories ................................................ 8,624,663 8,314,826 Prepaid expenses and other current assets .................. 3,295,001 1,647,055 Deferred income taxes ...................................... 1,770,000 961,000 ---------------------------- Total current assets .................................... 84,769,548 88,036,955 Property and equipment, net .................................. 1,863,007 839,415 Product rights, net .......................................... 1,502,520 192,633 Certificate of deposit, restricted ........................... 359,898 340,064 ---------------------------- $ 88,494,973 $89,409,067 ============================ LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable ........................................... $ 3,130,660 $ 5,134,683 Accrued expenses ........................................... 3,561,279 3,179,944 Accrued income taxes ....................................... 1,158,533 1,319,533 ---------------------------- Total current liabilities ................................ 7,850,472 9,634,160 ---------------------------- Stockholders' equity: Preferred stock -- authorized 8,483,589 shares; none issued or outstanding ................................ 0 0 Common stock-- $.01 par value; authorized 50,000,000 shares; issued and outstanding 19,294,570 shares in 1997 and 19,145,445 shares in 1996 ............................. 192,946 191,454 Additional paid-in capital ................................. 63,495,718 63,177,939 Treasury shares-- at cost; 961,511 shares in 1997 .......... (8,219,993) 0 Retained earnings .......................................... 25,175,830 16,405,514 ---------------------------- Total stockholders' equity .............................. 80,644,501 79,774,907 Commitments (notes 9 and 10) ---------------------------- $ 88,494,973 $89,409,067 ============================
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE FINANCIAL STATEMENTS. 14 STATEMENTS OF STOCKHOLDERS' EQUITY CNS, Inc.
YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995 COMMON STOCK TREASURY SHARES -------------------- ADDITIONAL ------------------------ TOTAL NUMBER PAR PAID-IN NUMBER RETAINED STOCKHOLDERS' OF SHARES VALUE CAPITAL OF SHARES COST EARNINGS EQUITY - --------------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 1994 ....... 17,041,656 $170,416 $ 24,229,583 0 $ 0 $(13,193,464) $ 11,206,535 Stock issued in connection with Employee Stock Purchase Plan ................. 5,365 54 22,377 0 0 0 22,431 Stock options exercised ......... 129,870 1,299 379,034 0 0 0 380,333 Tax benefit from stock options exercised ............. 0 0 485,000 0 0 0 485,000 Warrants exercised, less issuance costs of $35,000 .............. 210,961 2,109 712,440 0 0 0 714,549 Net income for the year ......... 0 0 0 0 0 14,076,494 14,076,494 -------------------------------------------------------------------------------------------- Balance at December 31, 1995 ....... 17,387,852 173,878 25,828,434 0 0 883,030 26,885,342 Proceeds from public stock offering less issuance costs of $2,469,000 ........... 1,525,000 15,250 35,449,926 0 0 0 35,465,176 Stock issued in connection with Employee Stock Purchase Plan ................. 893 9 11,048 0 0 0 11,057 Stock options exercised ......... 231,700 2,317 683,531 0 0 0 685,848 Tax benefit from stock options exercised ............. 0 0 1,205,000 0 0 0 1,205,000 Net income for the year ......... 0 0 0 0 0 15,522,484 15,522,484 -------------------------------------------------------------------------------------------- Balance at December 31, 1996 ....... 19,145,445 191,454 63,177,939 0 0 16,405,514 79,774,907 Stock issued in connection with Employee Stock Purchase Plan ................. 927 10 7,180 (1,489) 8,464 0 15,654 Stock options exercised ......... 77,300 773 241,308 (37,000) 50,062 0 292,143 Tax benefit from stock options exercised ............. 0 0 70,000 0 0 0 70,000 Warrants exercised .............. 70,898 709 (709) 0 0 0 0 Treasury shares purchased ....... 0 0 0 1,000,000 (8,278,519) 0 (8,278,519) Net income for the year ......... 0 0 0 0 0 8,770,316 8,770,316 -------------------------------------------------------------------------------------------- Balance at December 31, 1997 ....... 19,294,570 $192,946 $ 63,495,718 961,511 $(8,219,993) $ 25,175,830 $ 80,644,501 ============================================================================================
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE FINANCIAL STATEMENTS. 15 STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 1997 1996 1995 - -------------------------------------------------------------------------------------------------------------------------- Operating activities: Net income .......................................................... $ 8,770,316 $ 15,522,484 $ 14,076,494 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Net gain on sale of assets of discontinued operations ............. 0 0 (1,915,890) Depreciation and amortization ..................................... 460,044 259,822 187,428 Deferred income taxes ............................................. (809,000) (58,000) (418,000) Changes in operating assets and liabilities: Accounts receivable .............................................. 3,273,730 (6,834,938) (6,894,514) Inventories ...................................................... (309,837) 2,786,083 (9,975,900) Prepaid expenses and other current assets ........................ (1,647,946) (649,381) (752,055) Net assets of discontinued operations ............................ 0 0 (814,201) Accounts payable and accrued expenses ............................ (1,783,688) 5,383,967 5,048,857 ----------------------------------------------- Net cash provided by (used in) operating activities ............. 7,953,619 16,410,037 (1,457,781) ----------------------------------------------- Investing activities: Purchases of marketable securities .................................. (99,045,360) (177,630,971) (42,709,438) Sales and maturities of marketable securities ....................... 89,926,317 135,200,938 39,768,835 Payments for purchases of property and equipment .................... (1,239,918) (464,675) (383,810) Payments for product rights ......................................... (1,553,605) (141,309) (73,426) Purchase of certificate of deposit, restricted ...................... (19,834) (20,064) (320,000) Net proceeds from promissory note ................................... 0 0 595,611 ----------------------------------------------- Net cash used in investing activities ........................... (11,932,400) (43,056,081) (3,122,228) ----------------------------------------------- Financing activities: Net proceeds from sale of discontinued operations ................... 0 0 5,000,000 Net proceeds from public stock offering ............................. 0 35,465,176 0 Proceeds from the issuance of common stock under Employee Stock Purchase Plan ................................. 15,654 11,057 22,431 Proceeds from the exercise of stock options ......................... 362,143 685,848 380,333 Proceeds from exercise of common stock warrants ..................... 0 0 714,549 Purchase of treasury shares ......................................... (8,278,519) 0 0 ----------------------------------------------- Net cash (used in) provided by financing activities ............. (7,900,722) 36,162,081 6,117,313 ----------------------------------------------- Net (decrease) increase in cash and cash equivalents ............ (11,879,503) 9,516,037 1,537,304 Cash and cash equivalents: Beginning of year ................................................... 12,109,150 2,593,113 1,055,809 ----------------------------------------------- End of year ......................................................... $ 229,647 $ 12,109,150 $ 2,593,113 ----------------------------------------------- Supplemental disclosure of cash flow information: Cash paid during the year for interest .............................. $ 0 $ 0 $ 12,500 Cash paid during the year for income taxes .......................... 4,750,000 6,541,467 0 ===============================================
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE FINANCIAL STATEMENTS. 16 NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1997, 1996 AND 1995 NOTE 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BUSINESS CNS, Inc. ("the Company"), designs, manufactures and markets consumer products, primarily the Breathe Right(R) nasal strip. The Breathe Right nasal strip is a nonprescription, single use, disposable device that can reduce or eliminate snoring by improving nasal breathing and temporarily relieving nasal congestion. The Breathe Right nasal strip is sold over-the-counter in retail outlets, including drug, grocery and mass merchant stores. The Company has an international distribution agreement with 3M Company to market Breathe Right nasal strips outside the U.S. and Canada. REVENUE RECOGNITION Revenue from sales is recognized at the time products are shipped. ACCOUNTING ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and 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. FAIR VALUE OF FINANCIAL INSTRUMENTS All financial instruments are carried at amounts that approximate fair value. CASH EQUIVALENTS Cash equivalents consist primarily of money market funds. MARKETABLE SECURITIES The Company classifies its marketable debt securities as available-for-sale and records these securities at fair market value. Net realized and unrealized gains and losses are determined on the specific identification cost basis. Any unrealized gains and losses are reflected as a separate component of stockholders' equity. A decline in the market value of any available-for-sale security below cost that is deemed other than temporary, results in a charge to operations resulting in the establishment of a new cost basis for the security. INVENTORIES Inventories are valued at the lower of cost (determined on a first-in, first-out basis) or market. PROPERTY AND EQUIPMENT Property and equipment are stated at cost. Equipment is depreciated using the straight-line method over five years. Leasehold improvements are amortized over the lesser of the estimated useful life of the improvement or the term of the lease. PRODUCT RIGHTS Product rights, consisting of patents, trademarks and other product rights, are stated at cost and are amortized over three to seven years using the straight-line method. STOCK BASED COMPENSATION The Company follows the disclosure requirements for stock based compensation plans and, accordingly, no compensation expense has been recognized. FOREIGN SALES Foreign sales are made in U.S. dollars only. There are no currency conversions. ADVERTISING The Company expenses the production costs of advertising the first time the advertising runs. INCOME TAXES Deferred tax assets and liabilities and the resultant provision for income taxes are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. NET INCOME Per Share In 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 128, Earnings Per Share, which simplifies the standards for computing earnings per share. SFAS No. 128 replaces the presentation of primary earnings per share with a presentation of basic earnings per share, which excludes dilution. The Company adopted SFAS No. 128 during 1997 and replaced previously reported primary net income per share with basic net income per share. Basic net income per share has been computed based upon the weighted average number of common shares outstanding during the year. Diluted net income per share has been computed based upon the weighted average number of common and assumed conversion shares outstanding during the year. NEW ACCOUNTING STANDARDS In 1997, the FASB issued SFAS No. 130, Reporting Comprehensive Income and No. 131, Disclosures about Segments of an Enterprise and Related Information. The Company intends to adopt these standards in 1998 by making the required disclosures. Therefore, the adoption of these standards is not expected to have an effect on the Company's financial position or results of operations. NOTE 2 SALE OF DIVISION On June 1, 1995 the Company completed the sale of all the assets of its sleep disorder diagnostic products division. Net sale proceeds of $5,000,000 cash and a note receivable of $596,000 resulted in a gain on the sale of discontinued operations of $1,916,000. The net loss of this operation is shown on the statement of income as the loss from discontinued operations. NOTE 3 MARKETABLE SECURITIES Marketable securities, including estimated fair value based on quoted market prices or valuation models, are summarized as follows (in thousands): 17 NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1997 1996 - ------------------------------------------------------------------------ COST FAIR VALUE COST FAIR VALUE - ------------------------------------------------------------------------ Cash equivalents .......... $ 805 $ 805 $ 497 $ 497 Commercial paper .......... 0 0 2,486 2,486 Corporate bonds ........... 3,772 3,772 6,045 6,045 U.S. Government obligations 3,994 3,994 1,998 1,998 Municipal bonds ........... 50,887 50,887 39,313 39,313 - ------------------------------------------------------------------------ Total marketable securities $59,458 $59,458 $50,339 $50,339 ======================================================================== Maturities of marketable securities at December 31, 1997 are as follows (in thousands): COST FAIR VALUE - ------------------------------------------------------------- Due within one year .................. $22,566 $22,566 Due after one year through three years 36,892 36,892 - ------------------------------------------------------------- Total marketable securities .......... $59,458 $59,458 ============================================================= There were no realized gains or losses during 1997, 1996 or 1995. NOTE 4 ADVERTISING At December 31, 1997 and 1996 $1,337,000 and $212,000, respectively, of advertising costs were reported as assets. Advertising expense was $21,160,000 in 1997, $16,215,000 in 1996, and $11,839,000 in 1995. NOTE 5 DETAILS OF SELECTED BALANCE SHEET ACCOUNTS Details of selected balance sheet accounts are as follows (in thousands): 1997 1996 1995 - --------------------------------------------------------------- Allowance for doubtful accounts: Balance beginning of year .......... $210 $201 $ 55 Plus provision for doubtful accounts 5 123 154 Less charge offs ................... 5 114 8 - --------------------------------------------------------------- Balance end of year ............... $210 $210 $201 =============================================================== DECEMBER 31, 1997 1996 - --------------------------------------------------------------------- Inventories: Finished goods ............................... $6,475 $6,254 Work in process .............................. 468 462 Raw materials and component parts ............ 1,682 1,599 - --------------------------------------------------------------------- Total inventories ........................... $8,625 $8,315 - --------------------------------------------------------------------- Property and equipment: Production equipment ......................... $ 928 $ 789 Office equipment and information systems 1,477 376 - --------------------------------------------------------------------- 2,405 1,165 Less accumulated depreciation ................ 542 326 - --------------------------------------------------------------------- Property and equipment, net ................. $1,863 $ 839 - --------------------------------------------------------------------- Product rights: Product rights ............................... $1,920 $ 366 Less accumulated amortization ................ 417 173 - --------------------------------------------------------------------- Product rights, net ......................... $1,503 $ 193 - --------------------------------------------------------------------- Accrued expenses: Promotions and allowances .................... $1,926 $1,305 Royalties and commissions .................... 1,214 1,284 Salaries, incentives and paid time off ....... 273 392 Other ........................................ 148 199 - --------------------------------------------------------------------- Total accrued expenses ...................... $3,561 $3,180 ===================================================================== NOTE 6 STOCKHOLDERS' EQUITY Stock Options The Company's stock option plans allow for the grant of options to officers, directors, and employees to purchase up to 2,950,000 shares of common stock at exercise prices not less than 100% of fair market value on the dates of grant. The term of the options may not exceed ten years and vest in increments over 1 to 5 years from the grant date. The plans allow for the grant of shares of restricted common stock. No shares of restricted common stock have been granted under these plans as of December 31, 1997. Stock option activity under these plans is summarized as follows: WEIGHTED-AVERAGE SHARES EXERCISE PRICE SHARES AVAILABLE PER SHARE OUTSTANDING FOR GRANT - ------------------------------------------------------------------------ Balance at December 31, 1994 $ 2.50 1,047,600 832,622 Granted .................. 5.80 698,000 (698,000) Exercised ................ 2.93 (129,870) 0 Canceled ................. 4.88 (107,430) 107,430 - ------------------------------------------------------------------------ Balance at December 31, 1995 3.85 1,508,300 242,052 Granted .................. 17.61 175,000 (175,000) Exercised ................ 2.96 (231,700) 0 - ------------------------------------------------------------------------ Balance at December 31, 1996 5.65 1,451,600 67,052 Granted .................. 7.13 110,000 (110,000) Exercised ................ 2.56 (114,300) 0 Canceled ................. 16.79 (90,000) 90,000 Unused 1987 expired ...... -- 0 (31,702) Amend 1994 Plan .......... -- 0 750,000 - ------------------------------------------------------------------------ Balance at December 31, 1997 $ 5.29 1,357,300 765,350 ======================================================================== At December 31, 1997, the range of exercise prices and weighted-average remaining contractual life of outstanding options was $1.31 - $18.13 and 6.8 years, respectively. At December 31, 1997, 1996 and 1995, currently exercisable options aggregated 958,100, 775,700 and 653,000 shares of common stock, respectively and the weighted-average exercise price of those options was $4.00, $3.87 and $3.10, respectively. The per share weighted-average fair value of stock options granted during 1997, 1996 and 1995 is estimated as $2.38, $11.00 and $3.48, respectively on the date of grant using the Black-Scholes option pricing model with the following assumptions: volatility of 65%; risk-free interest rate of 6.25% in 1997 and 5.4% in 1996 and 1995; and an expected life of 6 years. The Company applies APB No. 25, Accounting for Stock Issued to Employees, and related interpretations in accounting for its plans. Accordingly, no compensation expense has been recognized for its stock-based compensation plans. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, Accounting for Stock-Based Compensation, the Company's net income and diluted earnings per share would have been reduced by approximately $350,000, or $.02 per share in 1997, $900,000, or $.05 per share in 1996 and $1.5 million, or $.08 per share in 1995. Pro forma net income reflects only options granted in 1997, 1996 and 1995. Therefore, the full impact of calculating compensation cost for stock options under SFAS No. 123 is not reflected in the 18 pro forma net income amounts presented because compensation cost is reflected over the options' vesting period and compensation cost for options granted prior to January 1, 1995 is not considered. EMPLOYEE STOCK PURCHASE Plan The Employee Stock Purchase Plan allows eligible employees to purchase shares of the Company's common stock through payroll deductions. The purchase price is the lower of 85% of the fair market value of the stock on the first or last day of each six-month period during which an employee participated in the plan. The Company has reserved 200,000 shares under the plan of which 138,802 shares have been purchased by employees as of December 31, 1997. WARRANTS During 1997 and 1995 warrants to purchase a total of 100,000 shares at $2.75 were exercised. The warrants had been issued in connection with an agreement to license a product to be marketed as the Breathe Right device. During 1995 warrants to purchase 200,000 shares at $3.75 were exercised. The warrants had been issued to the underwriter of the Company's 1994 public stock offering. In connection with an agreement to license a potential product, the licenser was issued a warrant during 1997 to purchase 25,000 shares of the Company's common stock exercisable at a price of $8.00 per share which expires November 2002. PREFERRED STOCK At December 31, 1997, the Company is authorized to issue 1,000,000 shares of Series A Junior Participating Preferred Stock upon a triggering event under the Company's stockholders' rights plan and 7,483,589 shares of undesignated preferred. NOTE 7 INCOME TAXES Income tax expense (benefit), from continuing operations, for the three years ended December 31, 1997, excluding tax on discontinued operations, is as follows (in thousands): CURRENT DEFERRED TOTAL - --------------------------------------------------------------- 1997: Federal ..................... $4,154 $(728) $ 3,426 State ....................... 505 (81) 424 - --------------------------------------------------------------- Income tax expense (benefit) $4,659 $(809) $ 3,850 - --------------------------------------------------------------- 1996: Federal ..................... $8,164 $ (52) $ 8,112 State ....................... 394 (6) 388 - --------------------------------------------------------------- Income tax expense (benefit) $8,558 $ (58) $ 8,500 - --------------------------------------------------------------- 1995: Federal ..................... $ 532 $(853) $ (321) State ....................... 30 (50) (20) - --------------------------------------------------------------- Income tax expense (benefit) $ 562 $(903) $ (341) =============================================================== Income tax expense (benefit) attributable to income from continuing operations differed from the amounts computed by applying the U.S. federal income tax rate of 35% as a result of the following (in thousands):
1997 1996 1995 - ------------------------------------------------------------------------------------- Computed tax expense ........................... $ 4,417 $ 8,408 $ 4,539 State taxes, net of federal benefit ............ 331 452 389 Tax exempt interest ............................ (765) (185) 0 Benefit of foreign sales corporation ........... (127) (417) 0 Change in deferred tax asset valuation allowance 0 0 (5,439) Other .......................................... (6) 242 170 - ------------------------------------------------------------------------------------- Actual tax expense (benefit) ................. $ 3,850 $ 8,500 $ (341) =====================================================================================
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities for 1997 and 1996 are presented below (in thousands): DECEMBER 31, 1997 1996 - ------------------------------------------------------- Deferred tax assets: Inventory items ............. $ 363 $ 294 Accounts receivable allowance 78 78 Product rights .............. 55 55 Accrued expenses ............ 1,328 574 Tax credits ................. 0 24 - ------------------------------------------------------- 1,824 1,025 Deferred tax liabilities: Property and equipment ...... (54) (64) - ------------------------------------------------------- Net deferred tax assets .... $ 1,770 $ 961 ======================================================= NOTE 8 SALES The Company had two significant customers, including 3M Company, who accounted for approximately 28% of total sales in 1997 and 42% of total sales in 1996, and had one significant customer who accounted for approximately 13% of total sales in 1995. Accounts receivable from these customers as of December 31, 1997 and 1996 were $5,082,000 and $6,762,000, respectively. Foreign sales by geographic area are as follows (in thousands): 1997 1996 1995 - ------------------------------------------------------ Europe ............... $4,319 $12,617 $ 162 Asia ................. 730 10,616 370 Other ................ 1,306 2,535 904 - ------------------------------------------------------ Total foreign sales $6,355 $25,768 $1,436 ====================================================== NOTE 9 LICENSE AGREEMENT The Company has an agreement to exclusively license the Breathe Right nasal strip. Royalties due under this agreement are 3% of net sales. To maintain the Company's license, it must make minimum royalty payments of $450,000 each year until patents for the product expire. Royalty expense was $1,995,000 in 1997, $2,647,000 in 1996 and $1,458,000 in 1995. NOTE 10 OPERATING LEASES The Company leases equipment and office space under noncancelable operating leases which expire over the next three years. Future minimum lease payments due in accordance with these leases as of December 31, 1997 are as follows (in thousands): YEAR ENDING DECEMBER 31, AMOUNT - ------------------------------------------------- 1998 ................................ $ 455 1999 ................................ 455 2000 ................................ 412 - ------------------------------------------------- Future minimum lease payments $1,322 ================================================= 19 NOTES TO FINANCIAL STATEMENTS Total rental expense for operating leases was $471,000 in 1997, $473,000 in 1996, and $377,000 in 1995. The Company's office space lease requires a $320,000 letter of credit to remain with the lessor. The letter of credit is secured by a $360,000 certificate of deposit. NOTE 11 EARNINGS PER SHARE A reconciliation of basic and diluted average common shares outstanding are as follows (in thousands): 1997 1996 1995 - --------------------------------------------------------------------------- Average common shares outstanding .......... 19,119 18,704 17,221 Assumed conversion of stock options ........ 682 1,028 1,083 Assumed conversion of warrants ............. 1 75 72 - --------------------------------------------------------------------------- Average common and assumed conversion shares 19,802 19,807 18,376 =========================================================================== Options to purchase 108,000 shares of common stock at $11.375 to $18.125 per share were outstanding during 1997 but were not included in the computation of diluted earnings per share because the exercise prices of the options were greater than the average market price of the common shares. The options expire in 2005 and 2006. INDEPENDENT AUDITORS' REPORT THE BOARD OF DIRECTORS AND STOCKHOLDERS CNS, INC.: We have audited the accompanying balance sheets of CNS, Inc. as of December 31, 1997 and 1996 and the related statements of income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of CNS, Inc. as of December 31, 1997 and 1996 and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 1997 in conformity with generally accepted accounting principles. /s/ KPMG PEAT MARWICK LLP Minneapolis, Minnesota January 21, 1998 COMMON STOCK INFORMATION PRICE RANGE The Common Stock of the Company is traded under the symbol "CNXS"on the Nasdaq National Market. The following table sets forth the high and low last sale prices of the Company's stock for the periods indicated. 1997 HIGH LOW - ----------------------------------------------------------- First Quarter $16 3/4 $ 8 Second Quarter 12 3/8 8 1/8 Third Quarter 9 1/2 6 5/8 Fourth Quarter 8 3/4 5 11/16 1996 HIGH LOW - ----------------------------------------------------------- First Quarter $25 7/8 $14 5/8 Second Quarter 25 1/8 19 Third Quarter 25 3/8 15 3/8 Fourth Quarter 20 1/2 13 1/2 SHAREHOLDERS As of March 3, 1998, there were approximately 850 owners of record of the Common Stock and an estimated 17,000 beneficial holders whose shares were registered in the names of nominees. DIVIDEND POLICY The Company has never paid any cash dividends on its Common Stock. The Company currently intends to retain any earnings for use in its operations and does not anticipate paying any cash dividends in the foreseeable future. EX-21.1 6 SUBSIDIARIES OF THE COMPANY EXHIBIT 21.1 SUBSIDIARIES OF THE COMPANY Jurisdiction Name of Subsidiary of Organization - ------------------ --------------- CNS FSC, Inc. Barbados EX-23.1 7 INDEPENDENT AUDITORS' CONSENT Exhibit 23.1 INDEPENDENT AUDITORS' CONSENT The Board of Directors CNS, Inc: We consent to incorporation by reference in the registration statements Nos. 33-19044, 33-29454, 33-42971, and 33-59719 on Form S-8 of CNS, Inc. of our report dated January 21, 1998, relating to the balance sheets of CNS, Inc. as of December 31, 1997 and 1996, and the related statements of income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1997, which report is incorporated by reference in the December 31, 1997 annual report on Form 10-K of CNS, Inc. KPMG Peat Marwick LLP Minneapolis, Minnesota March 27, 1998 EX-27.1 8 FINANCIAL DATA SCHEDULE
5 12-MOS DEC-31-1997 JAN-01-1997 DEC-31-1997 229,647 59,458,236 11,392,001 0 8,624,663 84,769,548 1,863,007 0 88,494,973 7,850,472 0 0 0 192,946 80,451,555 88,494,973 66,957,134 66,957,134 21,292,995 36,019,944 0 0 0 12,620,316 3,850,000 8,770,316 0 0 0 8,770,316 0.46 0.44
EX-27.2 9 FINANCIAL DATA SCHEDULE
5 9-MOS DEC-31-1997 JAN-01-1997 SEP-30-1997 6,483,930 62,106,859 7,877,679 0 9,485,513 90,231,344 1,687,702 0 93,561,668 7,881,940 0 0 0 192,946 85,486,782 93,561,668 45,631,043 45,631,043 14,598,201 23,850,037 0 0 0 9,443,438 2,950,000 6,493,438 0 0 0 6,493,438 0.34 0.33
EX-27.3 10 FINANCIAL DATA SCHEDULE
5 12-MOS 9-MOS 6-MOS 3-MOS 12-MOS DEC-31-1996 DEC-31-1996 DEC-31-1996 DEC-31-1996 DEC-31-1995 JAN-01-1996 JAN-01-1996 JAN-01-1996 JAN-01-1996 JAN-01-1995 DEC-31-1996 SEP-30-1996 JUN-30-1996 MAR-31-1996 DEC-31-1995 12,109,150 10,920,648 51,487,681 10,631,100 2,593,113 50,339,193 49,981,280 4,877,378 6,827,732 7,909,160 14,665,731 10,828,412 9,462,787 9,845,241 7,830,793 0 0 0 0 0 8,314,826 5,764,508 8,927,998 7,634,652 11,100,909 88,036,955 79,902,904 77,254,698 36,652,122 31,310,649 839,415 763,799 733,802 664,297 558,999 0 0 0 0 0 89,409,067 81,092,533 78,434,142 37,781,873 32,340,535 9,634,160 6,805,411 8,091,436 7,026,445 5,455,193 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 191,454 191,448 191,448 175,156 173,878 79,583,453 74,095,674 70,151,258 30,580,272 26,711,464 89,409,067 81,092,533 78,434,142 37,781,873 32,340,535 85,866,525 61,315,223 41,939,694 20,820,761 48,631,855 85,866,525 61,315,223 41,939,694 20,820,761 48,631,855 33,346,878 24,798,655 16,798,481 7,651,631 17,554,413 30,777,045 22,185,405 16,227,332 8,325,018 18,679,356 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 24,022,484 15,867,825 9,754,408 4,998,937 12,969,505 8,500,000 5,825,000 3,606,000 1,898,000 (341,000) 15,522,484 10,042,825 6,148,408 3,100,937 13,310,505 0 0 0 0 765,989 0 0 0 0 0 0 0 0 0 0 15,522,484 10,042,825 6,148,408 3,100,937 14,076,494 0.83 0.54 0.34 0.18 0.82 0.78 0.51 0.32 0.17 0.76
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