-----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, U82gSNXwVoAeAXZnHbDEMnJQdSFMJZlrr0gDhD07RcPUS82c1lt4hFBKLOmymPWb 4zCBVIOrQ1nSqPypFofHnw== 0001047469-98-012464.txt : 19980331 0001047469-98-012464.hdr.sgml : 19980331 ACCESSION NUMBER: 0001047469-98-012464 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980330 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: AVECOR CARDIOVASCULAR INC CENTRAL INDEX KEY: 0000883982 STANDARD INDUSTRIAL CLASSIFICATION: SURGICAL & MEDICAL INSTRUMENTS & APPARATUS [3841] IRS NUMBER: 411695729 STATE OF INCORPORATION: MN FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-21330 FILM NUMBER: 98578760 BUSINESS ADDRESS: STREET 1: 7611 NORTHLAND DR NORTH CITY: MINNEAPOLIS STATE: MN ZIP: 55428 BUSINESS PHONE: 6123919000 MAIL ADDRESS: STREET 1: 7611 NORTHLAND DR NORTH CITY: MINNEAPOLIS STATE: MN ZIP: 55428 10-K 1 FORM 10-K - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- 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 No.: 0-21330 AVECOR CARDIOVASCULAR INC. (Exact name of registrant as specified in its charter) MINNESOTA 41-1695729 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 7611 NORTHLAND DRIVE MINNEAPOLIS, MINNESOTA 55428 (Address of principal (Zip Code) executive offices)
Registrant's telephone number, including area code: (612) 391-9000 Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, $.01 PAR VALUE 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 Item 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 13, 1998, 8,020,562 shares of Common Stock of the registrant were outstanding, and the aggregate market value of the Common Stock of the registrant as of that date (based upon the last reported sale price of the Common Stock at that date by the Nasdaq National Market), excluding outstanding shares owned beneficially by officers and directors, was approximately $49,400,000. DOCUMENTS INCORPORATED BY REFERENCE Parts I and II of this Annual Report on Form 10-K incorporate by reference information (to the extent specific sections are referred to herein) from the registrant's Annual Report to Shareholders for the year ended December 31, 1997 (the "1997 Annual Report"). Part III of this Annual Report on Form 10-K incorporates by reference information (to the extent specific sections are referred to herein) from the registrant's Proxy Statement for its 1998 Annual Meeting to be held May 7, 1998 (the "1998 Proxy Statement"). - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- The matters discussed in this Annual Report on Form 10-K contain certain forward-looking statements. For this purpose, any statements contained in this Report that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, words such as "may," "will," "expect," "believe," "anticipate," "estimate" or "continue," the negative or other variations thereof, or comparable terminology, are intended to identify forward-looking statements. These statements by their nature involve substantial risks and uncertainties, and actual results may differ materially depending on a variety of factors, including the progress of product development and clinical studies, the timing of and ability to obtain regulatory approvals, the extent to which the Company's products gain market acceptance, the introduction of competitive products by others, the pricing related to competitive products, litigation regarding patent and other intellectual property rights, the availability of third-party reimbursement and other factors, as well as those set forth below under the caption "Important Factors" on page 20. MYOtherm-Registered Trademark- and OnCourse-Registered Trademark- are registered trademarks of the Company. Affinity-TM-, Signature-TM-, Trillium-TM-, Myotherm XP-TM-, Affinity XP-TM- and XP-TM- are trademarks of the Company. Windows-Registered Trademark- is a registered trademark of Microsoft Corporation. PART I ITEM 1. BUSINESS. (a) GENERAL DEVELOPMENT OF BUSINESS. AVECOR Cardiovascular Inc. (the "Company") develops, manufactures and markets specialty medical devices for heart/lung bypass surgery and long-term respiratory support. The Company's products include the AFFINITY microporous, hollow fiber membrane oxygenator and related blood reservoirs, a line of solid silicone membrane oxygenators and related blood reservoirs, the AFFINITY blood pump, the MYOTHERM cardioplegia delivery system, SIGNATURE custom tubing packs and the AFFINITY arterial filter. The Company was incorporated in Minnesota in December 1990 and began operations in 1991 when it purchased the surgical division of SCIMED Life Systems, Inc. (the "Predecessor Business"). The assets purchased included a line of solid silicone membrane oxygenators. Since the acquisition of the Predecessor Business, the Company has engaged in extensive product development, resulting in the introduction and receipt of regulatory approval from the U.S. Food and Drug Administration (the "FDA") for the following proprietary products:
PRODUCT APPROVAL DATE - ----------------------------------------------------- -------------- MYOTHERM cardioplegia delivery system October 1991 SIGNATURE custom tubing packs July 1993 AFFINITY oxygenator November 1993 AFFINITY blood reservoirs July 1994 AFFINITY arterial filter October 1995 MYOTHERM XP (improved cardioplegia delivery system) July 1997 AFFINITY blood pump August 1997 AFFINITY oxygenator with TRILLIUM bio-passive surface February 1998
1 In December 1992, the Company acquired Cardio Med Ltd., a corporation organized under the laws of England and Wales ("Cardio Med"). Cardio Med had been a distributor of the Company's disposable membrane oxygenators, cardiotomy reservoirs and cardioplegia systems and manufactured its own proprietary line of custom tubing packs. As a result of the acquisition, Cardio Med has become a wholly-owned subsidiary of the Company. Cardio Med's name has since been changed to AVECOR Cardiovascular Ltd. ("AVECOR Ltd."). During 1995, the Company incorporated AVECOR Foreign Sales Corporation as a wholly-owned subsidiary of the Company and opened a sales office in France, organized as AVECOR Cardiovascular France S.A.R.L., a French subsidiary of AVECOR Ltd. As used herein, the term "Company" refers to AVECOR Cardiovascular Inc., AVECOR Ltd., AVECOR Cardiovascular France S.A.R.L. and AVECOR Foreign Sales Corporation. The Company's principal executive offices are located at 7611 Northland Drive, Minneapolis, Minnesota 55428, and its telephone number is (612) 391-9000. (b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS. Since its inception, the Company has operated in the single industry segment of developing, manufacturing and marketing medical devices. (c) NARRATIVE DESCRIPTION OF BUSINESS. INDUSTRY BACKGROUND AND MARKETS INDUSTRY BACKGROUND. The Company's products are used in surgical procedures requiring heart/lung bypass, such as the treatment of coronary artery disease by coronary artery bypass graft surgery ("CABG" or "coronary bypass surgery"), heart valve replacement surgery and pediatric and neonatal congenital heart defect surgery. There were approximately 850,000 heart/lung bypass procedures performed worldwide in 1997, including approximately 400,000 of such procedures performed in the United States, and approximately 265,000 of such procedures performed in Europe. Certain of the Company's products are also used in non-surgical applications, such as the long-term cardiopulmonary support of premature infants, newborns and other patients with life-threatening respiratory disorders. The primary use of the Company's products is for heart/lung bypass procedures during the surgical treatment of coronary artery disease. Coronary artery disease, the leading cause of death in the United States, is the atherosclerotic narrowing of the coronary arteries that supply blood to the heart. Atherosclerosis is the accumulation of cholesterol and blood products on the inner lining of an artery that causes the arterial wall to thicken and lose elasticity, narrowing the inner diameter of the artery. According to an estimate by the American Heart Association, approximately 13,490,000 Americans have a history of heart attack, angina pectoris (chest pain), or both, which are generally associated with coronary artery disease. The American Heart Association estimated that, in the United States in 1996, coronary artery disease would result in 1,500,000 acute myocardial infarctions, or heart attacks, of which approximately 500,000 would result in death. In the late 1960s, cardiovascular surgeons pioneered coronary bypass surgery, a surgical treatment for severe cases of coronary artery disease in which blood vessel grafts are used to bypass the site of the blocked arteries. Several of these procedures or "grafts" may be performed during a single surgery in order to bypass atherosclerotic lesions in more than one of the coronary arteries, which is commonly referred to as "multi-vessel" coronary artery disease. Coronary bypass surgery generally requires that the patient be put on a heart/lung bypass circuit to enable the surgeon to operate on a still, relatively bloodless heart. The 2 heart/lung bypass circuit is a series of interconnected specialty medical devices that together function as a patient's heart and lungs by temporarily oxygenating and circulating blood while the patient's own heart and lungs are rendered inactive. The Company believes coronary bypass surgery accounts for approximately 75% of the total heart/lung bypass procedures performed in the United States and over 50% of the procedures performed in Europe. Although coronary bypass surgery is a highly invasive procedure, it has been shown to be highly effective in treating coronary artery disease, and the number of procedures performed annually in the United States has grown from approximately 200,000 in 1982 to over 400,000 in 1997 (multiple procedures may be performed during a single surgery where multi-vessel disease is present). The annual worldwide growth rate in the number of coronary bypass procedures has fluctuated from year to year for various reasons. Since the development of coronary bypass surgery, a number of non-surgical interventional treatments for coronary artery disease have been developed which, depending on the extent and nature of the disease as well as physician preference, may be used as an alternative to coronary bypass surgery. These non-surgical treatments, while generally less costly per procedure, have limitations and to date have not resulted in reduced demand for coronary bypass surgery. Percutaneous transluminal coronary angioplasty ("PTCA") was introduced in the early 1980s as a non-surgical treatment for coronary artery disease. PTCA is performed by guiding a balloon-tipped catheter to the site of an atherosclerotic lesion, followed by several courses of dilation under high balloon pressure. For many patients, PTCA represents a less costly and less traumatic alternative to bypass surgery, while for other patients it represents a preferred alternative to drug therapy. While the number of PTCA procedures performed grew significantly in the 1980s and early 1990s, the number of coronary bypass procedures performed annually also continued to grow during this period. Although the average cost of a PTCA procedure is approximately one-half of the average cost of coronary bypass surgery, the need for further interventions for many patients tends to significantly reduce the long-term cost differential between these two types of procedures. Studies have indicated that 30% to 50% of PTCA procedures are complicated by "restenosis," a renarrowing, or often reclosure, of the dilated vessel within six months. An artery complicated by restenosis often requires repeat procedures, reducing the overall cost-effectiveness of PTCA. For a significant number of PTCA patients, coronary bypass surgery is ultimately performed. In patients with multi-vessel coronary artery disease, a randomized study has shown that within three years of receiving treatment, only 14% of patients receiving coronary bypass surgery required retreatment ("revascularization") while 60% of patients receiving PTCA required revascularization. Additional studies have confirmed that approximately 20% of PTCA patients with multi-vessel disease will undergo coronary bypass surgery within one year of receiving PTCA. Because of the higher rates of revascularization of patients receiving PTCA rather than coronary bypass surgery, several studies have concluded that over a three-year period the overall average cost of PTCA procedures exceeds 75% of the average cost of coronary bypass surgery. In response to the limitations of PTCA, a variety of "second generation" interventional devices for coronary artery disease have been developed, including atherectomy devices (catheter devices that cut and remove atherosclerotic materials from the arterial wall), rotational ablation devices (catheter devices which use a rotating burr to remove material), laser catheter devices (devices that use laser energy to reduce accumulated materials in arteries) and coronary stents (expandable metal frames that are positioned within the diseased area in the coronary artery to maintain the vessel opening). Of these devices, coronary stents have demonstrated the best potential to date to reduce restenosis in a randomized population. Recent studies have concluded that the rate of restenosis in patients receiving coronary stents following PTCA is 3 approximately 30% lower than in patients treated only by PTCA. However, the use of stenting in connection with PTCA greatly increases the cost of the PTCA procedure. One study has indicated that the average cost per procedure for elective stenting in connection with PTCA was approximately twice the cost of PTCA without stenting (or approximately equal to the cost of coronary bypass surgery). In addition to the existing non-surgical treatments for coronary artery disease, an additional treatment modality has emerged for both coronary artery disease and heart valve replacement procedures (discussed below), which involves "least" or "minimally" invasive surgical procedures. These techniques involve small surgical incisions in the patient's chest in lieu of the larger incision used in traditional CABG or valve replacement surgeries. Specialized surgical instruments used in connection with endoscopes enable surgeons to perform CABG or valve replacement surgeries via these smaller incisions. In some variations of this type of procedure, only a modified form of the heart/lung bypass circuit is required, which includes an oxygenator and related disposables. However, in other variations of this type of procedure a heart/lung bypass circuit is not utilized. While this modality is in its developmental stages and currently requires significant surgical skill and training, the potential benefits to patients from this type of surgery are a reduced recovery period and risk of infection as a result of the smaller incision. While some of the patients currently eligible for treatment by these types of procedures are not candidates for more invasive and less costly procedures, there can be no assurance that this type of surgical procedure will not represent a significant portion of the CABG or heart valve replacement procedures in the future. Therefore, it cannot be determined at this time what effect, if any, the development and acceptance of these procedures may have on the market for the Company's disposable heart/lung bypass circuit components. A second significant use of the Company's products in conjunction with heart/lung bypass procedures is in heart valve replacement surgery. Heart valve replacement surgery is also an open heart surgical procedure, involving the replacement of valves that regulate the flow of blood between chambers in the heart. Valve replacement may be required where the valve has become narrowed or ineffective due to the build-up of calcium or scar tissue, or where there is a congenital defect or some other form of physical damage to the valve. Like coronary bypass surgery, valve replacement surgery requires that the patient be put on a heart/lung bypass circuit. The Company believes approximately 20% of the heart/lung bypass procedures performed in the United States were performed in heart valve replacement surgery and approximately 25% of the heart/lung bypass procedures performed in Europe were performed in heart valve replacement surgery. Pediatric and neonatal congenital heart defect surgery is another heart/lung bypass procedure which uses several of the Company's products. These procedures are undertaken to correct developmental defects in the heart of a child or infant. The Company believes approximately 5% of the heart/lung bypass procedures performed in the United States and approximately 10% of those performed in Europe were performed in connection with this type of corrective surgery. The primary non-surgical use of the Company's products is in connection with a procedure known as extracorporeal membrane oxygenation ("ECMO"). ECMO is the long-term cardiopulmonary support of premature infants, newborns and other patients with life threatening respiratory disorders. The relatively small ECMO market served by the Company is comprised of 118 established centers worldwide, in which approximately 1,500 neonatal ECMO procedures (procedures performed on children younger than one year) were performed in 1997. Neonatal ECMO procedures constitute the vast majority of all ECMO procedures performed. There has been relatively little growth in the overall ECMO market in recent years and the Company believes growth in this market will remain limited until technology overcomes complications that 4 are common in long-term respiratory support, such as intracranial bleeding due to the associated long-term use of anti-coagulants. Since the Company manufactures what it believes to be the only oxygenator that has received clearance from the FDA for sale for long-term cardiopulmonary support for periods greater than 24 hours, the Company believes it has a competitive advantage in this relatively small market. HEART/LUNG BYPASS CIRCUIT. In procedures requiring cardiopulmonary support, the patient is connected to a series of interconnected specialty medical devices, collectively called a heart/lung bypass circuit. The heart/lung bypass circuit functions as the patient's heart and lungs by temporarily oxygenating and circulating blood while the patient's own heart and lungs are rendered inactive. The devices in the heart/lung bypass circuit are operated by a skilled medical professional known as a perfusionist, under the direction of a surgeon. The primary components of a heart/lung bypass circuit, including the oxygenator, are single-use, disposable products. Heart/lung bypass circuits are customized for the particular practices of individual perfusionists. In a typical heart/lung bypass procedure, blood is removed via surgically inserted "cannulae" (hollow tubes with specifically designed tips that facilitate the drainage or infusion of blood into or out of a patient's body) from the patient's vena cava (the large vessels leading to the heart). The blood flows from the patient's vena cava by gravity into a venous blood reservoir where it is collected and "de-bubbled" (air is eliminated from the blood). In addition, blood that is suctioned from the patient or drained from the heart is filtered and de-bubbled through a cardiotomy reservoir. This blood is then also added to the venous blood reservoir. From the venous blood reservoir, the blood is mechanically pumped by a blood pump serving as a replacement for the patient's heart through an oxygenator. The oxygenator serves as a replacement for the patient's lungs by removing carbon dioxide from and adding oxygen to the blood. The carbon dioxide and oxygen levels in the blood are monitored with blood gas monitoring equipment, allowing the perfusionist to make the proper adjustments to maintain the correct concentrations. The oxygenator also controls the temperature of the blood by means of an integral heat exchanger connected to a heater-cooler console. The oxygenated blood is then returned to the patient through a final (arterial) filter that removes any potential air or small particles. This artificial heart/lung system is the primary component of the bypass circuit. In addition to the artificial heart/lung system, most bypass circuits also include a cardioplegia delivery system. During most cardiac surgical procedures, the heart is stopped (arrested) to provide the surgeon with a motionless field for the delicate surgery. When this occurs, the heart muscle receives very little blood supply. A cardioplegia system infuses specially formulated solutions (which often include oxygenated blood) directly into the patient's coronary arteries. In addition to delivering nutrients to the heart, these solutions are also used to arrest the heart and maintain prescribed temperatures. In order to salvage the patient's own blood during surgery, a cell-saver circuit may be used to collect and concentrate the patient's blood into washed, packed cells which can be reinfused at a later time to improve the patient's red blood cell count without the risks associated with donated blood. Another method of concentrating the patient's red blood cells is with the use of a hemoconcentrator. This device removes excess fluid from the patient's blood (concentrating the red blood cells) and also preserves the plasma of the blood that is generally discarded with typical blood cell salvaging. The heart/lung bypass circuit is completed by connecting all of the devices with tubing. Frequently, this tubing is pre-connected according to the instructions of individual perfusionists with all or some of the devices in the circuit and marketed as custom tubing packs. Increasingly, all of the components in the heart/lung bypass circuit are assembled and packaged in a complete, single container for a single heart/lung bypass procedure. 5 MARKETS. The Company's products are primarily sold to hospitals that perform heart/lung bypass surgery. There were approximately 1,000 hospitals in the United States and about 400 hospitals in Europe which performed these procedures in 1997. Over 400,000 heart/lung bypass procedures were performed in the United States in 1997, and approximately 265,000 heart/lung bypass procedures were performed in Europe in 1997. Coronary bypass surgeries constitute a significant portion of the total number of heart/lung bypass procedures performed each year. Although the number of heart/lung bypass procedures performed may have been less than the number of coronary bypass surgeries due to multiple grafts being performed during some surgeries, the number of graft procedures performed in the United States each year grew from less than 200,000 in 1982 to over 400,000 in 1997. The current annual worldwide market for disposable products and related hardware and accessories for heart/lung bypass surgery is estimated by industry analysts to be approximately $800 million, over $600 million of which is estimated to be attributable to disposable products. The two largest individual markets for disposable products are the oxygenator market, estimated at approximately $200 million in annual sales, and the custom tubing pack market, estimated at approximately $100 million in annual sales. The Company's current proprietary product offerings participate in an annual worldwide market for disposable products estimated to be approximately $480 million, and the Company anticipates that its proprietary products under development, including additional products coated with its new TRILLIUM bio-passive surface, should allow the Company to pursue a greater portion of the disposable product market. PRODUCTS The Company currently offers four primary product lines: the AFFINITY line; the solid silicone membrane oxygenator line; the MYOTHERM cardioplegia delivery system; and SIGNATURE custom tubing packs. "Other products" include products distributed by the Company which do not represent any of the Company's primary product lines and, combined or individually, do not represent a primary product line within the Company's business. The following table sets forth the amounts and percentages of the Company's consolidated net sales attributable to these four product lines for the periods shown.
YEARS ENDED DECEMBER 31, --------------------------------------------------- 1997 1996 1995 ------------- -------------- -------------- (DOLLARS IN THOUSANDS) AFFINITY line .............................. $26,185 56% $25,488 57% $18,329 55% SIGNATURE custom tubing packs .............. 9,803 21 7,402 17 3,459 10 Silicone membrane oxygenator line .......... 7,081 15 7,517 17 7,793 24 MYOTHERM cardioplegia deliver system ....... 3,655 8 3,994 9 3,759 11 Other products ............................. 140 0 - - - - ------ --- ------- --- ------- --- TOTAL ................................. $46,864 100% $44,401 100% $33,340 100% ------ --- ------- --- ------- ---
AFFINITY LINE. The Company's AFFINITY line is currently comprised of the AFFINITY oxygenator, the AFFINITY blood pump, a hardshell cardiotomy venous reservoir and a venous reservoir bag. The AFFINITY oxygenator is a microporous, hollow fiber membrane oxygenator which exchanges the carbon dioxide in the patient's blood for oxygen, returning oxygenated blood to the patient through the heart/lung bypass circuit. This oxygenator incorporates the Company's patented radial flow and graduated density fiber bundle, both of which were developed through the Company's use of "computational fluid dynamics." Computational fluid dynamics helped the Company design the AFFINITY oxygenator with features such as a lowered blood phase pressure drop, a more uniform flow of blood through the device's fiber 6 bundle, and reduced damage to the blood as it passes through the device's blood phase. The key features of the AFFINITY oxygenator include the following: - - HIGH GAS TRANSFER. The Company believes that the AFFINITY oxygenator offers superior gas transfer performance. Studies conducted by independent investigators have demonstrated that the AFFINITY oxygenator has gas transfer performance equal or superior to that of most competing oxygenators. The Company believes that most perfusionists desire oxygenators that provide optimum gas transfer performance to assure safety for patients requiring greater oxygen transfer capability, such as larger patients and patients operated on under lighter anesthesia or at warmer temperatures. - - LOW PRESSURE DROP. Studies conducted by independent investigators have determined the pressure drop across the blood phase of the AFFINITY oxygenator to be as low or lower than that of other leading products. The Company believes that perfusionists generally wish to avoid large pressure drops during heart/lung bypass procedures due to the risk of line failures associated with high pressure drop. - - LOW PRIMING VOLUME. The AFFINITY oxygenator has a priming volume which the Company believes to be one of the lowest priming volumes among oxygenators currently available. Lower priming volume can result in less set-up time for the perfusionist, reduced dilution of the patient's blood with priming solutions and a reduced use of the patient's blood for priming, which lessens the possibility that costly and potentially dangerous donor blood products will need to be introduced during the procedure. - - EASE OF USE. The AFFINITY oxygenator has been designed to be convenient to set up, prime and operate. The AFFINITY oxygenator's relatively small size and universal adaptability contribute to its ease of handling, and its clear case helps to assure quick, complete priming and ongoing visual checks during the procedure. The device's unique casing design and a proprietary manufacturing technique result in precise alignment of the uppermost blood port with the top of the fiber bundle, allowing for ease in venting air during the priming procedure. The Company believes that perfusionists have a preference for oxygenators that permit easy removal of air during priming and ease of monitoring for the presence of air during the procedure. Although competing oxygenators are generally designed to maximize one or more of these key features, the Company believes the performance of the AFFINITY oxygenator to be equal or superior to competing products across a broad range of performance characteristics: gas transfer capability, pressure drop, priming volume and ease of use. In February 1997, the Company received regulatory clearance from the FDA to market its AFFINITY oxygenator with TRILLIUM bio-passive surface. By adding the AFFINITY oxygenator with TRILLIUM bio-passive surface, the Company will be able to offer a product option that certain competitors now promote. The TRILLIUM bio-passive surface is produced by coating all blood-contact surfaces in the oxygenator with a non-leaching synthetic hydrophilic polymer which contains a small amount of heparin, a widely used anti-coagulant. This surface is designed to minimize activation of blood constituents which otherwise occurs as a result of contact with conventional synthetic surfaces. In the heart/lung bypass circuit, the blood reservoir serves as a filtering and storage device. The AFFINITY line offers two blood reservoirs, a hardshell cardiotomy venous reservoir and a venous reservoir bag. Computational fluid dynamics modeling was also used in the development of these reservoirs. The hardshell reservoir can be used as a stand-alone unit or can be integrated with the AFFINITY oxygenator in one unit. The venous reservoir bag maintains simplicity in its design while offering optimum priming ease, 7 efficient air handling and excellent mixing characteristics. By offering these blood reservoirs in the AFFINITY line, the Company is able to configure systems to meet its customers' needs. In July 1993, the Company began international marketing of the AFFINITY oxygenator. The Company began the commercial release of the AFFINITY oxygenator in the U.S. market in February 1994, following marketing clearance from the FDA. The Company received U.S. marketing clearance from the FDA for its AFFINITY blood reservoirs in July 1994 and began marketing the devices following clearance. The AFFINITY Blood Pump System incorporates a motor and control console, a rotor housing, rotor assembly and a disposable pump chamber. The Company believes that the AFFINITY Blood Pump System offers a number of clinical safety advantages over existing centrifugal or standard roller-type pumps. In particular, the modified roller-type design of the AFFINITY Blood Pump System is designed to (i) prevent significant negative pressure at the inlet, which minimizes the potential for cavitation; (ii) not permit the draining of the venous reservoir and the resulting introduction of air into the bypass circuit; (iii) not create high discharge pressures sufficient to disrupt the tubing connections in the bypass circuit; and (iv) not allow retrograde flow. The Company believes that the AFFINITY Blood Pump System is the first and only available blood pump to combine these safety features with performance comparable to available pumps. There can be no assurance that the AFFINITY Blood Pump System will be perceived as superior to currently available blood pumps, that competitors will not introduce future products with superior performance characteristics, or that the AFFINITY Blood Pump System will achieve market acceptance or generate material revenues for the Company at any time in the near future, if at all. See "Important Factors" on page 20. In August 1997, the Company received regulatory clearance from the FDA to market the AFFINITY Blood Pump System. By adding the AFFINITY Blood Pump System to its product line, the Company is now able to offer a complete line of proprietary devices comprising the major components of the heart/lung bypass circuit. SIGNATURE CUSTOM TUBING PACKS. The Company's SIGNATURE custom tubing packs include the tubing and other connections used to integrate the various components of the heart/lung bypass circuit and ECMO system. The components to be included in each tubing pack and the manner in which they are arranged and connected are determined by the specifications provided by the Company's individual customers. The Company has developed computer software that allows it to design and fully document custom tubing packs according to individual customer specifications and to quote prices based on these specifications within hours of a customer request. The Company believes that this service provides it with a significant competitive advantage. While many of the devices included in the Company's SIGNATURE custom tubing packs are manufactured by the Company, the Company currently does not manufacture all the devices that may be requested by customers. Consequently, the Company is currently required to purchase certain components of its SIGNATURE custom tubing packs from other medical device manufacturers. The Company received marketing clearance from the FDA for its SIGNATURE custom tubing packs in June 1993. In October 1995, the Company received FDA clearance to market its AFFINITY arterial filter. The Company began sales of this product to customers in late 1995, with full worldwide release in the first quarter of 1996. The AFFINITY arterial filter is the final component in the circuit of specialized medical devices used in heart/lung bypass surgery, ensuring that the oxygenated blood is free of air or particulate emboli before re-entering the patient's body. The Company believes that the AFFINITY arterial filter offers low volume priming, high visibility and excellent air handling and hemodynamics. The vast majority of 8 AFFINITY arterial filter devices are sold as components of its SIGNATURE custom tubing packs. Previously, the Company had sold filters from other manufacturers as part of its custom tubing packs. SILICONE MEMBRANE OXYGENATOR LINE. The Company's solid silicone membrane oxygenator line consists of the Company's solid silicone membrane oxygenator and associated cardiotomy reservoirs and the Company's ECMO (extracorporeal membrane oxygenation) devices. This product line was purchased by the Company from the Predecessor Business. The Company's solid silicone membrane oxygenators allow gases to pass to and from blood using proprietary silicone membrane technology, as opposed to the most widely used oxygenators that use microporous membrane technology (including the AFFINITY oxygenator). The solid silicone membrane technology permits, and may be sold for, extended use applications because it does not experience the performance deterioration over a longer period of use that occurs in a microporous membrane oxygenator. In addition, some perfusionists continue to prefer silicone membrane oxygenators for heart/lung bypass procedures. The Company believes that its solid silicone membrane oxygenator is the only oxygenator which is approved for sale for extended use of periods greater than 24 hours, providing the Company with a competitive advantage in this relatively small market. The Company markets a full line of solid silicone membrane oxygenators in several models and sizes. The Company's solid silicone membrane oxygenator is also part of the Company's ECMO system. ECMO is the long-term cardiopulmonary support of premature infants, newborns and other patients with life-threatening respiratory disorders. The ECMO system includes the membrane oxygenator, reservoir bladder bags and a heat exchanger. MYOTHERM CARDIOPLEGIA DELIVERY SYSTEM. The Company's MYOTHERM cardioplegia delivery system is used to infuse specially formulated solutions, which often include oxygenated blood, directly into the patient's coronary arteries while the heart is stopped during heart/lung bypass surgery. In addition to delivering nutrients to the heart, these solutions are also used to arrest the heart and maintain prescribed temperatures. The Company believes that the MYOTHERM cardioplegia delivery system provides superior levels of heat exchange performance for optimum temperature control during both the cooling and warming phases of heart/lung bypass surgery. The MYOTHERM cardioplegia delivery system also offers adaptability and convenience for varying cardioplegia techniques used by cardiovascular surgeons. The perfusionist is able to specify mixtures of cardioplegia solutions and blood in the MYOTHERM cardioplegia delivery system without changing the pump set-up. The Company released its MYOTHERM cardioplegia delivery system worldwide in October 1991. In July 1997, the Company received marketing clearance from the FDA for an improved MYOTHERM cardioplegia delivery system known as the MYOTHERM XP. The MYOTHERM XP offers lower priming volume, better air handling and a new safety valve to prevent an air pressure induced failure of the MYOTHERM XP while retaining all the other advantages of the predecessor MYOTHERM cardioplegia delivery system. ONCOURSE CONTINUOUS QUALITY CONTROL IMPROVEMENT SOFTWARE. In addition to the Company's medical device products, the Company introduced its ONCOURSE continuous quality improvement (CQI) manager in December 1995. This Microsoft Windows-based software program is currently offered free of charge to customers who make a major commitment to the Company's products. ONCOURSE CQI Manager guides perfusionists through the necessary steps in establishing a CQI program. In addition, it generates a 9 variety of useful reports for perfusionists, including the annual American Board of Cardiovascular Perfusion clinical activity report and several other specialized reports. In March 1997, the Company released ONCOURSE II, an improved version of its original ONCOURSE CQI software. The major improvements for ONCOURSE II include upgraded report generation capabilities, user-defined study parameters, tracking of blood usage during procedures, and a benchmarking utility to compare the host hospital data to aggregate data from other hospitals via online communications. Further improvements and upgrades are planned for 1998. Although the Company markets this product for sale to other customers, the Company does not expect that this product will contribute significantly to its results of operations in the foreseeable future. RESEARCH AND DEVELOPMENT The Company's research and development strategy encompasses: continuing the development of a complete line of products for the heart/lung bypass circuit, ensuring that existing products are enhanced or replaced, based on changing on market conditions and developing products which address new markets and opportunities outside of the heart/lung bypass market and which leverage the Company's core technologies and expertise. As an integral part of both its research and development and sales and marketing strategies, the Company strives to involve its customers to a large extent in its product development activities. Under confidentiality agreements, the Company consults with selected customers from time to time as to market needs and assessments of products under development by the Company. The Company believes that this practice allows it to receive end-user assessments of products in development at an early stage and to better assure market acceptance. The Company's research and development staff currently consists of 24 full-time engineers, scientists, designers and technicians. Research and development expenses in 1997 were $3,902,000, as compared with $3,651,000 in 1996 and $2,773,000 in 1995. The Company anticipates that 1998 research and development costs will increase approximately 10% over 1997 levels, as the Company moves to expand and improve its proprietary line of disposable medical devices. This forward-looking projection is dependent on the extent and timing of new product development and the impact of the regulatory process in obtaining marketing clearance for new products. The need or desire to modify the Company's existing products could also influence the level of research and development expenses. There can be no assurance, however, that the Company's research and development efforts will result in any commercially successful products. MARKETING The Company markets its products in the United States and internationally, with domestic sales accounting for 59%, 59% and 58% of consolidated net sales in 1997, 1996 and 1995, respectively. The majority of the Company's international sales are in Europe. To serve the U.S. market, the Company has developed a sales organization that markets its products directly to cardiovascular surgeons, perfusionists, neonatologists and ECMO specialists. This organization consists of a staff of 18 direct sales employees and is supplemented by seven independent sales representative organizations, all with cardiovascular sales experience. This network is managed by four regional sales managers and a vice president of marketing and sales. At its inception, the Company marketed its products primarily through distributors and independent sales representatives. Since that time, 10 the Company has shifted the composition of its distribution network in the United States to its current direct sales organization. Approximately 93% of the Company's U.S. sales in 1997 occurred through direct sales employees and independent sales representatives. The Company believes that this shift to a larger direct sales force allows better control of the sales process and assists the Company in developing closer relationships with its customers. During 1997, the Company terminated agreements with its last remaining United States distributor and its only Canadian distributor. At the time of termination, both distributors had an inventory of the Company's products which subsequently were sold to medical institutions and were not replenished by purchases from the Company. Sales to the territories formerly served by these distributors decreased approximately $1,400,000 in 1997 when compared to 1996. These markets are now being served by the Company's direct sales force. While management believes these revenue declines are temporary and caused by the transition to a direct sales force in these territories, this forward-looking expectation is primarily dependent on the ability of the direct sales personnel to maintain and develop relations and revenue levels at the medical institutions previously served by these distributors. Internationally, the Company sells its products through 41 cardiovascular distributors who cover most major foreign markets. The Company's U.K. subsidiary, AVECOR Ltd., is the base of the Company's international marketing efforts, and manufactures, assembles and distributes the Company's products to the majority of the Company's international distribution network. This international distribution network is managed by an international sales director and an export sales manager, both of whom are experienced in marketing heart/lung bypass devices in Europe. The Company's international distribution network is supplemented by seven direct sales employees, three in the U.K., two in France and two in Canada. In October 1995, the Company opened a sales office in France, which is organized as a subsidiary of AVECOR Ltd. Total export sales from the U.S. to unaffiliated entities (primarily to Europe and Asia and payable in U.S. dollars) and sales made by AVECOR Ltd. were $4,952,000 and $14,230,000, respectively for the year ended December 31, 1997; $4,912,000 and $13,111,000, respectively for the year ended December 31, 1996; and $3,480,000 and $10,702,000, respectively, for the year ended December 31, 1995. The Company currently has written agreements with 25 of its independent sales representatives and international distributors. These agreements generally impose geographic exclusivity and non-competition obligations on the Company's independent sales representatives and distributors. The Company's sales representative agreements typically include a provision that requires the Company to pay a commission to the sales representative for any sales made directly by the Company to customers within such sales representative's or distributor's territory. Distributor agreements generally do not require the Company to pay commission. The Company may typically terminate these agreements upon breach of the agreement by the distributor or sales representative, including breach of the quota or minimum sales obligations imposed by the agreement, as well as certain extraordinary events. The Company's products are primarily sold to hospitals that perform heart/lung bypass procedures. In the United States, the Company believes there are approximately 1,000 hospitals at which heart/lung bypass procedures are performed, while in Europe approximately 400 hospitals perform such procedures. There are approximately 118 hospitals worldwide where ECMO is performed. The Company's products are used by perfusionists, and the Company estimates that there are about 3,000 perfusionists practicing in the United States. A small portion of the Company's business is subject to longer term (longer than one year) commitments with customers. These commitments involve fixed pricing terms and minimum or exclusive 11 purchase obligations. Many of the Company's competitors, which have greater financial resources and broader and longer-standing product lines than the Company, have experienced relatively greater success in establishing these types of customer commitments. The Company anticipates that there will be increased use of these longer term, firm commitment arrangements in its markets due to cost concerns and other factors. The Company's sales and marketing strategy includes developing and maintaining a close working relationship with its customers in order to assess and satisfy their needs for products and services. The Company meets with certain designated customers several times each year, during which ideas are shared regarding the marketplace in general, specific products, products under development and existing or proposed programs. In lieu of expensive advertising and promotional materials, the Company maintains extensive contact with its customers for the purpose of educating them in the Company's technologies and manufacturing methods as well as to receive input and feedback about the Company's product development and customer service functions. The Company believes these efforts to be cost-effective in producing awareness of, and loyalty to, the Company's products. The Company conducts frequent training of its sales force to facilitate response to customer needs. The Company also maintains a 24-hour/day assistance program in order to respond quickly to clinical questions and problems encountered by its customers. The assistance services are provided by a former certified clinical perfusionist employed by the Company and are supplemented by other certified clinical perfusionists employed by the Company as well as a network of perfusionist consultants located across the country. No single customer accounted for more than 10% of the Company's 1997 net sales. COMPETITION The cardiovascular device market in which the Company competes is characterized by intense competition. This market is dominated by established manufacturers that have broader product lines, greater distribution capabilities, substantially greater capital resources and larger marketing, research and development staffs and facilities than the Company. Many of these competitors offer broader product lines within the specific heart/lung bypass product market and/or in the general field of medical devices and supplies. Broader product lines give many of the Company's competitors the ability to negotiate exclusive, long-term medical device supply contracts and, consequently, the ability to offer comprehensive pricing of their competing products. By offering a broader product line in the general field of medical devices and supplies, competitors may also have a significant advantage in marketing competing products to group purchasing organizations, health maintenance organizations and other managed-care organizations that increasingly seek to reduce costs through centralization of purchasing functions. In addition, the Company's competitors continue to use price reductions to preserve market share in the oxygenator and other product markets. Therefore, the Company must present competitive product pricing when required to protect or improve its market share in certain key areas. There can be no assurance that the Company's competitors will not use more significant and more prolonged price competition across the Company's product lines in the future. During 1995 and 1996, one of the Company's competitors, the Bentley Division of Baxter Healthcare Corporation, purchased three companies which provide contract perfusion services to hospitals. Although the Company believes that it is too early to assess the long-term effect of these acquisitions on the Company's business, sales to contract perfusion groups controlled by one of the Company's competitor decreased $750,000 to $1,100,000 for 1997 from $1,850,000 for 1996. The Company 12 believes that control of contract perfusion groups by its competitors will continue to have a negative impact on the Company's ability to market its products to such groups or to hospitals or other medical providers that contract with competitor-controlled groups for perfusion services, and could have a material adverse effect on the Company's business, financial condition and results of operation. This forward-looking statement is subject to the degree of control exerted by the Company's competitors with respect to purchasing decisions made by controlled groups of perfusionists, the extent of future acquisitions of contract perfusion groups by the Company's competitors, the breadth of the Company's product offerings relative to those competitors controlling contract perfusion groups, and the degree to which the Company's research and development and marketing efforts result in the successful commercialization of products with enhanced or superior performance characteristics. The Company's primary competitors within the heart/lung bypass market include COBE Cardiovascular Inc. (a subsidiary of Gambro, Inc.), Medtronic, Inc., the Bentley Division of Baxter Healthcare Corporation, C.R. Bard Inc., Sorin Biomedical, Inc. (a subsidiary of Fiat), Terumo Medical Corporation and SARNS Inc. (a subsidiary of 3M Company). The Company believes that the principal competitive factors in the market for heart/lung bypass and long-term respiratory support products are product performance, quality, price, ease of use, technical innovation, cost-effectiveness, field sales support, customer service and breadth of product line. The Company intends to continue to compete on the basis of its high performance products, innovative technologies, cost-effective manufacturing techniques, close customer relations and support and its strategy to increase and enhance, as dictated by market conditions, its offerings of products within the heart/lung bypass circuit and other medical device technologies. MANUFACTURING The Company manufactures oxygenators and other products and assembles custom tubing packs at its U.S. facility located in Minneapolis, Minnesota. The Company also performs certain final manufacturing processes with respect to its oxygenators and blood reservoirs and assembles SIGNATURE custom tubing packs at its Bellshill, Scotland facility. The Company's U.K. and U.S. manufacturing facilities have been inspected by the British Standards Institute ("BSI") and, as a result, the Company has received ISO 9001 certification. BSI is also the "Notified Body" that has verified that the Company's quality certification procedures conform with the essential requirements necessary for the Company to prepare a Declaration of Conformity and therefore place the "CE" mark on its products. See "Governmental Regulation" on page 14. As a part of the development process for new products, the Company simultaneously designs and develops manufacturing processes and equipment to be used to manufacture the products. Because of the Company's ability to design and produce its manufacturing equipment internally in conjunction with new product development, the Company has been able to implement a highly automated, cost-efficient manufacturing process for the products in its AFFINITY line. The Company manufactures its oxygenators, blood pump, blood reservoirs and ancillary products from standard raw materials, components and custom manufactured components presently purchased from outside suppliers. The Company intends to continue to purchase these raw materials, components and custom-manufactured components from outside suppliers in the future. While the Company believes that the raw materials, components and custom manufactured components used in the manufacture of its products are readily available from multiple sources, certain of these items are purchased from single 13 sources. Although the Company has qualified, or is in the process of investigating, alternate sources of supply for key components and materials, any significant interruption in supply of these items could have a material adverse effect on the Company's ability to manufacture its products. The Company has not experienced shortages or significant delays in supply of these materials and components from its suppliers. GOVERNMENTAL REGULATION The Company's products, development activities and manufacturing processes are subject to regulation by numerous governmental authorities, principally the FDA and corresponding foreign agencies. In the United States, the FDA administers the Federal Food, Drug and Cosmetics Act and amendments thereto, including the Safe Medical Devices Act of 1990. The Company is subject to the standards and procedures with respect to manufacture and marketing of medical devices contained in the Federal Food, Drug and Cosmetics Act and the regulations promulgated thereunder and is subject to inspection by the FDA for compliance with such standards and procedures. Noncompliance with applicable requirements can result in, among other things, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, failure of the government to grant premarket clearance or premarket approval for devices, withdrawal of marketing approvals and criminal prosecution. In the United States, medical devices are classified into one of three classes (class I, II or III), on the basis of the controls deemed necessary by the FDA to reasonably assure their safety and effectiveness. Under FDA regulations, class I devices are subject to general controls (E.G., labeling, premarket notification and adherence to good manufacturing practices) and class II devices are subject to general and special controls (E.G., performance standards, postmarket surveillance, patient registries and FDA guidelines ). In general, class III devices (E.G., life-sustaining, life-supporting and implantable devices, or new devices which have not been found substantially equivalent to a legally marketed device), in addition to being subject to general and special controls, must receive premarket approval ("PMA") by the FDA to ensure their safety and effectiveness. Before a new or significantly modified device can be introduced into the market, the manufacturer must generally obtain marketing clearance through a 510(k) notification or approval of a PMA application. A 510(k) clearance will be granted if the proposed device is "substantially equivalent" to a predicate device (I.E., a legally marketed class I or class II medical device, or a class III medical device for which the FDA has not called for the submission of a PMA application). Commercial distribution of a device for which a 510(k) notification is required can begin only after the FDA issues a written determination that the device is "substantially equivalent" to a predicate device. The FDA may determine that a proposed device is not substantially equivalent to a predicate device, or that additional information or data are needed before a substantial equivalence determination can be made. A request for additional data may require that clinical studies of the device's safety and efficacy be performed. The process of obtaining a 510(k) clearance typically can take several months to a year or longer. A PMA application must be filed if a proposed device is not substantially equivalent to a legally marketed class I or class II device, or if it is a class III device for which the FDA has called for a PMA application. Certain class III devices that were on the market before May 28, 1976 ("preamendments class III devices"), and devices that are substantially equivalent to them, can be brought to market through the 510(k) process until the FDA calls for the submission of PMA applications for preamendments class III devices. The process of obtaining a PMA can be expensive, uncertain and lengthy, frequently requiring anywhere from one to several years from the date the PMA is submitted to the FDA, if approval is obtained at all. Moreover, a PMA application, if granted, may include significant limitations on the indicated uses for which a product may be marketed. FDA enforcement policy strictly limits the marketing of approved 14 medical devices for unapproved or "off label" uses. In addition, product approvals can be withdrawn for failure to comply with regulatory standards or the occurrence of unforeseen problems following initial marketing. All of the Company's current products have been the subject of successful 510(k) submissions, and the Company believes that its products currently in development will also be eligible for the 510(k) submission process, although there can be no assurance that the FDA will agree with this view. Certain of the Company's products are within product categories set forth in an FDA order dated August 14, 1995, issued to all manufacturers of these devices, which requires all of such manufacturers to submit additional data to the FDA regarding the safety and the efficacy of the identified devices. The products affected include the Company's blood oxygenators, arterial filters and defoamers, which, by current FDA interpretation, include both cardiotomy and venous blood reservoirs. Each of these devices is currently classified by the FDA as a class III medical device which, because they were viewed as substantially equivalent to preamendments class III devices, were cleared for marketing through the 510(k) premarket notification process. Through its August 14, 1995 order, the FDA has requested data from the Company and other manufacturers of these devices in order to make a determination as to whether these products should be reclassified as either class I or class II medical devices. If the FDA were to determine that such devices should remain classified as class III medical devices, it would require manufacturers such as the Company to submit PMA applications concerning such devices within 90 days after the final FDA classification order. The Company has gathered the required data for submission to the FDA, and is working with various industry groups and the FDA to seek reclassification of these devices. Although the FDA order requiring the submission of data on blood oxygenators and arterial filters has characterized these devices as having a high potential for down-classification, and the Company believes that the devices will be reclassified, there can be no assurance that these devices will be reclassified. Although the FDA order requesting data on defoamers has characterized these devices as unlikely to be reclassified, and, therefore, likely to require PMA submission, the Company is currently working to seek down-classification. The Company's efforts, in conjunction with those of other manufacturers, are based on the belief that the types of blood reservoirs currently used in heart/lung bypass circuits are significantly different from the defoamers used with older, bubble-type oxygenators, and, based on safety and efficacy data, should be reclassified. While there can be no assurance that these efforts will be successful, the Company believes that the likelihood of reclassification of blood reservoirs is currently greater than indicated in the FDA order. Reclassification data on all of the affected products was submitted to the FDA for review on February 13, 1998. In the event that any of the devices are not reclassified, the Company and its competitors may be required to submit a PMA application. During the gathering and submission of data for any such PMA application and throughout the FDA review of this information, the Company and its competitors would most likely be allowed to continue marketing their products. As discussed above, the PMA application process can be expensive, uncertain and lengthy, and, if required, could have a material adverse effect on the Company's future business, financial condition or results of operations. The Company is also subject to regulation in each of the foreign countries in which it sells its products with regard to product standards, packaging requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements. Many of the regulations applicable to the Company's products in such countries are similar to those of the FDA. The national health or social security organizations of certain of such countries require the Company's products to be qualified before they can be marketed in those countries. The Company relies on its independent distributors and Company regulatory personnel, in countries where the Company has employed direct sales personnel, to comply with the majority of the foreign regulatory requirements. To date, the Company has not experienced significant difficulty in complying with these regulations. 15 The Company is subject to periodic inspections by the FDA, which is charged with auditing the Company's compliance with quality assurance systems established by the FDA and other applicable government standards. The Company is also subject to inspections by the United Kingdom's Medical Devices Directorate ("MDD") and other European regulatory agencies. Strict regulatory action may be initiated in response to audit deficiencies or to product performance problems. The Company believes that its manufacturing and quality control procedures are in compliance with the requirements of the FDA and MDD regulations. The Company's manufacturing facilities and processes are also subject to periodic inspection and review by BSI in conjunction with the Company's ISO 9001 certification. ISO certification is a series of standards that define the basics of establishing, documenting and maintaining an effective production quality management system. The Company believes that ISO certification creates value for the Company both internally, by providing an objective criteria for measuring the Company's quality assurance efforts, and externally, through customer recognition of, and demand for, products manufactured by ISO certified manufacturers. BSI is also the "Notified Body" that has verified that the Company's quality certification procedures conform with the "essential requirements" set forth by the MDD for the class of products produced by the Company. Conformity with these essential requirements enables the Company to prepare a Declaration of Conformity which supports the placement of the "CE" mark on the Company's products. The CE mark enables the Company's products to be marketed, sold and used throughout the European Union (the "EU"), subject to limited "safeguard" powers of member states. Presently, the CE mark is not required to be affixed to the Company's products (or those of its competitors) sold in the EU, but may be affixed during a transition period currently in effect and which began January 1, 1995. This transition period will end in June 1998, when all of the Company's products (and those of its competitors) will be required to comply with the essential requirements in order to be marketed in the EU. The financial arrangements through which the Company markets, sells and distributes its products may be subject to certain federal and state laws as well as regulations in the United States with respect to the provision of services or products to patients who are Medicare or Medicaid beneficiaries. The "fraud and abuse" laws and regulations prohibit the knowing and willful offer, payment or receipt of anything of value to induce the referral of Medicare or Medicaid patients for services or goods. In addition, the physician anti-referral laws prohibit the referral of Medicare or Medicaid patients for certain "Designated Health Services" to entities in which the referring physician has an ownership or compensation interest. Violations of these laws and regulations may result in civil and criminal penalties, including substantial fines and imprisonment. In a number of states, the scope of fraud and abuse or physician anti-referral laws and regulations, or both, have been extended to include the provision of services or products to all patients, regardless of the source of payment, although there is variation from state to state as to the exact provisions of such laws or regulations. In other states, and, on a national level, several health care reform initiatives have been proposed which would have a similar impact. The Company believes that its operations and its marketing, sales and distribution practices currently comply in all respects with all current fraud and abuse and physician anti-referral laws and regulations, to the extent they are applicable. Although the Company does not believe that it will need to undertake any significant expense or modification to its operations or its marketing, sales and distribution practices to comply with federal and state fraud and abuse and physician anti-referral regulations currently in effect or proposed, financial arrangements between manufacturers of medical devices and other health care providers may be subject to increasing regulation in the future. Compliance with such regulation could adversely affect the Company's marketing, sales and distribution practices, and may affect the Company in other respects not presently foreseeable, but which could have a material adverse impact on the Company's business, financial condition and results of operations. 16 THIRD-PARTY REIMBURSEMENT AND COST CONTAINMENT The Company's products are purchased by hospitals and other users, which then bill various third-party payors for the health care products and services provided to the patients. These payors, which include Medicare, Medicaid, private insurance companies and managed care organizations, reimburse part or all of the costs and fees associated with the procedures performed with these devices. Medicare and Medicaid reimbursement for hospitals is based on a fixed amount for admitting a patient with a specific diagnosis. Because of this fixed reimbursement method, hospitals have incentives to use less costly methods in treating Medicare and Medicaid patients, and will frequently make capital expenditures to take advantage of less costly treatment technologies. Frequently, reimbursement is reduced to reflect the availability of a new procedure or technique and, as a result, hospitals are generally willing to implement new cost saving technologies before these downward adjustments take effect. Likewise, because the rate of reimbursement for certain physicians who perform certain procedures has been, and may in the future be, reduced in the event of further changes in the resource-based relative value scale method of payment calculation, physicians may seek greater cost efficiency in treatment to minimize any negative impact of reduced reimbursement. Any amendments to existing reimbursement rules and regulations which restrict or terminate the reimbursement eligibility (or the extent or amount of coverage) of medical procedures using the Company's products or the eligibility (or the extent or amount of coverage) of the Company's products could have a material adverse impact on the Company's business, financial condition and results of operations. In response to the focus of national attention on rising health care costs, a number of changes to reduce costs have been proposed or have begun to emerge. There have been, and may continue to be, proposals by legislators and regulators and third-party payors to curb these costs. There has also been a significant increase in the number of Americans enrolling in some form of managed care plan, and over 80% of hospitals participate in or have agreements with HMOs. It has become a typical practice for hospitals to affiliate themselves with as many managed care plans as possible. Higher managed care penetration typically drives down the prices of health care procedures, which in turn places pressure on medical supply prices. This causes hospitals to implement tighter vendor selection and certification processes, by reducing the number of vendors used, purchasing more products from fewer vendors and trading discounts on price for guaranteed higher volumes to vendors. Hospitals have also sought to control and reduce costs over the last decade by joining group purchasing organizations or purchasing alliances. The Company cannot predict what continuing or future impact existing or proposed legislation, regulation or such third-party payor measures may have on its future business, financial condition or results of operations. Because the primary application of the Company's products is in coronary bypass procedures, changes in reimbursement policies and practices of third-party payors with respect to coronary bypass surgery could have a substantial and material adverse impact on sales of the Company's heart/lung bypass products. The development or increased use of more cost-effective treatments for coronary artery disease could cause such payors to decrease or deny reimbursement for coronary bypass surgery or to favor these other treatments. 17 PATENTS AND PROPRIETARY RIGHTS The Company protects its technology by filing patent applications for the patentable technologies that it considers important to the development of its business. The Company also relies upon trade secrets, know-how and continuing technological innovations to develop and maintain its competitive position. The Company currently holds eight U.S. patents and has three pending U.S. patent applications. In addition, the Company has six pending foreign patent applications. Four of the Company's present U.S. patents cover significant design features of the AFFINITY oxygenator, including the AFFINITY oxygenator's winding mandrel, graduated density fiber bundle and heat exchanger water diverter. The Company's other issued U.S. Patents cover the designs of the AFFINITY venous blood reservoirs and AFFINITY arterial filter. Also, the Company owns a patent relating to the use of its silicone membrane for cell culture applications. The Company has pending U.S. Patent applications relating to additional features of the AFFINITY venous blood reservoir, the AFFINITY arterial filter and its improved MYOTHERM XP cardioplegia heat exchanger. The Company's pending foreign patent applications consist of selected overseas filings addressing the same intellectual property addressed by the Company's issued and pending U.S. Patents. The three U.S. patents acquired by the Company from the Predecessor Business cover the Company's solid silicone membrane oxygenator product line and have expired. The Company believes that the market for solid silicone membrane oxygenators might not be large enough to justify the expenses associated with market entry by a competitor, and therefore, the effect of the expiration of these patents on the revenues of the Company will not be material. The Company, like other firms that engage in the development and marketing of medical technology products, must address issues and risks relating to patents and trade secrets. There can be no assurance that any of the Company's pending or future U.S. or foreign patent applications will result in issued patents, that any current or future U.S. or foreign patents of the Company will not be challenged or circumvented by competitors or others, or that such patents will be found to be valid or sufficiently broad to protect the Company's technology or provide the Company with its desired competitive advantage. The validity and breadth of claims covered in medical technology patents involve complex legal and factual questions and therefore may be highly uncertain. The Company may be required to institute litigation to enforce patents issued to the Company or to determine the enforceability, scope and validity of the proprietary rights of others. The Company also relies on trade secrets and proprietary know-how which it seeks to protect, in part, through confidentiality agreements with employees, consultants and other parties. There can be no assurance that these agreements will not be breached, that the Company will have adequate remedies for any breach, or that the Company's trade secrets will not otherwise become known to or independently developed by competitors. Claims by competitors and other third parties that the Company's products allegedly infringe the patent rights of others could have a material adverse effect on the Company. The medical device industry is characterized by frequent and substantial intellectual property litigation. Intellectual property litigation is complex and expensive, and the outcome of such litigation is difficult to predict. In March 1997, the Company filed a suit in U.S. District Court for the District of Minnesota, seeking to invalidate a newly issued U.S. patent held by Minntech Corporation ("Minntech"), a competing manufacturer of blood oxygenators and other medical devices, and requesting a determination that the Company's AFFINITY oxygenator does not infringe the Minntech patent. The Company filed the 18 suit in response to a December 1996 letter from Minntech, alleging that the AFFINITY oxygenator infringes certain claims under Minntech's patent, and requesting discussion regarding a possible license agreement. On October 6, 1997, the Magistrate Judge of the United States District Court vacated a previous order and granted a stay in the proceedings, including the suspension of discovery, pending the outcome of Minntech's request for re-issuance of the aforementioned patent. See "Legal Proceedings" on page 25. The Company's action against Minntech and any future litigation, regardless of outcome, could result in substantial expense to the Company and significant diversion of the efforts of the Company's technical and management personnel. In addition, if Minntech were successfully to bring an infringement counterclaim against the Company, or if the Company were to be subject to an adverse determination in any other legal proceeding in the future alleging patent infringement, the Company could become subject to an injunction preventing the manufacture and sale of the infringing products and to monetary damages, or might be forced to seek a license from the party alleging patent infringement in order to continue to manufacture and sell any infringing products, which it might not be able to obtain. The outcome of any such legal action, including the possibility of entering into such a license, could have a material adverse effect on the Company's business, financial condition and results of operations. Pursuant to an Asset Purchase Agreement dated June 7, 1991 ("Asset Purchase Agreement"), for approximately $1 million in cash and a $2.5 million note, the Company acquired the business and assets, and assumed certain liabilities, of the Predecessor Business. In addition, under the terms of a Royalty Agreement dated June 7, 1991 ("Royalty Agreement"), the Company is obligated to pay to SCIMED Life Systems, Inc. ("SCIMED") specified royalties based on a percentage of net sales (as defined) of products previously manufactured by the Predecessor Business and future products developed from then-existing technology if the Company achieves certain net sales thresholds with those products. The Royalty Agreement also provides for royalty payments on certain new generations of developed products, if any, which use certain technology embodied in the then-existing models of such products. In June 1996, the Royalty Agreement expired with respect to products previously manufactured by the Predecessor Business and expires with respect to current products under development at the time of the acquisition and certain new generation products in June 2001. The Company has charged $95,000 in 1996 and $178,000 in 1995 to operations for royalties due under the Royalty Agreement for sales of products previously manufactured by the Predecessor Business. No related royalty amounts accrued in 1997. The Company believes that none of the products in the AFFINITY line nor any of the Company's products currently under development (including the products with the TRILLIUM coating applied) will require royalty payments under the Royalty Agreement. In connection with the Asset Purchase Agreement, SCIMED also assigned to the Company ten trademarks (one of which is registered) related to the Company's current line of products previously manufactured by the Predecessor Business. The Company entered into a royalty agreement in connection with the Company's acquisition of an exclusive license to market the AFFINITY blood pump. The agreement requires the Company to make payments based on net sales of the pump chamber (the disposable portion of the AFFINITY blood pump system) and net profits of the pump console (the equipment portion of the AFFINITY blood pump system) through August 2002. The term of the agreement may be extended by the Company until the expiration of the last to expire of the patents covered by this agreement or the useful life of the know-how (as defined) licensed, whichever is longer. Under the terms of the agreement, the Company is required to pay minimum royalties each year. The Company incurred royalties of $55,000 for the year ended December 31, 1997 exceeded the minimum royalty related to the first year of the royalty agreement. 19 The Company also has use of an exclusive license allowing it to apply its TRILLIUM bio-passive surface to its products. The agreement requires the Company to make quarterly payments based on a percentage of net sales of products utilizing the bio-passive surface. The Company can retain exclusivity of the license if it pays minimum annual royalties. The Company incurred royalties of $35,000 for the year ended December 31, 1997 under this agreement. EMPLOYEES As of December 31, 1997, the Company employed 339 persons full-time including 29 in research and development, 223 in manufacturing, 53 in sales and marketing and 34 in general and administrative functions. The Company's employees are not represented by a union, and the Company considers its relationship with its employees to be good. (D) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES. Financial information about the Company's foreign and domestic operations and export sales is contained in Note 6 to the Company's Consolidated Financial Statements on page 18 of the Company's 1997 Annual Report and is incorporated herein by reference. ITEM 1A IMPORTANT FACTORS. The following factors are important and should be considered carefully in connection with any evaluation of the Company's business, financial condition, results of operations and prospects. Additionally, the following factors could cause the Company's actual results to differ materially from those reflected in any forward-looking statements of the Company. HIGHLY COMPETITIVE INDUSTRY The cardiovascular device market in which the Company competes is characterized by intense competition. This market is dominated by established manufacturers that have broader product lines, greater distribution capabilities, substantially greater capital resources and larger marketing, research and development staffs and facilities than the Company. Many of these competitors offer broader product lines than the Company within the specific heart/lung bypass product market and/or in the general field of medical devices and supplies, giving these competitors advantages in marketing and pricing their competing products. In addition, the Company's competitors will continue to use price reductions to preserve market share in the oxygenator and other product markets. There can be no assurance that the Company's competitors will not use more significant and more prolonged price competition across the Company's product lines in the future. Although with the addition of the Affinity blood pump the Company now offers a complete line of proprietary devices comprising the major components of the heart/lung bypass circuit, in order to compete more effectively with competitors the Company will continue working toward a more complete line of devices for the heart/lung bypass circuit with superior product performance at a competitive price. Even if the Company is able to develop or is thought to have developed such a line of products, there can be no assurance that the Company will be able to compete effectively. During 1995 and 1996, one of the Company's competitors, the Bentley Division of Baxter Healthcare Corporation ("Baxter"), purchased three companies that provide contract perfusion services to hospitals. Although the Company believes that it is too early to assess the long-term effect of these acquisitions on the Company's business, sales to contract perfusion groups controlled by one of the 20 Company's competitor decreased $750,000 to $1,100,000 for 1997 from $1,850,000 for 1996. The Company believes that control of contract perfusion groups by its competitors will continue to have a negative impact on the Company's ability to market its products to such groups or to hospitals or other medical providers that contract with competitor-controlled groups for perfusion services. These acquisitions, or other acquisitions by the Company's competitors of other companies providing contract perfusion services, could have a material adverse effect on the Company's future business, financial condition and results of operations. DEPENDENCE ON MARKET ACCEPTANCE The Company's products are intended to replace products currently being sold by its competitors. The success of the Company will depend, among other things, on the acceptance by the market of the Company's current products and the products it develops and introduces in the future. The Company believes it has developed and intends to further develop cost-competitive products that provide clinical performance advantages and convenience benefits to achieve more of a competitive advantage. Product development is expensive, and there can be no assurance that the Company's future product development efforts will further result in technologically superior products that can be manufactured at a reasonable cost. In addition, there is no assurance that the market will accept the Company's product offerings as superior to those currently available or that, if accepted as superior, the Company's product offerings will achieve significant sales due to the broader product lines, greater distribution capabilities, substantially greater capital resources and larger marketing staffs of the Company's competitors. Also, there can be no assurance that the Company's competitors will not succeed in developing or marketing products that are viewed by the marketplace as providing superior clinical performance or are less expensive as compared to the products currently marketed or to be developed by the Company. PATENTS AND PROPRIETARY RIGHTS The Company protects its technology through patents and trade secrets. There can be no assurance that any pending or future patent applications will result in issued patents or that any current or future patents will not be challenged, invalidated or circumvented or that the rights granted thereunder will provide any competitive advantage to the Company. There can also be no assurance that the Company's trade secrets or confidentiality agreements will provide meaningful protection of the Company's proprietary information or, in the event of a breach of any confidentiality agreement, that the Company will have adequate remedies. Furthermore, there can be no assurance that others will not independently develop similar technologies or duplicate any technology developed by the Company or that the Company's technology will not infringe patents or other rights owned by others. Claims by competitors and other third parties alleging that the Company's products infringe the patent rights of others could have a material adverse effect on the Company. The medical device industry is characterized by frequent and substantial intellectual property litigation. Intellectual property litigation is complex and expensive, and the outcome of such litigation is difficult to predict. In March 1997, the Company filed a lawsuit seeking to invalidate a newly issued U.S. patent held by Minntech Corporation ("Minntech"), a competing manufacturer of blood oxygenators and other medical devices, and requesting a determination that the Company's AFFINITY oxygenator does not infringe the Minntech patent. The Company filed the suit in response to a December 1996 letter from Minntech, alleging that the AFFINITY oxygenator infringes certain claims under Minntech's patent, and requesting discussion regarding a possible license agreement. The Company's action against Minntech and any future litigation, regardless of outcome, could result in substantial expense to the Company and significant diversion of the efforts of the Company's technical and management personnel. In addition, if Minntech 21 were successful in bringing an infringement counterclaim against the Company, or if the Company were to be subject to an adverse determination in any other future legal proceeding alleging patent infringement, the Company could become subject to an injunction preventing the manufacture and sale of the infringing products and to monetary damages, or might be forced to seek a license from the party alleging patent infringement in order to continue to manufacture and sell any infringing products, which it might not be able to obtain. The outcome of any such legal action, including the possibility of entering into such a license, could have a material adverse effect on the Company's business, financial condition and results of operations. See "Legal Proceedings" on page 25. RISK OF TECHNOLOGICAL OBSOLESCENCE The markets for the Company's current and future products are highly dependent on the number of surgical procedures performed each year requiring heart/lung bypass. The number of surgical procedures requiring heart/lung bypass is dependent on a range of factors, including the incidence of coronary artery disease, the effectiveness of alternative treatments for coronary artery disease and the availability of third-party reimbursement for heart/lung bypass procedures and other treatments. In addition, new surgical and other interventional procedures and/or drugs may be developed and become accepted in the future which could reduce the importance of procedures that use the Company's products. Accordingly, the Company's success will depend in large part on the continued importance of surgical procedures that use the Company's products and on the Company's ability to respond quickly to medical and technological changes through the development and introduction of new, cost-effective products. There can be no assurance that the Company's existing products or products in development will offer the same benefits at comparable prices as competing products, or that the Company's competitors will not develop new technologies that render the Company's products obsolete or not cost-competitive. DEPENDENCE ON INTERNATIONAL DISTRIBUTOR SALES Sales to distributors constitute a significant portion of the Company's business in foreign markets. With the exception of employing direct sales forces in the United Kingdom, France and Canada, all other international markets are served by distributors. The Company is dependent on these distributors to generate revenues from these foreign markets. There can be no assurance that such distributors will devote adequate resources to selling the Company's products. There can also be no assurance that the Company will be able to maintain its relationships with significant distributors, or, in the event of termination of such relationships, that new distributors will be found. The loss of a significant distributor could materially adversely affect the Company's future business, financial condition and results of operations if a new distributor or other suitable sales organization could not be found on a timely basis in the relevant geographic market. Changes in international economic conditions, including currency exchange rates, could also have a material adverse effect on the Company's business, financial condition and results of operations. Substantially all of the international transactions handled by the Company's distributors are denominated in U.S. dollars. Fluctuations in currency exchange rates may therefore reduce demand for the Company's products by increasing the price of the Company's products in the currency of the countries in which the products are sold. This situation will also reduce the distributors profitability and may cause the distributor to seek pricing concessions from the Company thus potentially reducing the Company's revenues and gross margins. 22 GOVERNMENTAL REGULATION Company's products, development activities and manufacturing processes are subject to extensive and rigorous regulation by the FDA and by comparable agencies in foreign countries. In the United States, the FDA regulates the introduction of medical devices as well as manufacturing, labeling and recordkeeping procedures for such products. The process of obtaining marketing clearance from the FDA for new products can be time consuming and expensive, and there is no assurance that such clearances will be granted or that FDA review will not involve delays that would adversely affect the Company's ability to commercialize additional products. Even if regulatory approvals to market a product are obtained from the FDA, these approvals may entail limitations on the indicated uses of the product. Marketing clearances by the FDA can also be withdrawn due to failure to comply with regulatory standards or the occurrence of unforeseen problems following initial approval. The FDA could also limit or prevent the manufacture or distribution of the Company's products and has the power to require the recall of such products. The FDA, various state agencies and foreign regulatory agencies inspect the Company and its facilities from time to time to determine whether the Company is in compliance with various regulations relating to manufacturing practices, validation, testing, quality control and product labeling. A determination that the Company is in violation of such regulations could lead to imposition of civil penalties, including fines, product recalls or product seizures and, in extreme cases, criminal sanctions. A significant portion of the Company's revenues are dependent upon sales of its products outside the United States through indpeendent distributors. International regulatory bodies have established varying regulations governing product standards, packaging requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements. The Company relies on its independent distributors and Company regulatory personnel, in countries where the Company has employed direct sales personnel, to comply with the majority of the foreign regulatory requirements. The inability or failure of independent distributors to comply with the varying regulations or the imposition of new regulations could retrict such distributors' ability to sell the Company's products internationally and thereby adversely effect the Company's future business, financial condition and results of operations. LIMITATIONS ON THIRD-PARTY REIMBURSEMENT The Company's products are purchased by hospitals and other users, which bill various third-party payors, such as government health programs, private health insurance plans, managed care organizations and other similar programs, for the health care goods and services provided to their patients. Third-party payors are increasingly challenging the prices charged for medical products and services and, in some instances, have put pressure on medical suppliers to lower their prices. The Company is unable to predict what changes will be made in the reimbursement methods used by third-party health care payors. There can be no assurance that the treatment of coronary artery disease using coronary artery bypass graft surgery will be considered cost-effective by third-party payors, that reimbursement for such surgery will be available or, if available, that payors' reimbursement levels will not adversely affect the Company's ability to sell its products on a profitable basis. In addition, the cost of health care has risen significantly over the past decade, and there have been, and may continue to be, proposals by legislators and regulators to curb these costs. Legislative action limiting reimbursement for certain procedures could have a material adverse effect on the Company's future business, financial condition and results of operations. 23 EXPOSURE TO PRODUCT LIABILITY CLAIMS; RISK OF PRODUCT RECALL The medical device industry historically has been litigious, and the manufacture and sale of the Company's products inherently entails a risk of product liability claims. Although the Company maintains product liability insurance in amounts believed to be adequate based upon the nature and risks of its business in general and its actual experience to date, there can be no assurance that one or more liability claims will not exceed the coverage limits of such policies or that such insurance will continue to be available on commercially reasonable terms, if at all. Further, the Company does not expect to be able to obtain insurance covering its costs and losses as the result of any recall of its products due to alleged defects, whether or not such a recall is instituted by the Company or required by a regulatory agency. While the Company has not experienced any product liability claims or recalls to date, a product liability claim, recall or other claim with respect to uninsured liabilities or in excess of insured limits could have a material adverse effect on the future business, financial condition and results of operations of the Company. ATTRACTION AND RETENTION OF KEY PERSONNEL The Company is dependent in large part upon its ability to attract and retain qualified scientific, technical and key management personnel due to the specialized scientific nature of the Company's business. There is intense competition for qualified personnel in the Company's industry and there can be no assurance that the Company will be able to continue to attract and retain qualified personnel for the development of its business. INTERRUPTION IN SOURCES OF SUPPLY The Company currently purchases, and will continue to purchase, raw materials and components for its products from outside vendors. Certain of the components used in the Company's products are purchased from single sources. Although the Company has qualified, or is in the process of investigating, alternate sources of supply for key components, any significant interruption in supply could have a material adverse effect on the Company's future business, financial condition and results of operations. ITEM 2. PROPERTIES. The Company's principal executive offices, research and development facilities and U.S. manufacturing facilities are located at 7611 Northland Drive, Minneapolis, Minnesota, consisting of approximately 100,000 square feet. The Company's United Kingdom manufacturing facility is located at Phoenix Crescent, Strathclyde Business Park, Bellshill, Scotland, U.K. ML43NJ, consisting of approximately 15,000 square feet. The Company leases such space through its AVECOR Ltd. subsidiary pursuant to a lease expiring in 2003. The lease provides for monthly rent of approximately $10,000 (based on current exchange rates) until mid-1998 when the monthly rent is subject to adjustment based upon current Scotland rental market rates. The Company also pays a pro rata share of operating expenses and real estate taxes. In July 1996, the Minnesota Pollution Control Agency granted the Company a five-year air emission facility permit for the Company's manufacturing operations at its facility located at 7611 Northland Drive, Minneapolis, Minnesota 55428. The Company believes that it has been in compliance with this permit since its issuance and that it is in compliance in all material aspects with federal and state 24 laws relating to environmental matters. However, expected future changes in federal or state regulations relating to air emissions could require the Company to install air emission control equipment or modify its manufacturing operations, which the Company believes would not have a material adverse effect on its business. ITEM 3. LEGAL PROCEEDINGS. In March 1997, the Company filed suit in U.S. District Court for the District of Minnesota, seeking to invalidate a newly issued U.S. patent held by Minntech Corporation ("Minntech"), a competing manufacturer of blood oxygenators and other medical devices, and requesting a determination that the Company's AFFINITY oxygenator does not infringe the Minntech patent. The Company filed the suit in response to a December 1996 letter from Minntech, alleging that the AFFINITY oxygenator infringes certain claims under Minntech's patent, and requesting discussion regarding a possible license agreement. The Company reviewed the subject patent and concluded, based on an opinion from its patent counsel, that none of the claims in the patent are infringed by the AFFINITY oxygenator, and that the patent is, in any event, invalid. On October 6, 1997, the Magistrate Judge of the United States District Court vacated a previous order and granted a stay in the proceedings, including the suspension of discovery, pending the outcome of Minntech's request for re-issuance of the aforementioned patent. The expense and effort potentially required to bring this action, as well as the outcome of any counterclaim successfully brought against the Company by Minntech, could have a material adverse effect on the Company's business, financial condition and results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matter was submitted for a vote of security holders during the fourth quarter of the fiscal year covered by this report. ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT. The Company's executive officers as of March 13, 1998, are as follows:
NAME AGE TITLE - ---- --- ----- Anthony Badolato 60 Chairman and Chief Executive Officer Gregory J. Melsen 45 Vice President-Finance, Treasurer and Chief Financial Officer Allan R. Seck 52 Vice President-Marketing and Sales William S. Haworth 54 Vice President-Engineering
ANTHONY BADOLATO. Mr. Badolato is a founder of the Company and has served as a director and Chief Executive Officer of the Company since April 1991. In May 1996, Mr. Badolato was named Chairman of the Company's Board of Directors. From April 1991 through January 1996, Mr. Badolato also served as President of the Company. From January 1989 through September 1990, Mr. Badolato was Vice President - Research and Development and Manufacturing of Bio-Medicus, Inc. ("Bio-Medicus"), a specialty cardiovascular products company. From 1969 to December 1988, Mr. Badolato was employed by Johnson & Johnson, a global health care company. While employed by Johnson & Johnson, Mr. Badolato 25 was employed by the Cardiovascular Division in various research and development and manufacturing positions over a period of 12 years, including Director of Research and Development from 1979 to 1988. GREGORY J. MELSEN. Mr. Melsen has served as Vice President-Finance, Treasurer and Chief Financial Officer of the Company since January 1996. From March 1994 through December 1995, Mr. Melsen was Chief Financial Officer of PACE Incorporated ("PACE"), a Minnesota-based environmental testing company that provided services through a national network of laboratories. Mr. Melsen served as a consultant from June 1993 through February 1994. From September 1984 to June 1993, Mr. Melsen was an audit partner with the Minnesota office of Deloitte & Touche. Mr. Melsen is a certified public accountant. ALLAN R. SECK. Mr. Seck is a founder of the Company and has been Vice President-Marketing and Sales of the Company since October 1995, and Vice President - Marketing from April 1991 to September 1995. From October 1988 to September 1990, Mr. Seck was Vice President-Marketing of Bio-Medicus. From 1968 to 1988, he was employed by Johnson & Johnson, primarily in its Cardiovascular Division (and, after September 1987 by Medtronic Inc., its successor by acquisition), in various marketing positions, including Group Product Director and Director of Sales. WILLIAM S. HAWORTH. Mr. Haworth has served as Vice President - Engineering since March 1997, Vice President-Research and Development of the Company from August 1993 to February 1997, and Director of Research and Development from August 1991 to July 1993. From September 1983 to August 1991, Mr. Haworth was employed by 3M Company in various research and development positions, including Technical Manager, Biosciences Laboratory from June 1988 to August 1991. From August 1982 to August 1983, Mr. Haworth worked as an independent consultant to manufacturers in the medical device industry. Prior to August 1982, Mr. Haworth was a College Lecturer in Engineering Science at Magdalen College, Oxford, working in a multidisciplinary team to develop heart valves, blood pumps, oxygenators and artificial kidneys. Mr. Haworth is the author of numerous publications in scientific and technical journals. 26 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The information under the caption "Common Stock Information" in the Company's 1997 Annual Report is incorporated herein by reference. On July 31, 1997, the Company sold 4,500 shares of its Common Stock pursuant to the exercise of underwriter's warrants issued in March 1992 in connection with the Company's initial public offering. All of such shares were sold to an individual formerly associated with the underwriter of that offering, and were sold at a price of $6.60 per share for a total consideration of $29,700. This sale was conducted without a registration under the Securities Act of 1933, as amended, in reliance on the exemptions provided by Section 4(2) and Regulation D. ITEM 6. SELECTED FINANCIAL DATA. The financial information in the table under the caption "Financial Highlights" in the Company's 1997 Annual Report is incorporated herein by reference. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information under the caption "Management's Discussion and Analysis of Results of Operations and Financial Condition" in the Company's 1997 Annual Report is incorporated herein by reference. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not Applicable. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Company's Consolidated Financial Statements and related notes thereto and the Report of Independent Accountants in the Company's 1997 Annual Report are incorporated herein by reference, as is the unaudited information set forth under the caption "Quarterly Operating Data" in the Company's 1997 Annual Report. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not Applicable. 27 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. (a) DIRECTORS OF THE REGISTRANT. The information under the captions "Election of Directors - Information About Nominees" and "Election of Directors - Other Information About Nominees" in the Company's 1998 Proxy Statement is incorporated herein by reference. (b) EXECUTIVE OFFICERS OF THE REGISTRANT. Information concerning Executive Officers of the Company is included in this Annual Report on Form 10-K under Item 4a, "Executive Officers of the Registrant." (c) COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT. The information under the caption "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's 1998 Proxy Statement is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION. The information under the captions "Election of Directors - Director Compensation" and "Executive Compensation" in the Company's 1998 Proxy Statement is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Company's 1998 Proxy Statement is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. None. 28 ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements, Related Notes, and Report of Independent Accountants: The following items are incorporated herein by reference from the pages indicated in the Company's 1997 Annual Report:
PAGE(S) --------- Consolidated Balance Sheets as of December 31, 1997 and 1996 .. 10 Consolidated Statements of Operations for the years ended December 31, 1997, 1996 and 1995 .............................. 11 Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 1997, 1996 and 1995 .............. 12 Consolidated Statements of Cash Flows for the years ended December 31, 1997, 1996 and 1995 .............................. 13 Notes to Consolidated Financial Statements .................... 14 to 19 Report of Independent Accountants ............................. 20
2. Financial Statement Schedules: The unaudited selected quarterly financial data included under the caption Quarterly Operating Data on page 20 of the Company's 1997 Annual Report is incorporated herein by reference. The following financial statement schedule and report of independent accountants thereon are included herein and should be read in conjunction with the financial statements referred to above (page numbers refer to pages in this Annual Report on Form 10-K): Report of Independent Accountants on Financial Statement Schedule ........................................... 32 Financial Statement Schedule: II - Valuation and Qualifying Accounts ........................ 33
All other schedules are omitted as the required information is inapplicable or the information is presented in the financial statements or related notes. 3. Exhibits: The exhibits to this Annual Report on Form 10-K are listed in the Exhibit Index on pages E-1 to E-4 of this Report. 29 A copy of any of the exhibits listed or referred to above will be furnished at $5.00 per exhibit to any person who was a shareholder of the Company as of March 13, 1998, upon receipt from any such person of a written request for any such exhibit. Such request should be sent to AVECOR Cardiovascular Inc., 7611 Northland Drive, Minneapolis, Minnesota 55428, Attention: Chief Financial Officer. The following is a list of each management contract or compensatory plan or arrangement required to be filed as an exhibit to this Annual Report on Form 10-K pursuant to Item 14(c): A. 1991 Stock Incentive Plan, as amended (Incorporated by reference to Exhibit 10.3 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996 (File No.0-21330)). B. AVECOR Cardiovascular Inc. Employee Stock Purchase Plan (Incorporated by reference to Exhibit 28.1 to the Company's Registration Statement on Form S-8 (File No.0-21330)). C. 1995 Non-Employee Director Option Plan (Incorporated by reference to Exhibit 10.5 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996 (File No.0-21330)). D. Confidentiality Agreement dated November 13, 1991 between the Company and Anthony Badolato (Incorporated by reference to Exhibit 10.7 to the Company's Registration Statement on Form S-1 (File No. 33-45731)). E. Confidentiality Agreement dated November 13, 1991 between the Company and Allan R. Seck (Incorporated by reference to Exhibit 10.10 to the Company's Registration Statement on Form S-1 (File No. 33-45731)). F. Form of Change in Control Agreement between the Company and each of Anthony Badolato, Gregory J. Melsen, Allan R. Seck and William S. Haworth (Incorporated by reference to Exhibit 10.10 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996 (File No.0-21330)). G. Form of Confidentiality Agreement between the Company and each of Gregory J. Melsen and William S. Haworth (Incorporated by reference to Exhibit 10.11 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996 (File No.0-21330)). (b) Reports on Form 8-K: None. (c) Exhibits: The response to this portion of Item 14 is included as a separate section of this Annual Report on Form 10-K. 30 (d) Financial Statement Schedules: The response to this portion of Item 14 is included as a separate section of this Annual Report on Form 10-K. 31 REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To the Shareholders and Board of Directors of AVECOR Cardiovascular Inc. Our report on the consolidated financial statements of AVECOR Cardiovascular Inc. has been incorporated by reference in this Form 10-K from the 1997 Annual Report to Shareholders of AVECOR Cardiovascular Inc. In connection with our audits of such financial statements, we have also audited the related financial statement schedule referred to in Item 14(a)(2) of this Form 10-K. In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein. /s/ COOPERS & LYBRAND L.L.P. COOPERS & LYBRAND L.L.P. Minneapolis, Minnesota March 16, 1998 32 AVECOR CARDIOVASCULAR INC. SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E -------- ---------- ---------------------- -------- -------- BALANCE AT CHARGED TO CHARGED BALANCE BEGINNING COSTS AND TO OTHER AT END DESCRIPTION OF PERIOD EXPENSES ACCOUNTS DEDUCTIONS OF PERIOD ----------- ---------- ---------- -------- ---------- --------- Allowance for doubtful accounts deducted from accounts receivable: For the year ended: December 31, 1997 $120,000 $240,000 - $ 26,000(1) $334,000 -------- -------- --------- -------- -------- -------- -------- --------- -------- -------- December 31, 1996 $ 93,000 $104,000 - $ 77,000(1) $120,000 -------- -------- --------- -------- -------- -------- -------- --------- -------- -------- December 31, 1995 $ 50,000 $ 43,000 - - $ 93,000 -------- -------- --------- -------- -------- -------- -------- --------- -------- -------- Valuation allowance deducted from inventories: For the year ended: December 31, 1997 $100,000 $167,000 - $140,000(2) $127,000 -------- -------- --------- -------- -------- -------- -------- --------- -------- -------- December 31, 1996 $ 50,000 $ 50,000 - - $100,000 -------- -------- --------- -------- -------- -------- -------- --------- -------- -------- December 31, 1995 $100,000 - - $ 50,000(2) $ 50,000 -------- -------- --------- -------- -------- -------- -------- --------- -------- --------
(1) Deductions from allowance resulting from write-off of bad debts. (2) Deductions from allowance resulting from disposal of inventories and other deductions to better estimate inventory reserve exposure. 33 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. Dated: March 27, 1998 AVECOR CARDIOVASCULAR INC. By /s/ ANTHONY BADOLATO ------------------------------------- Anthony Badolato CHIEF EXECUTIVE OFFICER Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 27, 1998 by the following persons on behalf of the registrant and in the capacities indicated.
SIGNATURE TITLE --------- ----- /s/ ANTHONY BADOLATO Director and Chief Executive Officer - -------------------------------- (Principal Executive Officer) Anthony Badolato /s/ GREGORY J. MELSEN Vice President -- Finance, Treasurer - -------------------------------- and Chief Financial Officer (Principal Gregory J. Melsen Financial and Accounting Officer) /s/ EDWARD E. STRICKLAND - -------------------------------- Director Edward E. Strickland /s/ DAVID W. STASSEN - -------------------------------- Director David W. Stassen /s/ J. GORDON WRIGHT - -------------------------------- Director J. Gordon Wright
34 AVECOR CARDIOVASCULAR INC. EXHIBIT INDEX TO ANNUAL REPORT ON FORM 10-K For the Fiscal Year Ended December 31, 1997
ITEM NO. METHOD OF FILING - -------- ---------------- 3.1 Second Restated Articles of Incorporation of the Company, as amended July 3, 1996 .................. Incorporated by reference to Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1996 (File No. 0-21330). 3.2 Bylaws of the Company, as amended May 3, 1996 ......... Incorporated by reference to Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1996 (File No. 0-21330). 4.1 Specimen form of the Company's Common Stock Certificate .................................... Incorporated by reference to Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996 (File No. 0-21330). 4.2 Second Restated Articles of Incorporation of the Company, as amended July 3, 1996 ................. See Exhibit 3.1. 4.3 Bylaws of the Company, as amended May 3, 1996 ........ See Exhibit 3.2. 4.4 Certificate of Designation, Preferences and Rights of the Company's Series A Junior Preferred Stock ..... Included in Exhibit 3.1 4.5 Rights Agreement dated June 26, 1996 between the Company and Norwest Bank Minnesota, N.A., which includes the form of Rights Certificate as Exhibit B ............................................ Incorporated by reference to Exhibit 4.1 to the Company's Current Report on Form 8-K dated June 26, 1996 (File No. 0-21330). 4.6 Amendment to Rights Agreement between the Company and Norwest Bank Minnesota, N.A., dated July 22, 1997 ........................................ Incorporated by reference to Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997 (File No. 0-21330). E-1 10.1 1991 Stock Incentive Plan, as amended ................ Incorporated by reference to Exhibit 10.3 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996 (File No. 0-21330). 10.2 AVECOR Cardiovascular Inc. Employee Stock Purchase Plan ........................................ Incorporated by reference to Exhibit 28.1 to the Company's Registration Statement on Form S-8 (File No. 33-55184). 10.3 1995 Non-Employee Director Option Plan .......................................... Incorporated by reference to Exhibit 10.5 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996 (File No. 0-21330). 10.4 Confidentiality Agreement dated November 13, 1991 between the Company and Anthony Badolato.............. Incorporated by reference to Exhibit 10.7 to the Company's Registration Statement on Form S-1 (File No. 33-45731). 10.5 Confidentiality Agreement dated November 13, 1991 between the Company and Allan Seck .................... Incorporated by reference to Exhibit 10.10 to the Company's Registration Statement on Form S-1 (File No. 33-45731). 10.6 Form of Change in Control Agreement between the Company and each of Anthony Badolato, Gregory J. Melsen, Allan R. Seck and William S. Haworth........... Incorporated by reference to Exhibit 10.10 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996 (File No. 0-21330). 10.7 Form of Confidentiality Agreement between the Company and each of Gregory J. Melsen and William S. Haworth .................................... Incorporated by reference to Exhibit 10.11 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996 (File No. 0-21330). 10.8 Missives of Let dated October 4, 7 and 8, 1993 and Lease Agreement between AVECOR Cardiovascular, Ltd. and Euromed Business Park Limited ................ Incorporated by reference to Exhibit 10.17 to the Company's Annual Report on Form 10-K for the year ended December 31, 1994 (File No. 0-21330). E-2 10.9 Settlement Agreement between Cobe Laboratories Inc. and the Company dated June 30, 1996.................... Incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1996 (File No. 0-21330). 10.10 Cobe Patent License To Avecor between Cobe Laboratories Inc. and the Company dated June 30, 1996.. Incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1996 (File No. 0-21330). 10.11 Avecor Patent License To Cobe between Cobe Laboratories Inc. and the Company dated June 30, 1996.. Incorporated by reference to Exhibit 10.3 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1996 (File No. 0-21330). 10.12 Loan Agreement dated January 30, 1997 between the Company and First Bank National Association............ Incorporated by reference to Exhibit 10.25 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996 (File No. 0-21330). 10.13 Note dated January 30, 1997 between the Company and First Bank National Association.................... Incorporated by reference to Exhibit 10.26 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996 (File No. 0-21330). 10.14 Mortgage, Security Agreement, Assignment of Leases and Rents and Fixture Financing Statement dated January 30, 1997 between the Company and First Bank National Association................................... Incorporated by reference to Exhibit 10.27 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996 (File No. 0-21330). E-3 10.15 Tax Increment Revenue Note dated February 1, 1997 issued to the Company by the Brooklyn Park Economic Development Authority.................................. Incorporated by reference to Exhibit 10.27 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996 (File No. 0-21330). 10.16 Distribution Agreement dated April 2, 1997 between the Company and Cardiovascular Diagnostics, Inc....... Incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1997 (File No.0-21330). 10.17 License Agreement dated January 16, 1995 between the Company and Michigan Critical Care Consultants, Inc. including Amendment dated November 7, 1997........ Filed herewith electronically.* 13.1 Portions of the Company's 1997 Annual Report to Shareholders incorporated herein by reference ......... Filed herewith electronically. 21.1 List of Subsidiaries of the Company ................... Incorporated by reference to Exhibit 21.1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995 (File No. 0-21330). 23.1 Consent of Coopers & Lybrand L.L.P..................... Filed herewith electronically. 27.1 Financial Data Schedule ............................... Filed herewith electronically.
* Portions of this exhibit have been omitted pursuant to a request for confidential treatment filed with the Securities and Exchange Commission. E-4 EX-10.17 2 EXHIBIT 10.18 LICENSE AGREEMENT LICENSE AGREEMENT NOTE: PORTIONS OF THIS EXHIBIT MARKED WITH "*'S" HAVE BEEN OMITTED PURSUANT TO A REQUEST FOR CONFIDENTIAL TREATMENT UNDER RULE 24b-2 OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. A COPY OF THIS EXHIBIT IN ITS ENTIRETY HAS BEEN FILED SEPARATELY WITH THE SECURITIES AND EXCHANGE COMMISSION. THIS AGREEMENT, entered into this 16th day of January, 1995, by and between Michigan Critical Care Consultants, Inc., a Michigan corporation with its principal place of business at 245 Jackson Industrial Drive, Suite J, Ann Arbor, Michigan 48103 (hereinafter "MC3") and AVECOR Cardiovascular Inc., a Minnesota corporation with its principal place of business at 13010 County Road 6, Plymouth, Minnesota 55441 (hereinafter "AVECOR"). WHEREAS, the Regents of the University of Michigan, a constitutional corporation of the State of Michigan (hereinafter "Michigan"), owns, controls or has rights with respect to certain technology relating to the design of passively filling blood pumps for use in connection with respiratory and/or circulatory support; WHEREAS, MC3 and Michigan have entered into a license agreement dated as of August 8, 1991 (hereinafter, the "Michigan License Agreement"), a copy of which is attached hereto as Exhibit I, under which Michigan has granted MC3 an exclusive license to such technology, including the right to sublicense such technology; WHEREAS, MC3 has developed and owns certain technology which is or may be useful in connection with AVECOR's manufacture, use, or sale of passively filling blood pumps; WHEREAS, MC3 is willing to grant to AVECOR a license to the Michigan technology and certain of MC3's technology, and AVECOR is willing to accept such license upon and subject to the terms and conditions hereinafter set forth; NOW, THEREFORE, in consideration of the premises and the mutual covenants set forth below, the parties mutually agree as follows: ARTICLE 1. DEFINITIONS The parties agree that the following words, terms and phrases where written with an initial capital letter shall, unless the context otherwise indicates, have the following meanings for purposes of this Agreement: (a) "Michigan Technology" shall mean Patents and Know-how licensed to MC3 under the Michigan License Agreement and relating to passively filling blood pumps for use in connection with respiratory and/or circulatory support, including specifically technology covered by U.S. Patents 5,222,880, 5,281,112 and 5,342,182 together with any reissues, continuations, extensions, divisionals, foreign patents and patent applications based thereon and more fully described in Michigan's Intellectual Property Office File Numbers 584 and 585. (b) "MC3 Technology" shall mean Patents and Know-how developed, owned or otherwise licensable by MC3 which are or may be useful in connection with the manufacture, use or sale of passively filling blood pumps and more specifically described in Exhibit II hereto, as such Exhibit may be amended form time to time by the parties in writing. (c) "Technology" shall mean the Michigan Technology and the MC3 Technology. (d) "Product" shall mean that certain blood pump for use in connection with respiratory and/or circulatory support (exclusive of applications relating to pumping breathable liquids) and more specifically described in Exhibit III attached hereto, including Improvements as defined below, and specifically encompassing both Disposables and Hardware, as such terms are defined below. (e) "Patents" shall mean all patents or applications therefor or reissues, continuations or extensions thereof relating to Products and which are owned, controlled, acquired or otherwise licensable by a party hereto during the term of this Agreement, including specifically the Licensed Patents as defined in the Michigan License Agreement. (f) "Know-how" shall mean all trade secrets and non-patented information, such as confidential information, inventions, intellectual property, discoveries, improvements, modifications, and enhancements, techniques, concepts, data, technical information and specifications (including engineering, testing and manufacturing specifications), diagrams, 2 schematics, charts and lists relating to Products or the Technology and owned, controlled, acquired or otherwise licensable by a party hereto during the term of this Agreement. (g) "Improvements" shall mean Know-How or Patents relating to modifications of or enhancements to Products developed by either party during the term of this Agreement which serve to improve, correct, update, adjust or change the design, performance characteristics, specifications or manufacturing processes of Products. (h) "Documentation" shall mean those elements of Know-how and other items of relevant information which are in writing or other tangible form including, without limitation, drawings, diagrams, blueprints, computer programs, technical publications, manuals, designs and artwork which relate to the manufacture, inspection, quality control, installation, maintenance, testing, operation and/or repair of Products. (i) "Subsidiary" shall mean any corporation more than fifty percent (50%) of whose securities having ordinary voting power for the election of directors are owned or controlled directly or indirectly by either party hereto. (j) "Unit" shall mean any individual Disposable or Hardware unit. (k) "Disposables" shall mean, with respect to Products, the disposable pump chamber. (l) "Hardware" shall mean, with respect to Products, the control console together with the pump rotor, rollers, motor, chamber supports, tensioning mechanism and related parts and equipment. (m) "Net Sales Price" shall mean the price received by AVECOR or its sublicensees from customers for the sale of Products only, expressly excluding revenue derived from other value added products or treatments, and less freight, duties, taxes, royalties paid to other licensors on treatment technologies applied to Products, discounts, returns and refunds; provided, such deductions are separately identified in customer invoices or specifically documented in the books and records of AVECOR kept pursuant to Article 4.7 hereof and set forth in the reports provided by AVECOR to MC3 pursuant to Article 4.6 hereof. Provided however that when the Disposable Products are packaged as a system and sold with other disposable medical devices and at a discounted sales price, then the net sales price assignable to 3 the Disposable Products shall be discounted at a rate not to exceed the discount rate applied to the other disposable medical devices included in the packaged system. (n) "Effective Date" shall mean the date set forth on the first page of this Agreement, being the date as of which the parties have duly executed this Agreement. ARTICLE 2. LICENSE GRANTS 2.1 MC3'S GRANT. MC3 hereby grants to AVECOR, subject to all the terms of this Agreement, an exclusive, non-transferable, royalty-bearing and worldwide right and license under Technology, Patents and Know-how owned, controlled, acquired or otherwise licensable by MC3 during the term of this Agreement to make, have made, use, lease, sell or otherwise transfer the Products in connection with respiratory and/or circulatory support applications, subject to: (a) those rights reserved to Michigan, the United States Government and/or third parties under Articles 3.3 and 3.4 of the Michigan License Agreement; (b) the right of MC3 to utilize the Technology in connection with applications relating to breathable fluids or to make, have made, use, lease and sell products relating to breathable fluids; (c) the right of MC3 to utilize the Technology in connection with applications other than respiratory and/or circulatory support and to make, have made, use, lease and sell products other than products in connection with respiratory and/or circulatory support applications; and (d) the right of MC3 to utilize the Technology in connection with its continued internal research, development and testing of the Products. 2.2 AVECOR'S GRANT. In the event AVECOR develops any Improvements to the Technology or Products during the term of this Agreement, AVECOR shall and hereby does grant to MC3, subject to all the terms of this Agreement, a non- exclusive, non-transferable, and worldwide right and license under Patents and Know-how owned, controlled, acquired or 4 otherwise licensable by AVECOR during the term of this Agreement to make, have made, use, lease, sell or otherwise transfer the Products incorporating any or all such Improvements for all purposes (including specifically for applications to breathable fluids) other than in connection with respiratory and/or circulatory support applications. The license granted by AVECOR under this Article 2.2 shall include the right to grant sublicenses to third parties; provided, that AVECOR shall receive the benefit of any Improvements developed by MC3's sublicensees with respect to Products, and AVECOR shall further receive a proportionate and commercially reasonable royalty to be mutually agreed upon by MC3 and AVECOR payable out of royalties received by MC3 from its sublicensees related to such Improvements. 2.3 SUBLICENSES. AVECOR shall not grant sublicenses under rights obtained hereunder from MC3 without the prior written consent of both MC3 and Michigan; provided, that MC3 hereby agrees that AVECOR may grant sublicenses under rights received pursuant to Article 2.1 above to any of its Subsidiaries for so long as they shall remain Subsidiaries of AVECOR, and AVECOR shall be entitled to sublicense third party contractors for the limited purpose of manufacturing parts and components of Products for sale by AVECOR, provided such third party contractors agree in writing to maintain the confidentiality of MC3's Know-how in accordance with the terms of Article 5 hereof and to promptly return all Documentation provided to them upon termination of their contracts with AVECOR. 2.4 SCOPE OF GRANT. No license is granted by either party to the other, either directly or by implication, estoppel or otherwise, under any Patents or Know-how other than specifically granted in Articles 2.1, 2.2 and 2.3 above. Nothing herein shall require either party to disclose to the other proprietary or confidential information received by such party from third parties which confidential information such party is precluded from disclosing to others. No right, license or privilege is granted hereunder by either party to the other to use such party's names, logos, trademarks or service marks, whether registered or not. ARTICLE 3. KNOW-HOW AND DOCUMENTATION TRANSFER 5 3.1 INITIAL DOCUMENTATION. Within thirty (30) days of the written request by AVECOR, MC3 shall provide AVECOR with all Documentation within the scope of the license grant contained in Article 2.1 above in reproducible form. 3.2 SUBSEQUENT DOCUMENTATION. In addition to the Documentation to be delivered pursuant to Article 3.1 above and within a reasonable time after it becomes available, each party shall deliver to the other party all Documentation within the scope of the license grants contained in Articles 2.1 and 2.2 above relating to Improvements to the Products developed by the delivering party during the term of this Agreement. Such Documentation shall likewise be in reproducible form. 3.3 STANDARDS OF MEASUREMENT. All Documentation provided by one party to the other in accordance with this Agreement shall be in the English language and shall conform to the standards of measurement then in use by the party delivering the Documentation. 3.4 TECHNICAL ASSISTANCE. In partial consideration for the technical assistance and license fee set forth in Article 4.1 below and at the request of AVECOR, MC3 shall provide AVECOR at AVECOR's facilities with up to eighty (80) hours of technical assistance through salaried employees of MC3 during a period of twelve (12) months from the date of this Agreement. All travel time of such MC3 employees to and from AVECOR's facilities shall count against the above eighty (80) hours of technical assistance. All requests for such technical assistance by AVECOR at its facilities must require no less than six (6) hours of scheduled services per request. Thereafter, each party shall provide the other party with a reasonable amount of technical assistance as requested by the other party in order to enable such other party to reduce to practical application Know-how transferred to it hereunder. The party receiving such technical assistance shall pay the party providing assistance at the providing party's then current rates for such services billed in one-half hour increments, plus reasonable travel and living expenses actually incurred in the course of providing such technical assistance. The party receiving technical assistance shall have the right to approve the individual or individuals providing such technical assistance prior to the initial rendering of such services. 6 3.5 GOVERNMENT LICENSES AND APPROVALS. MC3 shall assist AVECOR in obtaining any governmental licenses or approvals which may be required for the manufacture, use and/or sale of the Products as contemplated by this Agreement. All such assistance provided by MC3 shall count against the eighty (80) hours of technical assistance to be provided by MC3 under Article 3.4 above. MC3 acknowledges and agrees that AVECOR shall have the right to make all filings and obtain all licenses and approvals in AVECOR's name from the Food and Drug Administration (the "FDA") under the Federal Food, Drug and Cosmetic Act (the "Act") and regulations promulgated thereunder, and all other U.S. and foreign governmental determinations which are necessary to permit the commercial distribution of the Products within the United States and abroad. The cost of obtaining any requisite U.S. or foreign governmental approvals, licenses or permits shall be borne by AVECOR. ARTICLE 4. CONSIDERATION 4.1 TECHNICAL ASSISTANCE AND LICENSE FEE. In consideration for the Documentation delivered under Article 3.1 above, AVECOR shall pay to MC3 a technical assistance and license fee of ********************************. Such fee shall be payable by certified or cashier's check in two (2) equal installments. One-half of such fee shall be due within ten (10) days of the execution of this Agreement, and one-half shall be due upon submission by AVECOR to the FDA of a request for approval under Section 510(K) of the Act and the regulations thereunder. 4.2 ROYALTIES. In consideration for the rights and licenses granted to AVECOR by MC3 under Article 2.1 hereof, AVECOR shall pay to MC3 royalties as follows: (a) **************************************************************** ************************************************************************** ************************************************************************** ************************************************************************** ************************************************************************** ************************************************************************** 7 ************************************************************************** ******************************************. (b) **************************************************************** ************************************************************************** ******************************************. 4.3 MINIMUM ROYALTIES. AVECOR agrees to pay to MC3 a minimum annual royalty as set forth below. AVECOR's obligation to pay minimum annual royalties shall commence when AVECOR receives FDA approval with respect to a submission by AVECOR under Section 510(K) of the Act for U.S. marketing clearance of a Product developed under the Technology. Annual minimum royalties for each year commencing with FDA approval under this Article 4.3 shall be as follows: ***** ******** ***** ******** ***** ******** ***** ******** In the event AVECOR exercises its option pursuant to Article 9.1 to extend the term of this Agreement in accordance with such Article 9.1, the minimum annual royalty for the ********************** during the term of this Agreement shall be ************************************************** ************************************************************************** ***************. 4.4 PAYMENTS. Royalties on Disposables shall become due and payable upon the delivery of the Disposables by AVECOR or its sublicensees to the customer, and AVECOR shall pay all such royalties due and payable to MC3 within thirty (30) days of the close of the calendar quarter during the term of this Agreement in which the Products are delivered. Royalties on Hardware shall become due and payable from and after the first calendar year in which AVECOR realizes 8 a net profit from the sale of Hardware. Such royalties shall be due and payable within sixty (60) days after the close of such year and every calendar year thereafter during the term of this agreement in which AVECOR realizes a net profit on the sale of Hardware during such year. All payments for technical assistance provided by one party to the other pursuant to Article 3.4 hereof shall be payable within thirty (30) days of the date of the providing party's invoice therefor. All payments shall be made by bank transfer to the bank or banks designated in writing by MC3 or AVECOR as applicable from time to time during the term of this Agreement. All payments shall be made in United States dollars. All amounts not paid when due and payable hereunder shall bear interest from the date such amounts are due and payable at a rate of two (2) points above the prime lending rate as established by the Chase Manhattan Bank, N.A. in New York City, New York, or at such lower rate as may be required by law. Any royalties due hereunder based on sales in currencies other than United States dollars shall be determined by converting such foreign currencies into their equivalent in United States dollars at the exchange rate of such currency as reported in the WALL STREET JOURNAL on the last business day of the quarter during which such payments accrue. 4.5 TAXES. Except as provided in the definition of Net Sales Price, all fees and royalty payments due to MC3 under Articles 4.1, 4.2 and 4.3 above shall be without deduction for sales, use, excise, personal property or other similar taxes or other duties imposed on such payments by the government of any country or any political subdivision thereof and any and all such taxes shall be assumed by and paid by AVECOR. 4.6 REPORTS. No later than forty-five (45) days after the close of each calendar quarter during each year of this Agreement, AVECOR shall provide MC3 with a report relating to the prior calendar quarter setting forth the gross sales and total Net Sales Price of Products sold, the number of Units shipped, the amounts payable as royalties for the calendar quarter just ended, and the various calculations used to arrive at all such amounts, including the quantity, description (nomenclature and type designation), country of manufacture and, to the extent reasonably available, country of sale of Products. In case no royalties are due for any calendar quarter, AVECOR shall so report. The reports provided for hereunder shall be certified by an 9 authorized representative of AVECOR to be correct to the best of AVECOR's knowledge and information. 4.7 BOOKS AND RECORDS. AVECOR shall keep at its expense full and accurate books and records as may be necessary for the purpose of determining the amounts of royalties payable to MC3 pursuant to Articles 4.2 and 4.3 above. AVECOR shall make such books and records available to MC3 or its accountants or other representatives upon written request by MC3 during normal business hours throughout the term of this Agreement and for a period of six (6) years after the date of origination of any such books or records for the limited purpose of verifying AVECOR's payments of royalties. The rights and obligations of this Article 4.7 shall survive termination of this Agreement. 4.8 BEST EFFORTS OBLIGATION. During the term of this Agreement, AVECOR agrees to use its best efforts to develop, test, manufacture, market, sell and technically support the Products and further agrees to use its best efforts to obtain all necessary approvals from the FDA and all other governmental agencies whose approval is necessary to manufacture, market or sell the Products. AVECOR agrees that its best efforts shall include, at a minimum, the obligation to use at least the same level of effort in connection with the Products as it uses in connection with its other products. In the event of an assignment by AVECOR of this Agreement pursuant to Article 11.2(i) hereof to any successor in interest to the business of AVECOR, in addition to the requirements of Article 11.2 with respect to minimum royalties, AVECOR agrees to secure, as a condition of such assignment, that the assignee shall expressly agree in writing to the fulfillment of the terms of this Article 4.8. ARTICLE 5. CONFIDENTIALITY 5.1 PROTECTION OF KNOW-HOW. Each party shall, and shall require its employees, agents and sublicensees to, protect all Know-how, and other proprietary information, delivered or disclosed to it pursuant to this Agreement against unauthorized disclosure to third parties during the term of this Agreement and for three (3) years thereafter by maintaining all such Know- how in confidence with at least the same degree of care as it uses to maintain the confidentiality of its 10 own information of a confidential nature. Each party shall not divulge and shall cause its employees, agents and sublicensees not to divulge, in whole or in part, such Know-how to any third party or to any of its own personnel not having a need to know during the term of this Agreement and for a period of three (3) years thereafter; provided, that neither party shall be liable for the use or disclosure of Know-how which: (a) was in the possession of the receiving party prior to its receipt from the disclosing party; (b) is or becomes part of the public knowledge or literature through no fault of the receiving party; (c) is or becomes available to the receiving party from a source other than the disclosing party and having no obligation to the disclosing party in respect thereof; or (d) is made available by the disclosing party to a third party unaffiliated with the disclosing party on an unrestricted basis. 5.2 SURVIVING OBLIGATION. The obligation of each party to protect against the unauthorized use or disclosure of Know-how or other proprietary information shall survive any termination of this Agreement. 5.3 MARKETING DISCLOSURES. Notwithstanding Article 5.1 above, AVECOR shall be entitled to make such limited and reasonable disclosures of information concerning the Products as are customary and necessary to market the Products to its customers. ARTICLE 6. WARRANTY AND LIABILITY 6.1 WARRANTY. Each party warrants and represents that it has the legal power to extend and receive the rights granted hereunder with respect to its Patents and Know-how. EXCEPT AS PROVIDED ABOVE, MC3, INCLUDING ITS OFFICERS AND EMPLOYEES, MAKES NO REPRESENTATIONS AND EXTENDS NO WARRANTIES OF ANY KIND, EITHER 11 EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO THE IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE, AND ASSUMES NO RESPONSIBILITIES WHATEVER WITH RESPECT TO THE DESIGN, DEVELOPMENT, MANUFACTURE, USE, SALE OR OTHER DISPOSITION BY AVECOR OR ITS SUBLICENSEES OF THE PRODUCTS. 6.2 QUALITY CONTROL. AVECOR warrants and covenants that it will follow the same quality control standards which AVECOR has adopted or shall in the future adopt for itself, provided they are reasonably required to maintain Product quality. 6.3 AVECOR'S INDEMNITY. AVECOR hereby agrees to indemnify and hold harmless MC3 and Michigan, and their respective officers, employees and agents, from and against any claim, demand, liability, damages, loss or costs arising out of any claims of third parties against MC3 or Michigan which arise out of the manufacture, sale, use or operation of any Products sold or otherwise transferred by AVECOR, or the use by AVECOR of any invention related to the Technology. MC3 or Michigan, as appropriate, shall promptly notify AVECOR in writing of any such claim and shall permit AVECOR through its counsel to defend the same and shall give AVECOR all available information, assistance and authority (at AVECOR's expense) to assume such defense. AVECOR shall have control of the defense of any such claim, including appeals from any judgment and any negotiations for settlement or compromise of such claim with full authority to enter into a binding settlement or compromise. MC3 shall be entitled to participate at its option and expense through counsel of its own selection, and may join in any legal actions related to any such claims, demands, damages, losses and expenses. 6.4 INDIRECT OR CONSEQUENTIAL DAMAGES. THE ENTIRE RISK AS TO PERFORMANCE OF THE PRODUCTS IS ASSUMED BY AVECOR AND ITS SUBLICENSEES. In no event shall MC3, including its officers and employees, be responsible or liable for any indirect, special, incidental, or consequential damages or lost profits of AVECOR or its sublicensees, users or any other individual or entity regardless or legal theory. The above limitations on liability apply even though MC3, its officers or employees may have been advised of the possibility thereof. 12 6.5 PRODUCT LIABILITY INSURANCE. AVECOR shall purchase and maintain in effect during the term of this Agreement a policy of product liability insurance which adequately covers claims that may reasonably arise with respect to any Products manufactured, sold, licensed or otherwise distributed by AVECOR and which specifies MC3 and Michigan, including their officers and employees, as additional insured parties. 6.6 NO REPRESENTATIONS. AVECOR shall not, and shall require that its sublicensees do not, make any statements, representations or warranties or accept any liabilities or responsibilities whatsoever to or with regard to any person or entity which are inconsistent with any disclaimer or limitation included in this Article 6, except for normal and customary warranties with respect to the Products for which AVECOR and its sublicensees will be fully and solely liable. 6.7 MICHIGAN DISCLAIMERS. AVECOR acknowledges the terms of Article 12, Disclaimer of Warranty and Limitations on Liability, contained in the Michigan License Agreement and expressly agrees to the disclaimers of warranty made therein by Michigan, to the limitations on liability set forth therein for the benefit of Michigan and that the risk of performance of the Products manufactured by AVECOR hereunder rests solely with AVECOR and not with MC3, all as more specifically set forth in such Article 12. ARTICLE 7. INTELLECTUAL PROPERTY RIGHTS 7.1 NO WARRANTY. Neither party, including its respective officers and employees, makes any representations or warranties that any Patent is or will be held valid, or that the manufacture, use, sale or other distribution of any Products will not infringe upon any patent or other rights not vested in either party. 7.2 PATENT PROSECUTION, MAINTENANCE. Each party shall control all aspects of filing, prosecuting, and maintaining its Patents, including foreign filings and Patent Cooperation Treaty filings. Each Party shall notify the other party of all information received by it relating to the filing, prosecution and maintenance of Patents, including any lapse, revocation, surrender, invalidation or abandonment of any of its Patents. AVECOR shall, at its own expense, perform all actions 13 and execute or cause to be executed all documents necessary to support such filing, prosecution, or maintenance of both the MC3 and AVECOR Patents.. 7.3 SUBSTITUTION RIGHTS. Either party may in its sole discretion decide to refrain from or to cease prosecuting or maintaining any of its Patents, including any foreign filing or any Patent Cooperation Treaty filing. In the event that a party makes such decision with respect to a U.S. patent or patent application, or with respect to a foreign filing or Patent Cooperation Treaty filing which has been requested in writing by the other party, such party shall notify the other party promptly and in sufficient time to permit the other party at its sole discretion to continue such prosecution or maintenance at the other party's expense. If the other party elects to continue such prosecution or maintenance, the party who has elected to cease prosecuting or maintaining the Patent shall execute such documents and perform such acts at the other party's expense as may be reasonably necessary for the other party to so continue such prosecution or maintenance. ARTICLE 8. ADDITIONAL COVENANTS 8.1 COMPLIANCE WITH LAWS. AVECOR shall comply with all provisions of any applicable laws, regulations, rules and orders relating to the licenses granted hereunder and to the testing, production, transportation, export, packaging, labeling, sale or use of Products, or otherwise applicable to AVECOR's activities hereunder. AVECOR shall obtain such written assurances regarding export and re-export of technical data contained in the Technology as may be required by U.S. Office of Export Administration regulations, and AVECOR hereby gives such written assurances to MC3 as may be required under those regulations. 8.2 PUBLICITY. AVECOR agrees to refrain from using the name of Michigan in publicity or advertising without the prior written approval of Michigan's Director of the Intellectual Properties Office. Reports in scientific literature and presentations of joint research and development work are not considered publicity. 14 8.3 PRODUCT MARKING. AVECOR agrees to mark Products with appropriate patent notices if and when applicable, as approved by MC3, which approval will not be unreasonably withheld. 8.4 MANUFACTURE IN THE UNITED STATES. AVECOR agrees to substantially manufacture all Products in the United States. 8.5 GOVERNMENT APPROVALS. It is understood that AVECOR has the responsibility to do all that is reasonably necessary to obtain any governmental approvals to manufacture and/or sell the Products. 8.6 REGISTRATION OR RECORDATION. If the terms of this Agreement, or any assignment or license under this Agreement, are or become such as to require that this Agreement or license or any part hereof be registered with or reported to a national or supranational agency in any country or area in which AVECOR or its sublicensees do business, AVECOR will, at its expense, undertake such registration or report. Prompt notice and appropriate verification of the act of registration or report of any agency ruling resulting from such filing or notice will be supplied by AVECOR to MC3. Any formal recordation of this Agreement or any license herein granted which is required by the law of any country as a prerequisite to enforceability of this Agreement or license in the courts of any such country or for any other reason shall also be carried out by AVECOR at its expense, and appropriately verified proof of recordation shall be promptly furnished to MC3. ARTICLE 9. TERMINATION 9.1 TERM. This Agreement shall enter into force upon the date first above written and shall continue in force for an initial term of five (5) years from the date on which AVECOR receives approval from the FDA with respect to the submission of a request for the Products under Section 510(K) of the Act and its regulations. Upon the expiration of such initial term, AVECOR may, at its sole option, upon written notice to MC3, extend the term of this Agreement until the expiration of the last to expire of the Patents then covered by this Agreement or the useful life of the Know-how licensed hereunder, whichever is longer. 15 9.2 TERMINATION. Notwithstanding the provisions of Article 9.1 above, this Agreement may be terminated in accordance with the following provisions: (a) By either party immediately upon written notice in the event: (i) the other party is adjudicated bankrupt, files for bankruptcy, goes into liquidation, makes an assignment for the benefit of creditors or otherwise loses control of its business; or (ii) the other party breaches any material term, condition or obligation of this Agreement and fails to cure such breach within sixty (60) days of receiving written notice thereof from the non- breaching party. (b) By AVECOR immediately upon written notice in the event that any of the Technology is adjudicated by a court of competent jurisdiction to be invalid and such adjudication is final and unappealable; provided that such Technology is material to the Products and provided further that, in the event such Technology is adjudicated invalid by a lower court and MC3 appeals from such judgment, MC3 shall indemnify and hold harmless AVECOR from and against all costs, damages and liabilities incurred by AVECOR and arising out of the continued use of the Technology and the manufacture, use, sale and/or lease of Products between the date of the judgment of the lower court and the final, unappealable adjudication referred to above. (c) By the party whose performance is not prevented by an event of Force Majeure on written notice to the other party should an event of Force Majeure continue for more than six (6) months as provided in Article 10.3 below. (d) Automatically upon the expiration of sixty (60) days after the termination of the Michigan License Agreement, subject to AVECOR's rights pursuant to Article 9.3(e) below. 9.3 CONSEQUENCES OF TERMINATION. The rights and obligations of the parties in the event of termination shall be as follows: 16 (a) event of termination by either party under Article 9.2(a)(i) above, all licenses granted hereunder shall continue and all obligations of AVECOR to make payments hereunder in accordance with the terms of this Agreement shall likewise continue. In addition, in the event of the commencement of an insolvency or bankruptcy proceeding or reorganization involving MC3 or if MC3 makes an assignment for the benefit of creditors, AVECOR shall be entitled to complete access to all Patents, Know-how and Documentation of MC3 and all embodiments thereof and any Documentation or Know-how not in AVECOR's possession will promptly be delivered to AVECOR upon AVECOR's request. In the event of the commencement of an insolvency or bankruptcy proceeding or reorganization involving AVECOR, MC3 shall have all of the remedies available to it at law in the event AVECOR is unable to carry out its obligations under this Agreement. The representations, warranties and covenants set forth in this Article 9.3(a) shall survive the execution, delivery, termination or expiration of this Agreement. (b) In the event of termination of this Agreement by MC3 under Article 9.2(a)(ii) or Article 9.2(c) above, the license granted by MC3 to AVECOR pursuant to Article 2.1 hereof shall terminate. AVECOR shall cease using all Technology licensed to it hereunder by MC3 for any purpose, including specifically the manufacture and sale of Products, and shall return to MC3 all Documentation transferred to AVECOR and shall destroy all other copies of such Documentation; provided, however, that AVECOR shall not be so obligated to the extent that such Documentation and Know-how pertains to the maintenance or repair of Products for which royalties have been paid and which AVECOR normally provides to its customers in the ordinary course of business for the purpose of permitting adequate technical support of the Products. In the event of such termination, the license granted to MC3 by AVECOR pursuant to Article 2.2 hereof shall survive termination of this Agreement and continue in full force and effect. (c) In the event of termination of this Agreement by AVECOR under Article 9.2(a)(ii) above and in the event AVECOR secures a judgment of a court of competent jurisdiction which judgment is final and unappealable and which holds that MC3 is in material breach of this Agreement, the license granted by MC3 to AVECOR pursuant to 17 Article 2.1 hereof shall continue for a period of five years from the date such final judgment is issued; provided, that, in such case, AVECOR shall have no further obligation to pay royalties to MC3 pursuant to Articles 4.2 and 4.3 hereof. Further, in the event of such termination, the license granted by AVECOR to MC3 pursuant to Article 2.2 hereof shall terminate forthwith, and MC3 shall cease using any AVECOR Patents and Know-How relating to improvements for any purpose. Additionally, notwithstanding anything else in this section, termination by AVECOR does not affect any sublicenses of AVECOR technology that may have been lawfully granted by MC3. MC3 shall promptly return all Documentation provided to it by AVECOR, and shall destroy all copies of such Documentation. Notwithstanding the termination of this Agreement by AVECOR pursuant to Article 9.2(a)(ii) above, until such time as AVECOR shall have secured the final and unappealable judgment referred to above, the license grants contained in Articles 2.1 and 2.2 hereof shall continue and AVECOR shall be obligated to continue paying royalties to MC3 pursuant to Articles 4.2 and 4.3 hereof and to otherwise observe and comply with its obligations contained herein. (d) In the event of termination of this Agreement by AVECOR pursuant to Article 9.2(b) above, all licenses granted hereunder shall terminate forthwith, and each party shall cease using any of the other party's Patents and Know-How for any purpose. Each party shall promptly return to the other party all Documentation provided to it by the other party, and shall destroy all copies of such Documentation. (e) In the event of the termination of this Agreement pursuant to Article 9.2(d) above, MC3 shall be obligated to immediately notify AVECOR in writing of the termination of the Michigan License Agreement. Within sixty (60) days of receipt of such notice of termination of the Michigan License Agreement, AVECOR may by written notice to Michigan elect to continue in force this Agreement on and subject to the terms and conditions set forth herein and, for all purposes of this Agreement, Michigan shall be substituted for MC3 and shall assume all obligations and acquire all rights of MC3 hereunder. 18 ARTICLE 10. FORCE MAJEURE 10.1 DEFINITION AND NOTICE. Force Majeure shall mean any event, not existing as of the date of this Agreement and not reasonably foreseeable or within the control of the parties as of such date, which prevents in whole or part the performance by one of the parties of its obligations hereunder, including, without limitation the following: acts of State or governmental action, (including, without limitation, failure to grant any license or approval required for performance hereunder), crisis, war, strikes, natural catastrophe, and prolonged shortage of energy supplies. Any party affected by an event of Force Majeure shall promptly provide the other party with written notice describing such event, its cause and possible consequences. Upon giving such notice, the party whose performance is prevented by the event of Force Majeure shall be relieved of any liability hereunder, except for the obligation to pay amounts due and owing, but only to the extent and only for so long as its performance is prevented by the event of Force Majeure. 10.2 SUSPENSION OF PERFORMANCE. During the period the performance of one of the parties has been suspended by reason of Force Majeure, the other party may likewise suspend performance of all or part of its obligations, except for the obligation to pay amounts due and owing, to the extent commercially reasonable. 10.3 TERMINATION. If the event of Force Majeure preventing performance shall continue for more than six (6) consecutive months, the party whose performance is not prevented by such event of Force Majeure may terminate this Agreement on written notice to the other party without any liability hereunder, except the obligation to make payments due to such date. ARTICLE 11. GENERAL PROVISIONS 11.1 COMPLETE AGREEMENT. This Agreement, including the Recitals and the Exhibits attached hereto, constitutes the complete agreement of the parties with respect to the subject matter hereof and there are no representations, agreements, or conditions not expressly set forth herein. 19 11.2 ASSIGNMENT. This Agreement may not be assigned by either party without the prior written consent of the other party and, in the absence of such consent, any attempted assignment will be null and void; provided, however, that (i) subject to the terms set forth below in this Article 11.2, either party may assign its rights and obligations under this Agreement to any successor in interest of all or substantially all of the business of such party by merger, purchase or operation of law; and (ii) MC3 may assign its rights and obligations hereunder to Michigan. In the event of an assignment by AVECOR pursuant to Article 11.2(i) above to any successor in interest to the business of AVECOR, whether by way of merger, purchase or operation of law, the minimum annual royalty payable by AVECOR under Article 4.3 hereof shall, for the three (3) years immediately following the year of such assignment, be an amount equal to the minimum royalty otherwise provided for each of such three (3) years pursuant to Article 4.3 or the amount of royalties actually paid by AVECOR under Article 4.2 in the complete calendar year immediately prior to such assignment, whichever is greater. All terms and conditions of this Agreement will be binding on and inure to the benefit of the successors and permitted assigns of the parties. 11.3 GOVERNING LAW. This Agreement shall be governed by and construed in accordance with the laws of the State of Michigan. 11.4 AMENDMENT. Any change, extension, revision, or waiver of or under this Agreement will be valid and binding only if in writing and duly executed by the party agreeing to be bound thereby. 11.5 SECRECY. The parties hereto expressly agree that the financial terms of this Agreement are strictly confidential. Each party shall, and shall cause its employees, agents and sublicensees to, maintain in absolute secrecy the financial terms of this Agreement, and shall not disclose any of such information to any third party or to any of its own personnel not having a need to know without the prior written authorization of the other party; provided, that neither party shall be liable for the disclosure of the above information to the extent such disclosure is required to comply with any state or federal securities laws. 20 11.6 INVALIDITY. In the event that any term, provision, or covenant of this Agreement shall be determined by a court of competent jurisdiction to be invalid, illegal, or unenforceable, that term will be curtailed, limited, or deleted, but only to the extent necessary to remove such invalidity, illegality, or unenforceability, and the remaining terms, provisions, and covenants shall not in any way be affected or impaired thereby. In the event that the time period of any covenant shall be held unenforceable as a matter of law, said covenant will be interpreted to be effective for an enforceable time period. 11.7 NOTICES. Any notice, demand, or request given to, made, or required to be made hereunder shall be deemed sufficiently made if given in writing, and sent by registered mail, return receipt requested, to the parties at the following addresses: If to AVECOR: AVECOR Cardiovascular, Inc. 13010 County Road 6 Plymouth, MN 55441 Attention: Mr. Allan R. Seck If to MC3: Michigan Critical Care Consultants, Inc. 245 Jackson Industrial Drive, Suite J Ann Arbor, MI 48105 Attention: Mr. Patrick Montoya or to such other addresses as the parties may from time to time specify by written notice in compliance with this Article 11.6. Any such notice shall be deemed to have been served on the fifth (5th) day after the day on which the letter was posted. 11.8 AVECOR agrees that all terms of the Michigan License Agreement, attached as Exhibit I, which, by their nature, apply to MC3 sublicensees, shall apply to AVECOR, whether such terms are expressly restated in this Agreement. 11.9 INTERPRETATION. AVECOR agrees that the terms of the Michigan License Agreement, which by their nature apply to MC3 sublicensees, shall apply to AVECOR, whether or not such terms are expressly restated in this Agreement. 21 IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be duly executed as of the date first above written. Michigan Critical Care AVECOR Cardiovascular Inc. Consultants, Inc. (MC3) (AVECOR) By: /S/ Patrick Montoya By: /S/ Norman C. McGibbon ---------------------------------- ----------------------------------- Its: President Its:Treasurer ---------------------------------- ---------------------------------- 22 EXHIBIT II PRODUCTS 23 AMENDMENT TO LICENSE AGREEMENT This Amendment to License Agreement (this "Amendment"), effective as of November 7, 1997, is made by and between Michigan Critical Care Consultants, Inc. ("MC3") and AVECOR Cardiovascular Inc. ("AVECOR"). A. AVECOR and MC3 have entered into a License Agreement, dated as of January 16, 1995 (the "License Agreement"). B. Section 4.2(b) of the License Agreement requires AVECOR to pay royalties to MC3 out of AVECOR's "net profit" for Hardware from and after the first calendar year in which AVECOR generates a net profit on the sale of Hardware. C. The term "net profit" is presently not defined in the License Agreement and the parties wish to define such term for the purposes of Section 4.2(b) of the License Agreement. In consideration of the foregoing premises and intending to be legally bound, AVECOR and MC3 agree as follows: 1. AMENDMENT OF SECTION 4.2(b). Section 4.2(b) of the license agreement is amended by adding the following to the end of such section: For the purposes of this Section 4.2(b), the definition of "net profit" with respect to Hardware sold during a given period ("NET PROFIT") will be defined as the Net Sales Price of such Hardware, less its Cost, which is defined as the sum of the Material, Labor and Overhead used to produce the Hardware. For this purpose: (i) "Material" is defined as the sum of the standard cost of the parts used to produce the Hardware, as determined by AVECOR's standard bill of materials for the Hardware (as the same may be changed from time to time) and accumulated by AVECOR's manufacturing software for the Hardware produced. (ii) "Labor" is defined as the sum of the standard cost of the direct labor hours used to produce the Hardware, as determined by AVECOR's standard parts' routings (as the same may be changed from time to time) and accumulated by AVECOR's manufacturing software for the Hardware produced. (iii) "Overhead" is defined as the sum of the actual manufacturing and quality expenses used to produce the Hardware, excluding Material and Labor, as currently assigned by AVECOR's monthly product costing system in the course of its normal financial reporting. Subject to the foregoing sentence, "actual manufacturing and quality expenses" include department expenses, manufacturing labor variances, material purchase price variances, warranty expenses and other material adjustments, where "department expenses" include production supplies and other indirect expenses, production administration, warehousing, production engineering, quality administration, raw material receiving inspection, sterilization, quality engineering, product testing and other necessary departmental expenses as required by AVECOR's quality processes. Provided, however, that all of the above calculations will be determined in accordance with Generally Accepted Accounting Principles at the time of calculation, applied on a consistent basis. AVECOR's calculation of Cost and Net Profit will be included in each report required by Section 4.6 below for each period in which royalties are due under Section 4.2(b). AVECOR will keep and maintain records of its calculations of Cost and Net Profit on Hardware pursuant to Section 4.7 below, and MC3 will have the right to inspect such records as provided in such Section. 2. DEFINED TERMS. Unless otherwise defined herein, capitalized terms used in this Amendment will have the meanings given in the License Agreement. 3. EFFECTIVE DATE. Notwithstanding the later execution of this Addendum, the parties hereby agree that this Addendum will be deemed to be effective as of the effective date of the License Agreement. 4. PRIORITY. In the event of any conflict or inconsistency between the terms of this Amendment and the License Agreement, the terms of this Amendment will be controlling. 5. NO OTHER CHANGES. Except as specifically amended by this Amendment, all other provisions of the License Agreement remain in full force and effect. AVECOR and MC3 have caused this Amendment to be duly executed on their behalf by their respective duly authorized representatives as of the date first written above. MICHIGAN CRITICAL CARE AVECOR CARDIOVASCULAR INC. CONSULTANTS, INC. By: /s/ Patrick Montoya By: /s/ Gregory J. Melsen ---------------------------------------- ---------------------------- Its: President Its: Treasurer --------------------------------------- --------------------------- 2 EX-13.1 3 EXHIBIT 13.1 PORTIONS OF ANNUAL REPORT AVECOR-TM- CARDIOVASCULAR ANNUAL REPORT 1997 ABOUT THE COMPANY AVECOR Cardiovascular Inc. is a worldwide leader in the development, manufacture and marketing of specialty medical devices for heart/lung bypass surgery and long-term respiratory support. The Company's product line includes hollow fiber and silicone membrane oxygenators, a blood pump, blood reservoirs, cardioplegia systems, arterial filters, custom tubing packs and blood monitoring devices. ON THE COVER AVECOR's revolutionary new blood pump is shown at the right in a typical perfusion set-up with the AFFINITY oxygenator and hardshell cardiotomy reservoir at the left. Except for the historical financial information contained herein, the matters discussed in this annual report contain certain forward-looking statements. For this purpose, any statements contained in this annual report that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, words such as "may," "will," "expect," "believe," "anticipate," "estimate" or "continue," the negative or other variations thereof, or comparable terminology, are intended to identify forward-looking statements. These statements by their nature involve substantial risks and uncertainties, and actual results may differ materially depending on a variety of factors, including the progress of product development and clinical studies, the timing of and ability to obtain regulatory approvals, the extent to which the Company's products gain market acceptance, the introduction of competitive products by others, the pricing related to competitive products, litigation regarding patent and other intellectual property rights, the availability of third-party reimbursement and other factors, as well as those set forth from time to time in the Company's filings with the Securities and Exchange Commission, including the Company's Annual Report on Form 10-K for the year ended December 31, 1997. MYOtherm-Registered Trademark- and OnCourse-Registered Trademark- are registered trademarks of the Company. Affinity-TM-, Signature-TM-, Trillium-TM-, Myotherm XP-TM-, Affinity XP-TM- and XP-TM- are trademarks of the Company. Windows-Registered Trademark- is a registered trademark of Microsoft Corporation.
FINANCIAL HIGHLIGHTS AVECOR CARDIOVASCULAR, INC. AVECOR CARDIOVASCULAR INC. FOR THE YEARS ENDED DECEMBER 31, ------------------------------------------------------------------------------------ 1997 1996 1995 1994 1993 - --------------------------------------------------------------------------------------------------------------------------------- OPERATING DATA: Net sales $46,864,000 $44,401,000 $33,340,000 $21,486,000 $14,125,000 Cost of sales 27,574,000 25,986,000 18,180,000 12,556,000 9,067,000 ------------------------------------------------------------------------------------- Gross profit 19,290,000 18,415,000 15,160,000 8,930,000 5,058,000 Operating Expenses: Selling, general and administrative 13,428,000 11,885,000 8,727,000 6,779,000 5,044,000 Litigation expense -- 4,205,000 170,000 -- -- Research and development 3,902,000 3,651,000 2,773,000 2,309,000 1,891,000 ------------------------------------------------------------------------------------- Operating income (loss) 1,960,000 (1,326,000) 3,490,000 (158,000) (1,877,000) Interest income 495,000 725,000 586,000 143,000 204,000 Interest expense 383,000 -- -- -- -- ------------------------------------------------------------------------------------- Income (loss) before income taxes 2,072,000 (601,000) 4,076,000 (15,000) (1,673,000) Income tax provision (benefit) 745,000 (34,000) 780,000 24,000 (23,000) ------------------------------------------------------------------------------------- Net income (loss) $ 1,327,000 $ (567,000) $ 3,296,000 $ (39,000) $(1,650,000) ------------------------------------------------------------------------------------- ------------------------------------------------------------------------------------- Diluted earnings (loss) per share $ .17 $ (.07) $ .45 $ (.01) $ (.26) ------------------------------------------------------------------------------------- ------------------------------------------------------------------------------------- Weighted average common and common equivalent shares outstanding(1) 7,990,000 7,767,000 7,353,000 6,390,000 6,361,000 ------------------------------------------------------------------------------------- ------------------------------------------------------------------------------------- BALANCE SHEET DATA: Working capital $20,204,000 $20,563,000 $26,247,000 $10,150,000 $ 9,725,000 Total assets 42,759,000 37,161,000 33,519,000 15,877,000 15,031,000 Long-term debt 4,694,000 -- -- -- -- Shareholders' equity 32,618,000 29,938,000 29,322,000 13,145,000 12,970,000
(1) WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT SHARES OUTSTANDING ARE CALCULATED ACCORDING TO THE DEFINITION OF "DILUTED EARNINGS PER SHARE" AS DEFINED BY THE FINANCIAL ACCOUNTING STANDARDS BOARD (FASB) IN STATEMENT ON FINANCIAL ACCOUNTING STANDARDS NO. 128, EARNINGS PER SHARE. ALL PERIODS PRESENTED WERE PREPARED UNDER THIS NEW STANDARD FOR COMPUTING EARNINGS PER SHARE. 1 TO OUR SHAREHOLDERS: A little over six years ago, we set out to build a major medical device company -- one that would be a leader in the cardiopulmonary market. Our strategy emphasized the creation of innovative products that could be manufactured cost-effectively. Building on the base of an aging $9 million product line acquired from another manufacturer, we have launched a steady stream of new products that have enabled AVECOR Cardiovascular to grow at a compounded 35% annual rate over the last five years. A MARKET LEADER. Today, AVECOR Cardiovascular is a $47 million company. After only three years on the market, our AFFINITY oxygenator has set new records for rapid growth, achieving a 15% market share to rank third in industry sales. Our arterial filter has a 10% market share after two years. THE TECHNOLOGY LEADER. The AFFINITY oxygenator is recognized as the technology leader in its field and has become the standard against which new products are judged. Our AFFINITY pump system provides patients, surgeons and perfusionists with unprecedented safety and high performance. Products under development will help us maintain our position on the leading edge of technology. MANUFACTURING STRENGTH. Our state-of-the-art manufacturing facility uses a completely paperless process for the documentation required by regulators. Our products are designed for manufacturing ease, and we believe that our manufacturing costs on leading product lines are the lowest in the industry. STRONG DISTRIBUTION. In 1997, we completed our transition to a direct sales force in North America. With 24 direct sales personnel and seven manufacturers representatives, we have built strong distribution capabilities that we plan to leverage with the acquisition of complementary technologies and products. We have an extensive international distributor network, augmented by a new agreement with St. Jude Medical to handle sales of AVECOR products in Central America, South America and Mexico. OUR RESULTS FOR 1997 reflected continued growth, with net sales increasing to $46,864,000, up 6% from 1996. Net income was $1,327,000, equal to 17 cents per share. In the previous year, the Company reported a loss of $567,000, or 7 cents per share, after non-recurring charges for litigation expense that amounted to $2.6 million after taxes. Sales growth was led by SIGNATURE custom tubing packs, up 32%, and the AFFINITY oxygenator line, which increased 3%. These gains were offset by declines in the Company's older silicone membrane oxygenator line, down 6%, and the MYOtherm cardioplegia system, which was down 8%. Results in the second half of the year were held down by three factors -- the strength of the U.S. dollar, which reduced international sales; inventory reduction by two former distributors who were replaced by the direct sales force; and lower gross margin resulting from both lower average selling prices and higher product costs due to reduced production volumes. We continued to invest in research and development during 1997, spending $3.9 million to pursue a number of new product opportunities. R&D spending rose 7% over 1996 and is anticipated to increase approximately 10% in 1998 as we continue to expand and improve our product line. Selling, general and administrative expenses also increased in 1997, mainly reflecting costs of developing the direct sales force and introducing new products. NEW PRODUCTS. We are excited by the reception given our new AFFINITY PUMP SYSTEM by perfusionists and surgeons. Early users have praised the pump's safety features and performance, and we are on plan in terms of the number of hospitals that have ordered the pump or are evaluating the system. The pump is the safest on the market. It will not drain the 2 blood reservoir, cannot overpressurize the perfusion circuit, and prevents hazardous retrograde flow. We began selling the pump in Europe during the second quarter of 1997 and began U.S. introduction late in the third quarter after receiving clearance from the Food and Drug Administration in August. Our new MYOTHERM-Registered Trademark- XP CARDIOPLEGIA SYSTEM was also introduced late in the year and has been enthusiastically received by customers. It employs second-generation technology for superior heat exchange and ease of use. We received marketing clearance from the FDA in late February of 1998 for the AFFINITY oxygenator with TRILLIUM-TM- BIO-PASSIVE SURFACE. All blood-contact surfaces in the oxygenator are coated with a non-leaching synthetic hydrophilic polymer which contains a small amount of heparin. The special surface is designed to minimize activation of blood constituents which otherwise occurs as a result of contact with conventional synthetic surfaces. Many of our customers prefer circuit components which have been coated to enhance bio-compatibility. We will offer the coating as an option on the AFFINITY oxygenator and plan to file additional 510(k) applications during 1998 for coated versions of other components in the heart-lung bypass circuit. RESEARCH AND DEVELOPMENT activities during 1998 will focus heavily on additional applications of the blood pump, including a vacuum-assisted version for the small but growing segment of the market that uses vacuum-assisted venous drainage. This potential product could also become a key component in a simplified circuit used to support minimally invasive surgery, and could be used as a ventricular assist pump -- a high-profile market which could stimulate further interest in the AFFINITY pump for cardiac surgery. We anticipate filing a 510(k) application with the FDA in the second quarter of 1998 for our SATURATION/HEMATOCRIT monitoring device. We are completing work on this innovative product, which uses a spectrometer for improved accuracy and can read oxygen saturation in the patient's blood through the walls of tubing used in the perfusion circuit. Because there is no disposable component, it reduces costs for the hospital. We believe the technology will serve as a platform for the development of additional monitoring applications in cardiac surgery and in intensive care units. Another focus of our research will be to conduct studies intended to demonstrate improved patient care through the use of our technology. This will both help us compete and also command premium pricing for our products. Early animal and in vitro studies, for example, indicate that our bio-passive surface preserves platelet numbers and function and maintains bleeding time at base-line levels during two- or three-hour perfusions. This could reduce blood loss and the need for a transfusion during and after surgery. We are continuing to diversify our product offerings, and believe that our newest products will advance our multiple goals of improving patient care, lowering costs and fueling revenue growth. All of us at AVECOR are excited about what we have accomplished in a very short period of time. We appreciate the continued support and encouragement of our shareholders. Sincerely, /s/ ANTHONY BADOLATO ANTHONY BADOLATO CHIEF EXECUTIVE OFFICER MARCH 12, 1998 3 PRODUCT REVIEW The products of AVECOR Cardiovascular Inc. are used primarily in heart/lung bypass surgery and for long-term respiratory support. The annual worldwide market for specialty medical devices used in bypass surgery is estimated at $800 million, of which more than $600 million is attributable to disposable products. The Company's current products include: THE AFFINITY-TM- OXYGENATOR. The AFFINITY is a microporous, hollow fiber membrane oxygenator that quickly became one of the market leaders nationally following its U.S. introduction in 1994. During a bypass procedure, the oxygenator takes the place of the patient's lungs, removing carbon dioxide and adding oxygen to the blood. The AFFINITY is a state-of-the-art device that studies have shown to be one of the most efficient oxygenators on the market. It combines high gas transfer with low pressure drop. Its compact size provides low priming volumes; its clear polycarbonate case permits high visibility of all phases of the unit's operation. The AFFINITY oxygenator was estimated to be the third best-selling oxygenator in the U.S. for 1997, with a market share of approximately 15%. SOLID SILICONE MEMBRANE OXYGENATORS. The Company markets a complete line of these oxygenators in several models and sizes. This technology permits extended use of the oxygenator for certain applications without the deterioration of performance that microporous membrane oxygenators may experience. This is particularly important for procedures that entail long-term support. AFFINITY-TM- BLOOD PUMP SYSTEM. The AFFINITY blood pump incorporates an innovative design that offers superior blood-handling characteristics and cost advantages over the centrifugal pumps and roller pumps that are widely used in heart/lung bypass surgery today. AVECOR introduced the pump in the U.S. late in the third quarter of 1997 following clearance from the FDA in August. European distribution began late in the second quarter following clinical trials at multiple sites. A study* published in THE JOURNAL OF EXTRA-CORPOREAL TECHNOLOGY reported that the inherent physical characteristics of the design used in the AFFINITY pump make it impossible for the pump to produce dangerous positive or negative pressures, and that the design "possesses important safety advantages over roller and centrifugal pumps for cardiopulmonary bypass applications." BLOOD RESERVOIRS. The Company produces a hardshell cardiotomy reservoir and venous reservoir bags. These devices are used to filter and store blood during bypass surgery. The Company began marketing two new reservoirs in mid-1994. MYOTHERM-TM- XP CARDIOPLEGIA DELIVERY SYSTEM. AVECOR introduced this new generation of the MYOtherm product line following FDA clearance in July 1997. The system is 4 used to infuse specially formulated solutions, which often include oxygenated blood, directly into the patient's coronary arteries while the heart is stopped during bypass surgery. In addition to delivering nutrients to the heart, these solutions are also used to arrest the heart and maintain prescribed temperatures. The MYOtherm XP cardioplegia system was designed for superior performance and ease of use while incorporating improved manufacturing efficiencies. ECMO SYSTEM. The Company produces a system for extracorporeal membrane oxygenation (ECMO), which is the long-term cardiopulmonary support of premature infants, newborns and other patients with life-threatening respiratory disorders. The system includes reservoir bags, heat exchangers and a range of different-sized membrane oxygenators. SIGNATURE-TM- CUSTOM TUBING PACKS. All or some of the devices used in a heart/lung bypass procedure can be pre-connected and sold in a custom tubing pack. The components to be included in the pack and the exact way they are arranged and connected are determined by the specifications provided by our customer. The Company has developed computer software that allows it to design custom tubing packs according to these individual specifications and to quote prices within hours of a customer request. AVECOR began assembling and selling custom tubing packs in Europe in 1992 and in the United States in mid-1993. AFFINITY-TM- ARTERIAL FILTER. The AFFINITY filter is the final safety component in the circuit of specialized medical devices used in heart/lung bypass surgery, ensuring that the oxygenated blood is free of air or particulate emboli before reentering the patient's body. The filter offers low-volume priming, high visibility, excellent air handling and excellent hemodynamics. The Company introduced this product for evaluation by customers late in 1995, with full release worldwide in the first quarter of 1996. The Company previously sold filters from other manufacturers as part of its custom tubing packs. ONCOURSE-TM- CONTINUOUS QUALITY CONTROL (CQI) MANAGER. OnCourse CQI Manager is a Windows-Registered Trademark--based software program that guides perfusionists through the necessary steps in establishing a CQI program. In addition, it generates a variety of useful reports for perfusionists, including the annual American Board of Cardiovascular Perfusion clinical activity report and several custom reports which address non-compliance, standards of perfusion and equipment preventative maintenance. Introduced in late 1995, the software is currently offered to AVECOR customers who make a major commitment to AVECOR products -- another important product line differentiation for AVECOR in the marketplace. *J. Patrick Montoya, Ph.D., Scott I. Merz, Ph.D., and Robert H. Bartlett, M.D., "Significant Safety Advantages Gained with an Improved Pressure Regulated Blood Pump," THE JOURNAL OF EXTRA-CORPOREAL TECHNOLOGY, June 1996, pp. 71-78. 5 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The following discussion of the Company's results of operations and financial condition should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto. OVERVIEW AVECOR Cardiovascular Inc. (the "Company") develops, manufactures and markets specialty medical devices for heart/lung bypass surgery and long-term respiratory support. The Company was incorporated on December 13, 1990, and in June 1991, acquired the business and assets and assumed certain liabilities of the surgical division of SCIMED Life Systems, Inc. (the "Predecessor Business"). On December 1, 1992, the Company acquired AVECOR Cardiovascular Ltd. (formerly Cardio Med Ltd.) pursuant to which AVECOR Cardiovascular Ltd. became a wholly-owned subsidiary of the Company. AVECOR Cardiovascular Ltd. had formerly been a distributor for the Company in the United Kingdom. In October 1995, the Company opened a sales office in France which is organized as a wholly-owned subsidiary of AVECOR Cardiovascular Ltd. The assets acquired by the Company from the Predecessor Business included the Company's line of solid silicone membrane oxygenators. Since that time, the Company has engaged in extensive product development, resulting in the introduction and receipt of regulatory approval from the U.S. Food and Drug Administration (the "FDA") for the following proprietary products:
PRODUCT APPROVAL DATE - ------------------------------------------------------------------------------- MYOtherm cardioplegia delivery system October 1991 Signature custom tubing packs July 1993 Affinity oxygenator November 1993 Affinity blood reservoirs July 1994 Affinity arterial filter October 1995 MYOtherm XP (improved cardioplegia delivery system) July 1997 Affinity blood pump August 1997 Affinity oxygenator with Trillium bio-passive surface February 1998
RESULTS OF OPERATIONS COMPARISON OF THE YEAR ENDED DECEMBER 31, 1997 WITH THE YEAR ENDED DECEMBER 31, 1996 NET SALES. Net sales increased 6% to $46,864,000 for 1997 from $44,401,000 for 1996. This increase was principally the result of a higher volume of product shipments of the Company's Signature custom tubing packs and Affinity product line. Overall, average prices of product shipments declined slightly when compared to 1996. Signature custom tubing pack and the Affinity product line net sales increased $2,401,000 and $697,000 from 1996, respectively. A significant portion of the Affinity revenue increase was attributed to the Affinity blood pump which the Company began marketing internationally in June 1997. The Company received FDA marketing approval for this product in August 1997. These increases were partially offset by decreases in the silicone membrane oxygenator line which decreased by $436,000 and the Myotherm cardioplegia line which decreased by $339,000. Management believes the decline in net sales of the Myotherm cardioplegia line to be temporary as customers delayed their purchasing decisions in anticipation of the Company's launch of its new version of the Myotherm cardioplegia system (Myotherm XP) which received marketing clearance from the FDA in July 1997. The Myotherm XP was launched both in the United States and internationally in early 1998. Sales to customers located outside of the United States were approximately 41% of consolidated net sales for 1997 and 1996. During the third quarter of 1997, the Company terminated agreements with its last remaining United States distributor and its only Canadian distributor. Sales in the territories formerly represented by these distributors decreased approximately $1,400,000 in 1997 when compared to 1996. These markets are now being served by the Company's direct sales force. While management believes these revenue declines are temporary and caused by the transition to a direct sales force in these territories and the depletion of product inventories of the former distributors, this forward-looking expectation is primarily dependent on the ability of the direct sales personnel to maintain and develop relations and revenue levels at the medical institutions previously served by these distributors. Although revenues from distributors in the continental European countries and Asia increased about $800,000 during the twelve months ended December 31, 1997 when compared to the corresponding period in 1996, these distributors' sales for the six-month period ended December 31, 1997 decreased approximately $690,000 when compared to the six-month period ended December 31, 1996 and decreased about $983,000 when compared to the six-month period ended June 30, 1997. During the latter half of 1997, currencies in Europe and Asia substantially weakened relative to the U.S. dollar and the U.K. pound sterling. The Company believes that these types of fluctuations in currency exchange rates reduce demand for the Company's products by increasing the price of the Company's products in the currency of the countries in which the product is sold. Given the inherent uncertainty of exchange rates, the Company cannot predict if these exchange rate variances will remain constant, reverse or worsen. Sales to the Company's formerly exclusive Mexican distributor declined about $340,000 in 1997 when compared to 1996. On October 9, 1997, the Company entered into an agreement with St. Jude Medical to distribute the Company's products in Mexico and in Central and South America. Previous sales in these countries have not been significant to the Company. The formerly exclusive Mexican distributor will continue to market the Company's silicone membrane product line in Mexico. The aforementioned factors impacted sales within all of the Company's product lines. The revenue declines discussed above were exceeded by revenue growth in the Company's other domestic and foreign markets. The Company has continued to experience decreased sales to contract perfusion groups controlled by certain of its competitors. Sales to contract perfusion groups controlled by one of the Company's competitors decreased $750,000 to $1,100,000 for 1997 from $1,850,000 for 1996. The Company believes that control of contract perfusion groups by its competitors will continue to have a negative impact on the Company's ability to market its products to such groups or to 6 hospitals or other medical providers that contract with competitor-controlled groups for perfusion services, and could have a material adverse effect on the Company's business, financial condition and results of operation. This forward-looking statement is subject to the degree of control exerted by the Company's competitors with respect to purchasing decisions made by controlled groups of perfusionists, the extent of future acquisitions of contract perfusion groups by the Company's competitors, the breadth of the Company's product offerings relative to those competitors controlling contract perfusion groups, and the degree to which the Company's research and development and marketing efforts result in the successful commercialization of products with enhanced or superior performance characteristics. COST OF SALES/GROSS PROFIT. Gross profit as a percentage of net sales decreased to 41.2% for 1997 from 41.5% for 1996. The cost of sales percentage for 1997 was unfavorably impacted by significant increases in sales of the Company's lower-margin Signature custom tubing pack line, as well as competitive pricing pressures in the marketplace. The mix of products sold in any period will influence the cost of sales and gross profit for the period. Affinity oxygenator costs continued to improve due to material cost and efficiency improvements, although these improvements were largely offset by an ongoing decrease in average selling prices and reduced production volume, primarily in the fourth quarter, due to lower-than-expected sales volume. The Company believes the gross profits in early 1998 will continue to be negatively influenced because of these reduced production levels. The Company's future gross profit margin percentages will be influenced by the ongoing pressures of the competitive pricing environment, changes in the sales mix, the required levels of production, new product introductions and the extent of further manufacturing efficiencies or improved material costs, if any. Given the uncertainty associated with new product introductions, the ultimate realization of any such manufacturing efficiencies or material cost improvements, and the continuing price pressures characteristic in the Company's markets, the Company cannot be certain if its gross profit margin will be maintained, improve or decline. SELLING, GENERAL AND ADMINISTRATIVE AND LITIGATION EXPENSE. Selling, general and administrative expenses increased 13% to $13,428,000 for 1997 from $11,885,000 for 1996. This increase is primarily attributed to costs associated with the continuing development of a direct sales force in certain of the Company's territories formerly served by distributors and independent sales representatives and costs incurred for the introduction of new products, including the Affinity blood pump. As a percent of sales, selling, general and administrative expenses increased to 28.7% for 1997 from 26.8% for 1996. Management anticipates that selling, general and administrative expenses for the year ended December 31, 1998 will be higher than the year ended December 31, 1997 and will approximate 1997 as a percentage of sales dollars. This forward-looking statement will be influenced by revenue levels achieved by the Company, its ability to attract and retain qualified sales personnel as the Company continues to develop its direct sales force, and the timing and extent of promotional activities associated with the introduction of the MYOtherm XP, Affinity oxygenator with Trillium bio-passive surface and other new product introductions, if any. On July 17, 1996, the Company reached an agreement with COBE Laboratories Inc. (COBE) to settle COBE's patent suit against the Company. The terms of the settlement with COBE provided for the Company to make net payments totaling $2,200,000. Two net payments of $1,100,000 were made in August 1996 and August 1997, respectively. The Company recorded settlement costs and professional expenses of approximately $4,205,000 in 1996 in connection with the COBE suit. No related expenses were incurred for the COBE matter in 1997. RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses increased 7% to $3,902,000 for 1997 from $3,651,000 for 1996. This increased research and development spending is a result of the Company's ongoing efforts to pursue a number of potential and realized product opportunities including the Myotherm XP, Affinity blood pump, the Affinity oxygenator with Trillium bio-passive surface and new oxygen saturation/hematocrit technology. The Company received the appropriate marketing clearances from the FDA for the Myotherm XP, Affinity blood pump and Affinity oxygenator with Trillium bio-passive surface in July 1997, August 1997 and February 1998, respectively. There can be no assurance that the Myotherm XP, Affinity blood pump or Affinity oxygenator with Trillium bio-passive surface will become commercially successful. The Company anticipates that research and development expenses for 1998 will increase approximately 10% over 1997 levels, as the Company moves to expand and improve its proprietary line of disposable medical devices. This forward-looking projection is dependent upon the extent and timing of new product development and the impact of the regulatory process in obtaining marketing clearance for new products, including a new oxygen saturation/hematocrit device which is expected to be submitted to the FDA in the second quarter of 1998. The need or desire to modify the Company's existing products could also influence the level of research and development expenses. There can be no assurance, however, that the Company's research and development efforts will result in regulatory submissions to the FDA as set forth above, if at all, or will result in any commercially successful products. The forward-looking statements regarding anticipated regulatory submissions contained in this paragraph will be impacted by the results of the Company's development efforts, the availability of any required clinical data, any changes in the regulatory scheme for such products, and the Company's assessment of the cost and anticipated benefit of such submissions. INTEREST. Interest income decreased to $495,000 for 1997 from $725,000 for 1996. This decrease in interest income is primarily due to the use of cash and cash equivalents and investments for the Company's new facility, the purchase of manufacturing molds and equipment, additional inventories needed to support the Company's new product lines and revenue growth, and the costs associated with the COBE matter. Interest income during 1997 and 1996 was earned primarily from the investment of the remaining net proceeds from the Company's June 1995 stock offering. At December 31, 1997, the majority of these remaining net proceeds were invested with two investment portfolio managers who invested in bank certificates of deposit, U.S. government securities, agency paper, money markets, commercial paper and corporate obligations. Interest expense for 1997 was $383,000 and exclusively due to the mortgage on the new facility. The closing on the facility purchase occurred in late January 1997. 7 INCOME TAX PROVISION. For 1997, a tax provision of $745,000 was recorded as compared to a tax benefit of $34,000 for 1996. The 1997 and 1996 effective tax rates differ from the normal U.S. statutory tax rate primarily due to losses incurred by the Company's French subsidiary for which no tax benefit has been recognized because of uncertainty of realization, offset by the generation of research and experimentation credits. NET INCOME (LOSS). Net income was $1,327,000 or $.17 per share, on a diluted basis, for 1997 compared to a net loss of $567,000 or $.07 per share, on a diluted basis, for 1996. The 1996 loss is primarily due to litigation and settlement expense incurred during 1996 in connection with the COBE lawsuit, which resulted in a charge to operations of $4,205,000. COMPARISON OF THE YEAR ENDED DECEMBER 31, 1996 WITH THE YEAR ENDED DECEMBER 31, 1995 NET SALES. Net sales increased 33% to $44,401,000 for 1996 from $33,340,000 for 1995. This increase was principally the result of a higher volume of product shipments of the Company's Affinity product line and Signature custom tubing packs. Overall, average prices associated with 1996 product shipments declined slightly from those of 1995 in response to competitive pricing in the market place. Selective price increases were implemented in the last half of 1996. Sales from the Affinity product line and Signature custom tubing packs increased $7,159,000 and $3,943,000 from 1995, respectively. The favorable impact of increased net sales of these product lines was partially offset by a decrease of $276,000 in net sales of the Company's older solid silicone membrane oxygenator product line. COST OF SALES/GROSS PROFIT. Gross profit as a percentage of net sales decreased to 41.5% for 1996 from 45.5% for 1995. The cost of sales percentage for 1996 was unfavorably impacted by significant increases in sales of the Company's lower-margin Signature custom tubing pack line, as well as competitive pricing pressures in the marketplace. Higher production volumes continued to improve Affinity oxygenator product costs, although these improvements were offset, primarily by an ongoing decrease in average selling prices due to the Company being in a competitive pricing environment. Also, optimal volume-related manufacturing efficiencies were not achieved throughout 1996 for production of the Company's Affinity arterial filter. Production of the Affinity arterial filter began on or about December 31, 1995. SELLING, GENERAL AND ADMINISTRATIVE AND LITIGATION EXPENSE. Selling, general and administrative expenses increased 36% to $11,885,000 for 1996 from $8,727,000 for 1995. This increase is attributed to costs associated with the continuing development of a direct sales force in certain of the Company's territories formerly served by distributors and independent sales representatives and the overall increase in support needed to achieve the Company's sales levels. In connection with the Company's development of a direct sales force, in October 1995, the Company opened a sales office in France from which it fields a direct sales force to serve the French market. The Company recorded non-recurring charges in the fourth quarter of 1996 associated with relocation and lease abandonment expenses in connection with the consolidation of the Company's U.S. operations from four leased facilities into one owned property and the addition and subsequent resignation of a Chief Operating Officer. Additionally, the Company recorded settlement costs and professional fees of $4,205,000 in 1996, in connection with the COBE suit, compared to $170,000 in 1995 (see Note 9). RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses increased 32% to $3,651,000 for 1996 from $2,773,000 for 1995. This increased research and development spending was a result of the Company's efforts to pursue a number of potential product opportunities, including the Affinity blood pump. INTEREST INCOME. Interest income increased to $725,000 for 1996 from $586,000 for 1995. Interest income during 1996 and 1995 was earned primarily from the investment of the remaining net proceeds from the Company's June 1995 stock offering. At December 31, 1996, the majority of these remaining net proceeds were invested with two investment portfolio managers who invested in U.S. government securities, agency paper, money markets, commercial paper and corporate obligations. INCOME TAX PROVISION. For 1996, a tax benefit of $34,000 was recorded as compared to a tax provision of $780,000 for 1995. The 1996 effective tax rate differs from the normal statutory tax rate primarily due to losses incurred by the Company's French subsidiary for which no tax benefit has been recognized because of uncertainty of realization, offset by the generation of research and experimentation credits. The 1995 tax provision reflects an effective rate which benefited from use of previously generated net operating loss carryforwards and research and experimentation credits. NET INCOME (LOSS). Net loss was $567,000 or $.07 per share, on a diluted basis, for 1996 compared to net income of $3,296,000 or $.45 per share, on a diluted basis, for 1995. The 1996 loss was primarily due to litigation and settlement expense incurred during 1996 in connection with the COBE lawsuit, which resulted in a charge to operations of $4,205,000. LIQUIDITY AND CAPITAL RESOURCES For 1997, the Company used $891,000 in operating activities compared to $2,470,000 used for operating activities in 1996. The net change of $1,579,000 is primarily the result of $3,100,000 of cash usages during 1996 related to the COBE litigation compared to $1,100,000 of cash usages during 1997, smaller increases in levels of inventories and reduced prepaid expenses. These operating provisions for cash were partially offset by a smaller increase in accrued expenses in 1997 when compared to 1996, reduced accounts payable and increased accounts receivable balances in 1997 when compared to 1996. The Company's inventories have continued to increase as a result of inventories needed to support the Company's new product lines, revenue growth and, in part, as a result of lower than anticipated shipments of the Affinity product line primarily in the third and fourth quarters of 1997. The Company believes that its existing cash and cash equivalents and short-term investments, as well as anticipated cash generated from operations, will be sufficient to satisfy the Company's cash requirements for the foreseeable future. Cash expenditures for capital additions, other than the purchase of the new facility and related furniture, fixtures and equipment, totaled $4,628,000 in 1997 compared to $1,979,000 in 1996. These expenditures were primarily related to equipment, molds and tooling necessary to begin the production and marketing of the Affinity blood pump and MYOtherm XP, and to increase production efficiencies and reduce raw material 8 costs of the Affinity oxygenator and related blood reservoirs. The 1997 investment in equipment includes $1,494,000 related to the Affinity blood pump. This pump equipment is placed with customers in exchange for a long-term commitment to purchase disposable products from the Company. During 1997, the expenditures for furniture, fixtures and equipment additions related to the Company's new U.S. manufacturing, research and development and administrative facility were approximately $760,000. Leases for the Company's U.S. manufacturing, research and development and administrative facilities expired on December 31, 1996. In January 1997, the Company consolidated its four separate facilities into a newly constructed facility, which the Company has purchased. The cost of this facility and related additions was approximately $9,650,000. To finance the total cost of this project, the Company entered into a $5,167,000 bank note payable agreement in January 1997 and, in addition, expended $4,483,000 out of corporate funds, including $650,000 paid in 1996. The note payable agreement bears interest at 8.11% and requires monthly principal payments of $21,531, plus interest, through January 2002 with the remaining principal and interest due February 2002. The note payable is collateralized by the new corporate headquarters and manufacturing facility and, among other things, requires the Company to meet certain ratios related to leverage, debt service and cash flow. Additionally, the bank note payable agreement prohibits the Company from distributing dividends to its shareholders. At December 31, 1997, the Company had no restricted cash or investments. Of the $4,450,000 which was restricted at December 31, 1996 for purchase of the new facility, $1,000,000 was used in payment of the facility and $3,450,000 became unrestricted, was reinvested and is being used for general corporate purposes, research and development and working capital. The Company's capital expenditures for 1998 are expected to approximate those of 1997, excluding the amounts paid in 1997 for the new facility and related additions. This estimate includes additional equipment, molds and tooling for new oxygen saturation/hematocrit technology, the Affinity blood pump, the MYOtherm XP and for furthering the production of the Affinity oxygenator line. The foregoing forward-looking statements relating to the amount of capital expenditures and ultimate cash usage are dependent on the progress of the Company's product development efforts, the outcome of certain patent matters (see Note 9), the timing of the receipt of FDA marketing clearances for any future products and the investment in opportunities to further existing products' production related to improved production efficiencies and quality, and reduced cost. FOREIGN CURRENCY TRANSACTIONS Transactions by the Company's international subsidiaries are negotiated, invoiced and paid in various foreign currencies, primarily pounds sterling and U.S. dollars. Accordingly, the Company is currently subject to risks associated with fluctuations in exchange rates between the various currencies. Substantially all of the Company's other international transactions are denominated in U.S. dollars. Fluctuations in currency exchange rates in other countries may therefore reduce the demand for the Company's products by increasing the price of the Company's products in the currency of the countries in which the products are sold. YEAR 2000 ISSUES Computer programs have historically been written to abbreviate dates by using two digits instead of four digits to identify a particular year. The so-called "Year 2000" problem or "millennium bug" is the inability of computer software or hardware to recognize or properly process dates ending in "00." As the year 2000 approaches, significant attention is being focused on updating or replacing such software and hardware in order to avoid system failures, miscalculations or business interruptions that might otherwise result. The Company has reviewed its internal information systems and believes that the costs and effort to address the Year 2000 problem will not be material to its business, financial condition or results of operations, and, to the extent necessary, may be resolved through replacement and upgrades to the software it licenses from third parties. The Company has also reviewed its OnCourse software product, the software embedded in its Affinity blood pump console and the software for its saturation/hematocrit monitor under development and believes them to be Year 2000 compliant. However, the Year 2000 problem may also adversely impact the Company by affecting the business and operations of parties with which the Company transacts business. The Company has not initiated any formal communication with such parties regarding the Year 2000 problem, and is unable to determine the likelihood or potential impact of any such event. There can be no assurance that the Company will be able to effectively address Year 2000 issues internally in a cost-efficient manner and without interruption to its business, or that Year 2000 difficulties encountered by its suppliers, customers or other parties will not have a material impact on the Company's business, financial condition and results of operations. NEW ACCOUNTING PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board issued Statement 131, "Disclosures About Segments of an Enterprise and Related Information," a new standard of reporting information about operating or business segments in financial statements. The new standard will be effective for the Company's annual financial statements in 1998. Although the Company has not specifically evaluated what impact, if any, this new standard will have on the Company's current reporting of operating and business segments, the Company believes it will continue reporting as one operating and business segment. In June 1997, the Financial Accounting Standards Board issued Statement 130, "Reporting Comprehensive Income," a new standard requiring the reporting and display of "comprehensive income" (defined as the change in equity of a business enterprise during a period from sources other than those resulting from investments by owners and distributors to owners) and its components in a full set of general purpose financial statements. The new standard will be effective for the Company's annual financial statements in 1998. The Company's cumulative translation adjustment is considered a component of "comprehensive income," however the Company has not evaluated what other components of its changes in equity would be components of "comprehensive income." 9
CONSOLIDATED BALANCE SHEETS AVECOR CARDIOVASCULAR, INC. AS OF DECEMBER 31, 1997 1996 - --------------------------------------------------------------------------------------------------------------- ASSETS Current assets: Cash and cash equivalents $ 1,215,000 $ 6,114,000 Short-term investments 3,727,000 2,638,000 Accounts receivable, net 8,277,000 7,298,000 Inventories 10,634,000 9,476,000 Deferred taxes 1,315,000 1,274,000 Other current assets 330,000 744,000 ----------------------------- Total current assets 25,498,000 27,544,000 Restricted cash and investments -- 4,450,000 Property, plant and equipment, net 16,689,000 4,808,000 Other assets 572,000 359,000 ----------------------------- Total assets $42,759,000 $37,161,000 ----------------------------- ----------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 1,978,000 $ 2,790,000 Accrued expenses 3,058,000 3,091,000 Current maturities of long-term debt 258,000 -- Accrued litigation settlement -- 1,100,000 ----------------------------- Total current liabilities 5,294,000 6,981,000 Deferred grant 153,000 205,000 Deferred taxes -- 37,000 Long-term debt 4,694,000 -- Commitments and contingencies (Notes 5 and 9) Shareholders' equity: Serial preferred stock, par value $.01 per share; authorized 2,000,000 shares; none issued Common stock, par value $.01 per share; authorized 20,000,000 shares; issued and outstanding shares 8,021,000 and 7,812,000 shares at December 31, 1997 and 1996, respectively 80,000 78,000 Additional paid-in capital 30,482,000 29,024,000 Retained earnings 1,936,000 609,000 Cumulative translation adjustments 120,000 227,000 ----------------------------- Total shareholders' equity 32,618,000 29,938,000 ----------------------------- Total liabilities and shareholders' equity $42,759,000 $37,161,000 ----------------------------- -----------------------------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE CONSOLIDATED FINANCIAL STATEMENTS. 10
CONSOLIDATED STATEMENTS OF OPERATIONS AVECOR CARDIOVASCULAR, INC. FOR THE YEARS ENDED DECEMBER 31, 1997 1996 1995 - ---------------------------------------------------------------------------------------------------------- Net sales $46,864,000 $44,401,000 $33,340,000 Cost of sales 27,574,000 25,986,000 18,180,000 ----------------------------------------------- Gross profit 19,290,000 18,415,000 15,160,000 Operating expenses: Selling, general and administrative 13,428,000 11,885,000 8,727,000 Litigation expense -- 4,205,000 170,000 Research and development 3,902,000 3,651,000 2,773,000 ----------------------------------------------- Operating income (loss) 1,960,000 (1,326,000) 3,490,000 Interest income 495,000 725,000 586,000 Interest expense 383,000 -- -- ----------------------------------------------- Income (loss) before income taxes 2,072,000 (601,000) 4,076,000 Income tax provision (benefit) 745,000 (34,000) 780,000 ----------------------------------------------- Net income (loss) $ 1,327,000 $ (567,000) $ 3,296,000 ----------------------------------------------- ----------------------------------------------- Earnings per share: Basic $ 0.17 $ (0.07) $ 0.47 ----------------------------------------------- ----------------------------------------------- Diluted $ 0.17 $(0.07) $ 0.45 ----------------------------------------------- -----------------------------------------------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE CONSOLIDATED FINANCIAL STATEMENTS. 11
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY AVECOR CARDIOVASCULAR, INC. FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995 COMMON STOCK ADDITIONAL CUMULATIVE ------------ PAID-IN RETAINED TRANSLATION SHARES PAR VALUE CAPITAL EARNINGS ADJUSTMENTS TOTAL - ------------------------------------------------------------------------------------------------------------------------------------ Balances at December 31, 1994 6,414,000 $64,000 $15,205,000 $(2,120,000) $ (4,000) 13,145,000 Sale of share pursuant to public stock offering, net of expenses of $1,283,000 1,161,000 12,000 12,641,000 -- -- 12,653,000 Sale of shares for cash pursuant to Employee Stock Purchase Plan 18,000 -- 178,000 -- -- 178,000 Exercise of stock options 71,000 1,000 (155,000) -- -- (154,000) Tax benefit realized upon exercise of stock options -- -- 255,000 -- -- 255,000 Net income for 1995 -- -- -- 3,296,000 -- 3,296,000 Cumulative translation adjustments -- -- -- -- (51,000) (51,000) --------------------------------------------------------------------------------- Balances at December 31, 1995 7,664,000 77,000 28,124,000 1,176,000 (55,000) 29,322,000 Exercise of stock warrants, net of expenses of $35,000 85,000 1,000 528,000 -- -- 529,000 Sale of shares for cash pursuant to Employee Stock Purchase Plan 23,000 -- 250,000 -- -- 250,000 Exercise of stock options 40,000 -- (70,000) -- -- (70,000) Tax benefit realized upon exercise of stock options -- -- 192,000 -- -- 192,000 Net loss for 1996 -- -- -- (567,000) -- (567,000) Cumulative translation adjustments -- -- -- -- 282,000 282,000 --------------------------------------------------------------------------------- Balances at December 31, 1996 7,812,000 78,000 29,024,000 609,000 227,000 29,938,000 Exercise of stock warrants 5,000 -- 28,000 -- -- 28,000 Sale of shares for cash pursuant to Employee Stock Purchase Plan 34,000 -- 283,000 -- -- 283,000 Exercise of stock options 168,000 2,000 975,000 -- -- 977,000 Shares issued pursuant to Medical Advisory Board agreement 2,000 -- 29,000 -- -- 29,000 Tax benefit realized upon exercise of stock options -- -- 143,000 -- -- 143,000 Net income for 1997 -- -- -- 1,327,000 -- 1,327,000 Cumulative translation adjustments -- -- -- -- (107,000) (107,000) --------------------------------------------------------------------------------- Balances at December 31, 1997 8,021,000 $80,000 $30,482,000 $ 1,936,000 $ 120,000 $32,618,000 --------------------------------------------------------------------------------- ---------------------------------------------------------------------------------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE CONSOLIDATED FINANCIAL STATEMENTS. 12
CONSOLIDATED STATEMENTS OF CASH FLOWS AVECOR CARDIOVASCULAR, INC. FOR THE YEARS ENDED DECEMBER 31, 1997 1996 1995 - ------------------------------------------------------------------------------------------------------------------------------- Cash flows from operating activities: Net income (loss) $ 1,327,000 $ (567,000) $ 3,296,000 Adjustments to reconcile net income (loss) to net cash (used in) provided by operating activities: Depreciation and amortization 1,748,000 1,375,000 1,063,000 Accretion of discount on investments (280,000) (508,000) (189,000) Provision for bad debts 214,000 104,000 42,000 Deferred income taxes (78,000) (867,000) (370,000) Stock compensation 29,000 -- -- Deferred grant (52,000) (67,000) (19,000) Changes in operating assets and liabilities: Accounts receivable (1,292,000) (958,000) (2,088,000) Inventories (1,185,000) (3,547,000) (1,696,000) Other current assets 401,000 (199,000) (127,000) Accounts payable (762,000) 122,000 946,000 Accrued expenses 139,000 1,542,000 623,000 Accrued litigation settlement (1,100,000) 1,100,000 -- --------------------------------------------------- Net cash (used in) provided by operating activities (891,000) (2,470,000) 1,481,000 --------------------------------------------------- Cash flows from investing activities: Purchase of property, plant and equipment (12,628,000) (2,629,000) (1,146,000) Purchase of short-term investments (6,891,000) (6,183,000) (7,666,000) Proceeds upon sale or maturity of short-term investments 6,082,000 11,810,000 2,000,000 Restricted cash and investments 3,450,000 (4,450,000) -- Increase in other assets (222,000) (53,000) (162,000) --------------------------------------------------- Net cash used in investing activities (10,209,000) (1,505,000) (6,974,000) --------------------------------------------------- Cash flows from financing activities: Net proceeds from sales of common stock 283,000 250,000 12,831,000 Net proceeds from options exercised 977,000 (70,000) (154,000) Net proceeds from warrants exercised 28,000 529,000 -- Borrowings on long-term debt 5,167,000 -- -- Principal payments on long-term debt (215,000) -- -- Grant proceeds -- 102,000 -- --------------------------------------------------- Net cash provided by financing activities 6,240,000 811,000 12,677,000 --------------------------------------------------- Effect of exchange rates on cash (39,000) 100,000 (41,000) --------------------------------------------------- Net (decrease) increase in cash and cash equivalents (4,899,000) (3,064,000) 7,143,000 --------------------------------------------------- Cash and cash equivalents at beginning of year 6,114,000 9,178,000 2,035,000 --------------------------------------------------- Cash and cash equivalents at end of year $ 1,215,000 $ 6,114,000 $ 9,178,000 --------------------------------------------------- --------------------------------------------------- Supplemental disclosure: Significant non-cash investing and financing transaction: Use of restricted funds for purchase of the U.S. facility $ 1,000,000 -- -- Accounts payable recorded for the purchase of property, plant and equipment -- $ 387,000 -- Cash paid for income taxes $ 235,000 $ 57,000 $ 654,000 Cash paid for interest $ 348,000 -- --
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE CONSOLIDATED FINANCIAL STATEMENTS. 13 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BUSINESS DESCRIPTION AND SIGNIFICANT ACCOUNTING POLICIES: BUSINESS DESCRIPTION: AVECOR Cardiovascular Inc. (the "Company") was incorporated on December 13, 1990. The Company develops, manufactures and markets specialty medical devices for heart/lung bypass surgery and long-term respiratory support. PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of AVECOR Cardiovascular Inc. and its wholly-owned subsidiaries, AVECOR Cardiovascular Ltd. and AVECOR Foreign Sales Corporation, after elimination of all significant intercompany transactions and accounts. CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS: For financial reporting purposes, the Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. The Company's cash and cash equivalent balances are concentrated primarily with two investment managers, the majority of which is invested in daily money market funds. Short-term investments consist of bank certificates of deposit, U.S. government securities, agency paper, commercial paper and other corporate obligations, and money market instruments and are classified as short-term in the balance sheet based on their maturity date. All of the Company's short-term investments mature in 1998 and are considered by management to be "available for sale." At December 31, 1997 and 1996, the estimated fair value of the short-term investments approximated their cost. Unrealized gains and losses were not significant. At December 31, 1997, the Company had no restricted cash or investments. At December 31, 1996, cash and short-term investements totaling $4,450,000 were restricted as to their use. CONCENTRATIONS OF CREDIT RISK: The Company's accounts receivable are primarily due from hospitals and independent foreign distributors located mainly in the U.S. and Western Europe. Although the Company does not require collateral from its customers, concentrations of credit risk in the U.S. are somewhat mitigated by a large number of geographically dispersed customers. The Company does not presently anticipate credit risk associated with foreign trade receivables (see Note 6), although collection could be impacted by the underlying economies of the respective countries. INVENTORIES: Inventories are stated at the lower of cost or market, with cost determined on the first-in, first-out method. PROPERTY, PLANT AND EQUIPMENT: Property, plant and equipment are carried at cost less accumulated depreciation and amortization. Depreciation and amortization are generally recorded using the straight-line method over estimated useful asset lives. The Company's new U.S. facility carries asset lives of forty, fifteen and seven years for the building and shell, improvements, and equipment and furniture, respectively. The cost of molds, tooling and dies is capitalized and depreciated generally over periods of three to five years using straight-line or units of production methods. Other equipment and leasehold improvements are generally carry estimated useful lives of five years or less (shorter of asset life or lease term for leasehold improvements). See "REVENUE RECOGNITION" below for the Company's policy with regards to its blood pump equipment placed with customers. Maintenance, repairs and minor improvements are charged to expense as incurred while major betterments and renewals are capitalized. When assets are sold or retired, the cost and related accumulated depreciation and amortization are removed from the accounts and the resulting gain or loss is included in operations. LONG-LIVED ASSETS: The recoverability of long-lived assets is assessed annually or whenever adverse events or changes in circumstances or business climate indicate that the expected cash flows previously anticipated warrant reassessment. When such reassessments indicate the potential of impairment, all business factors are considered and, if the carrying values of long-lived assets are not likely to be recovered from future net operating cash flows, they will be written down for financial reporting purposes. REVENUE RECOGNITION: For all products, other than when the equipment portion of the Affinity blood pump system is shipped to the customer but title remains with the Company, the Company recognizes sales upon product shipment. During 1997, the Company began marketing the Affinity blood pump system. This blood pump system has both equipment and disposable products which are manufactured and marketed by the Company. Typically, when the equipment portion of the system is shipped, title to the equipment remains with the Company. Subsequently, the total cost of this equipment is realized through ongoing sales of disposable products to the customer, and accordingly is amortized and recorded as a charge to operations over the life of the equipment, generally using an asset life of three to five years. RESEARCH AND DEVELOPMENT: Research and development costs are expensed as incurred. INCOME TAXES: The Company accounts for income taxes using the liability method. The liability method provides that deferred tax assets and liabilities are recorded based on the differences between the tax bases of assets and liabilities and their carrying amounts for financial reporting purposes ("temporary differences") using enacted tax rates in effect in the years in which the differences are expected to reverse. Temporary differences relate primarily to the allowance for doubtful accounts, obsolete inventory allowances, and accruals for vacation, product liability and warranty costs. 14 NET INCOME (LOSS) PER SHARE: In February 1997, the Financial Accounting Standards Board issued Statement No. 128, a new standard for computing and presenting earnings per share. As required, the Company adopted this new standard in the fourth quarter of 1997. Net income (loss) per share for all periods presented have been computed by dividing net income (loss) by the weighted average number of common shares outstanding ("basic EPS") and by the weighted average number of common and common equivalent shares outstanding ("diluted EPS"). Common equivalent shares relate to stock options and stock warrants when their effect is not antidilutive. For all periods presented, the weighted average common and common equivalent shares outstanding are as follows:
FOR THE YEARS ENDED DECEMBER 31, 1997 1996 1995 - ----------------------------------------------------------------------------------- Weighted average common shares outstanding 7,921,000 7,767,000 7,046,000 Common equivalent shares outstanding: Option equivalents 68,000 -- 262,000 Warrant equivalents 1,000 -- 45,000 ----------------------------------------- Weighted average common and common equivalent shares outstanding 7,990,000 7,767,000 7,353,000 ----------------------------------------- -----------------------------------------
FOREIGN CURRENCY TRANSLATION: All assets and liabilities of the Company's international subsidiaries are translated to U.S. dollars at year-end exchange rates, while elements of the statement of operations are translated at average exchange rates in effect during the year. Translation adjustments arising from the use of differing exchange rates are included in cumulative translation adjustments in shareholders' equity. USE OF 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. The most significant areas which require the use of management's estimates relate to the determination of the allowances for doubtful accounts receivable and obsolete inventories, the need for a valuation allowance on deferred tax assets and the determination related to the probability of the patent contingency matter. 2. BALANCE SHEET INFORMATION: The following provides additional information concerning selected balance sheet accounts as of December 31, 1997 and 1996:
1997 1996 - ---------------------------------------------------------------------------- Accounts receivable, net: Accounts receivable $ 8,611,000 $ 7,418,000 Allowance for doubtful accounts (334,000) (120,000) --------------------------- $ 8,277,000 $ 7,298,000 --------------------------- --------------------------- Inventories: Raw materials $ 3,758,000 $ 3,424,000 Work-in-progress 2,189,000 2,343,000 Finished goods 4,687,000 3,709,000 --------------------------- $10,634,000 $ 9,476,000 --------------------------- --------------------------- Property, plant and equipment, net: Land $ 1,409,000 $ -- Building 7,413,000 557,000 Machinery and equipment 5,181,000 3,324,000 Office and laboratory equipment 3,448,000 2,430,000 Molds, tooling and dies 3,011,000 2,183,000 Leasehold improvements 829,000 786,000 Equipment placed with customers 1,494,000 -- --------------------------- 22,785,000 9,280,000 Accumulated depreciation and amortization (6,096,000) (4,472,000) --------------------------- $16,689,000 $ 4,808,000 --------------------------- --------------------------- Accrued expenses: Payroll $ 150,000 $ 472,000 Vacation 319,000 288,000 Commissions 290,000 447,000 Income taxes 709,000 616,000 Real estate taxes 355,000 -- Other 1,235,000 1,268,000 --------------------------- $ 3,058,000 $ 3,091,000 --------------------------- ---------------------------
3. SHAREHOLDERS' EQUITY: SERIAL PREFERRED STOCK: The Company's Second Restated Articles of Incorporation, as amended, provide for 2,000,000 shares of preferred stock, par value $.01 per share, issuable in series ("Serial Preferred Stock"). The Board of Directors is empowered to authorize the issuance and establish the terms of any shares of the Serial Preferred Stock without shareholder approval. In 1996, the Board of Directors authorized 200,000 shares for issuance as Series A Junior Preferred Stock under the Shareholder Rights Plan. STOCK INCENTIVE PLAN: The Company's 1991 Stock Incentive Plan ("Plan") provides for granting to eligible employees and certain other individuals nonqualified and incentive options. The Company has reserved 1,050,000 shares of common stock for issuance under the Plan. At December 31, 1997 there were 20,000 shares remaining for grant under the Plan. In December 1997, the Company's Board of Directors authorized, subject to shareholder approval, an additional 450,000 shares of common stock to be reserved for issuance under the Plan. Also, in December 1997, the Company's Board of Directors authorized 50,000 stock option grants under the Plan, subject to shareholder approval of the increase in shares reserved under the Plan. Options granted under the Plan are generally exercisable beginning one year from the date of grant in cumulative yearly amounts of 25% of the shares under option and expire, if not exercised, five to ten years after the date of grant. Pursuant to the terms of the Plan, optionees may use cash, tender previously owned shares, or be credited for a portion of the shares exercised to reimburse the Company for the cost of excercising the options and the taxes due on 15 the recognized gain. The shares tendered from the optionee or credited at time of exercise are at the fair market value of the stock on the transaction date. No common shares were credited to optionees to satisfy such obligations in 1997. In 1996, 19,000 common shares valued at $278,000 and, in 1995, 33,000 shares valued at $486,000 were credited the optionees at the exercise date to satisfy such obligations. Upon the occurrence of a change of control (as defined), all outstanding options become immediately exercisable in full and all restrictions with respect to outstanding restricted stock awards immediately lapse. The Plan also provides for stock bonuses and awards of restricted shares of the Company's common stock to eligible recipients. Restricted shares awarded may not be sold, assigned, or otherwise transferred by the recipient until the shares awarded become free of restrictions on transferability. All shares still subject to restrictions will be forfeited and returned to the Plan if affiliation with the Company terminates. Plan administrators may waive or accelerate the lapsing of restrictions. There were no stock bonuses and no restricted shares issued under the Plan for the years ended December 31, 1997, 1996 and 1995. A summary of option transactions under the Plan for 1997, 1996 and 1995 follows:
WEIGHTED AVERAGE OPTION EXERCISE PRICE RANGE SHARES PRICE PER SHARE PER SHARE - ------------------------------------------------------------------------------------ Balances, December 31, 1994 570,000 $6.65 $1.00 - $9.94 Options granted 42,000 $10.63 $8.38 - $12.63 Options exercised (104,000) $3.20 $1.00 - $9.88 Options cancelled (3,000) $9.88 $9.88 -------- Balances, December 31, 1995 505,000 $7.67 $1.00 - $12.63 Options granted 309,000 $12.32 $10.88 - $14.75 Options exercised (58,000) $3.58 $1.00 - $12.00 Options cancelled (113,000) $11.99 $9.88 - $12.00 -------- Balances, December 31, 1996 643,000 $9.51 $2.00 - $14.75 Options granted 286,000 $8.28 $7.00 - $12.00 Options exercised (168,000) $5.81 $2.00 - $9.94 Options cancelled (77,000) $11.16 $6.38 - $14.00 -------- Balances, December 31, 1997 684,000 $9.72 $5.13 - $14.75 -------- --------
The following table summarizes information about stock options outstanding and exercisable at December 31, 1997:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE - ----------------------------------------------------------------------------------- WEIGHTED- AVG. WEIGHTED- WEIGHTED- RANGE OF REMAINING AVG. AVG. EXERCISE NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE PRICES OUTSTANDING LIFE PRICE EXERCISABLE PRICE - ----------------------------------------------------------------------------------- $5.13 - $7.00 29,000 2.0 years $6.72 19,000 $6.57 $7.13 182,000 9.9 years $7.13 -- -- $7.63 - $10.00 222,000 3.1 years $9.74 114,000 $9.70 $10.13 - $14.75 251,000 3.4 years $11.94 56,000 $12.00 ------- ------- 684,000 5.0 years $9.72 189,000 $10.08 ------- ------- ------- -------
1995 NON-EMPLOYEE DIRECTOR PLAN: In 1995, the Company's Board of Directors authorized, and in 1996, the Company's shareholders approved, a reserve of 250,000 shares of the Company's common stock for issuance to Non-Employee Directors of the Company, pursuant to the 1995 Non-Employee Director Plan (the "1995 Director Plan"). Options granted under the 1995 Director Plan vest on a cumulative basis, with one third exercisable as of the date of grant and the remainder becoming exercisable in equal installments on each of the first and second anniversaries of the date of grant. Each option expires and is no longer exercisable on the date ten years from its date of grant. Options to purchase 42,000 shares at $13.38 and 10,500 shares at $12.25 per share were granted during 1995 and 1996, respectively. At December 31, 1997, there were 197,500 options available for grant under the 1995 Director Plan. The following table summarizes information about stock options outstanding and exercisable at December 31, 1997:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE - ----------------------------------------------------------------------------------- WEIGHTED- AVG. WEIGHTED- WEIGHTED- RANGE OF REMAINING AVG. AVG. EXERCISE NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE PRICES OUTSTANDING LIFE PRICE EXERCISABLE PRICE - ----------------------------------------------------------------------------------- $12.25-$13.38 52,500 7.7 years $13.15 49,000 $13.21
ACCOUNTING FOR STOCK-BASED COMPENSATION: The Company adopted Financial Accounting Standards Board Statement No. 123, "Accounting for Stock-Based Compensation", in 1996. The Company has continued to measure compensation cost for its stock-based compensation plans using the intrinsic value-based method of accounting and, therefore, the new standard has had no effect on the Company's operating results. Had the Company used the fair value-based method of accounting for its 1991 Stock Incentive Plan and 1995 Non-Employee Director Plan beginning with options granted in 1995 and charged this compensation cost along with the value of the shares granted through the Employee Stock Purchase Plan against income, over the plans' vesting periods, based on the fair value of options at the date of grant, net income (loss) and diluted earnings (loss) per share for 1997, 1996 and 1995 would have been as follows:
1997 1996 1995 - ---------------------------------------------------------------------------------- Net income (loss) As reported $1,327,000 $(567,000) $3,296,000 Pro forma $1,011,000 $(845,000) $3,117,000 Diluted earnings (loss) per share As reported $ 0.17 $ (0.07) $ 0.45 Pro forma $ 0.13 $ (0.11) $ 0.42
The pro forma information above includes stock options granted and stock purchased under the Employee Stock Purchase Plan in 1995, 1996 and 1997. The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model for the 1991 Stock Incentive Plan and the 1995 Non-Employee Director Plan. The assumptions for 1997, 1996 and 1995 were as follows: 16
1997 1996 1995 - ------------------------------------------------------------------------------------ 1991 1995 1991 1995 1991 1995 INCENTIVE DIRECTOR INCENTIVE DIRECTOR INCENTIVE DIRECTOR PLAN PLAN PLAN PLAN PLAN PLAN - ------------------------------------------------------------------------------------ Risk-free interest rates 5.8%-6.6% 6.2% 5.2%-6.8% 6.2% 6.2%-7.8% 6.6% Expected life 4.3-8 years 8 years 4.3 years 8 years 4.3 years 8 years Expected volatility 50% 50% 50% 50% 50% 50% Expected dividends 0% 0% 0% 0% 0% 0%
WARRANTS: In connection with the completion of its initial public offering of common shares in 1992, the Company granted to the representatives of the underwriters warrants for 90,000 shares of common stock at an exercise price of $6.60 per share. During 1997 and 1996, the Company issued 5,000 and 85,000 shares of common stock, respectively, pursuant to the exercise of these warrants. At December 31, 1997, there are no outstanding warrants. EMPLOYEE STOCK PURCHASE PLAN: The AVECOR Cardiovascular Inc. Employee Stock Purchase Plan ("Stock Purchase Plan"), which is available to substantially all employees, enables eligible employees to contribute up to 10% of their wages toward quarterly purchases of the Company's common stock at 85% of market value on the first or last day of each calendar quarter, whichever had the lower stock price. The Company has reserved 100,000 shares of common stock for issuance under the Stock Purchase Plan. Employees purchased 34,000 shares at an average price of $7.72 per share in 1997, 23,000 shares at an average price of $11.00 per share in 1996, and 18,000 shares at an average price of $10.17 per share in 1995. In 1997, the Company's Board of Directors authorized, subject to shareholder approval, an additional 125,000 shares of common stock to be reserved for issuance under the Stock Purchase Plan. At December 31, 1997, there were no shares of common stock available for purchase under this plan. SHAREHOLDER RIGHTS PLAN: In June 1996, the Company adopted a shareholder rights plan, pursuant to which the Company declared a dividend distribution of one Preferred Share Purchase Right on each share of the Company's Common Stock outstanding on August 2, 1996. Each Right entitles the holder to buy one-thousandth of a share of the Company's Series A Junior Preferred Stock, or a combination of securities and assets of equivalent value, at an exercise price of $80.00, subject to adjustment. The description and terms of the Rights are set forth in a Rights Agreement dated June 26, 1996, between the Company and Norwest Bank Minnesota, N.A., as Rights Agent. 4. LONG-TERM DEBT: In January 1997, the Company purchased a new corporate headquarters and manufacturing facility for $9,650,000 and consolidated its former four separate U.S. facilities. In connection with this purchase, the Company entered into a $5,167,000 bank note payable agreement in January 1997 and, in addition, utilizing restricted cash and investments, funded the remaining cost of the new building. The bank note payable agreement bears interest at 8.11% and requires monthly principal payments of $21,531, plus interest, through January 2002 with the remaining principal and interest due February 2002. The bank note payable is collateralized by the new corporate headquarters and manufacturing facility and, among other things, requires the Company to meet certain ratios related to leverage, debt service and cash flow. Additionally, the bank note payable agreement prohibits the Company from distributing dividends to its shareholders. The Company believes the fair value of this debt approximates its carrying value at December 31, 1997. At December 31, 1997, remaining principal payments on the bank note payable are as follows:
YEAR ENDING DECEMBER 31 - ------------------------------------------------------------------------- 1998 $ 258,000 1999 258,000 2000 258,000 2001 258,000 2002 3,920,000 ---------- $4,952,000 ---------- ----------
5. COMMITMENTS LEASES: In 1996 and years prior, the Company leased all of its facilities and certain equipment pursuant to operating leases. The leases for the Company's United States operating facilities expired in December 1996, at which time the Company occupied its new corporate headquarters. The Company's facility near Glasgow, Scotland is leased for a period of ten years ending in October 2003. This lease agreement provides for adjustment of minimum rentals based upon market rates in 1998 and requires minimum monthly rental payments plus real estate taxes and applicable common facility operating expenses. Rent expense, including allocated real estate taxes and operating expenses, under all rental agreements was $325,000, $725,000 and $596,000 for the years ended December 31, 1997, 1996 and 1995, respectively. The following is a schedule of future minimum lease payments pursuant to the terms of the non-cancellable leases for the Glasgow, Scotland facility described above:
YEAR ENDING DECEMBER 31 - ------------------------------------------------------------------------- 1998 $147,000 1999 147,000 2000 147,000 2001 147,000 2002 147,000 2003 112,000 -------- $847,000 -------- --------
ROYALTY AGREEMENTS: SILICONE PRODUCTS -- In connection with the Company's June 1991 acquisition of the Surgical Division of SCIMED Life Systems, Inc. (the Predecessor Business), the Company entered into a royalty agreement with SCIMED. The agreement required the Company to make payments to SCIMED primarily based on net sales (as defined), through June 1996, of products previously manufactured by the Predecessor Business as of the acquisition date. The Company incurred royalties of $95,000 and $178,000 for the years ended December 31, 1996 and 1995, respectively, under this agreement. 17 The agreement also provides for royalty payments should the Company develop and sell new products (new generation products) using certain technology embodied in product models developed by the Predecessor Business. This element of the agreement expires in June 2001. The Company has not paid or incurred any such royalties through December 31, 1997. AFFINITY BLOOD PUMP -- The Company also entered into a royalty agreement in connection with the Company's acquisition of an exclusive license to market the Affinity blood pump. This agreement requires the Company to make payments based on net sales of the pump chamber (the disposable portion of the Affinity blood pump system) and net profits of the pump console (the equipment portion of the Affinity blood pump system) through August 2002. The term of the agreement may be extended by the Company until the expiration of the last-to-expire of the patents covered by this agreement or the useful life of the know-how (as defined) licensed, whichever is longer. Under the terms of the royalty agreement, the Company must pay minimum royalties each year. The Company's royalties incurred of $55,000 for the year ended December 31, 1997 exceeded the minimum royalty related to the first year of the royalty agreement. BIO-PASSIVE SURFACE -- The Company also has use of an exclusive license allowing it to apply a bio-passive surface to its products. The agreement requires the Company to make quarterly payments based on a percentage of net sales of products utilizing the bio-passive surface. The Company can retain exclusivity of the license if it pays minimum annual royalties. The Company incurred royalties of $35,000 for the year ended December 31, 1997 under this agreement. PRODUCT LIABILITY: The Company is self-insured on product liability claims below a certain dollar limitation and maintains product liability insurance above this limitation per claim and in the aggregate. CONFIDENTIALITY AND NON-COMPETE AGREEMENTS: The Company has entered into confidentiality and non-compete agreements with certain employees. If any of these employees are terminated, the Company is conditionally required to pay the employee 75% of his or her base salary, as defined, during the non-compete period (one to two years) if the employee remains unemployed during this period. 6. INDUSTRY SEGMENT INFORMATION: Since its inception, the Company has operated in the single industry segment of developing, manufacturing and marketing medical devices. The Company distributes its products through its direct sales force and independent sales representatives in the United States, Canada, the United Kingdom and France. Additionally, the Company distributes its products through foreign independent distributors, primarily in Europe and Asia, who then market the products directly to medical institutions. During 1997, the Company terminated agreements with its last remaining domestic distributor and its only Canadian distributor. A direct sales force now serves the markets formerly assigned to these distributors. Management does not believe the Company is significantly dependent upon any one distributor for the ultimate sale of products to medical institutions. Sales to distributors accounting for 10% or more of the Company's net sales were as follows:
1997 1996 1995 - -------------------------------------------------------------------------------- Distributor #1 (1) (1) $3,503,000
(1) Accounted for less than 10% of the Company's net sales. Total export sales from the U.S. to unaffiliated entities (primarily to Europe and payable in U.S. dollars) were $4,952,000, $4,912,000 and $3,480,000, respectively, for the years ended December 31, 1997, 1996 and 1995. At December 31, 1997 and 1996, consolidated accounts receivable include $4,366,000 and $3,738,000, respectively, due from customers located outside of the U.S.
YEAR ENDED DECEMBER 31 - ---------------------------------------------------------------------------------- AVECOR AVECOR CARDIOVASCULAR CARDIOVASCULAR INC. LTD. CONSOLIDATED - ----------------------------------------------------------------------------------- 1997 Sales to unaffiliated customers $32,634,000 $14,230,000 $46,864,000 Operating income 1,640,000 320,000 1,960,000 Identifiable assets 36,705,000 6,054,000 42,759,000 1996 Sales to unaffiliated customers 31,290,000 13,111,000 44,401,000 Operating income (loss) (1,738,000) 412,000 (1,326,000) Identifiable assets 30,699,000 6,462,000 37,161,000 1995 Sales to unaffiliated customers 22,638,000 10,702,000 33,340,000 Operating income 2,806,000 684,000 3,490,000 Identifiable assets 27,902,000 5,617,000 33,519,000
During the years ended December 31, 1997, 1996, and 1995, AVECOR Cardiovascular Ltd. made capital expenditures of approximately $393,000, $146,000 and $57,000, respectively. In June 1997, the Financial Accounting Standards Board issued Statement 131, "Disclosures About Segments of an Enterprise and Related Information," a new standard of reporting information about operating or business segments in financial statements. The new standard will be effective for the Company's annual financial statements in 1998. Although the Company has not specifically evaluated what impact, if any, this new standard will have on the Company's current reporting of operating and business segments, the Company believes it will continue reporting as one operating and business segment. 7. RETIREMENT SAVINGS PLAN: The AVECOR Cardiovascular Inc. Retirement Savings Plan (the "Savings Plan") is a profit sharing plan which provides for voluntary pre-tax employee contributions and discretionary employer matching and profit sharing contributions and is intended to satisfy the requirements of Section 401(k) of the Internal Revenue Code. Generally, all employees of the Company who are over 21 years of age and who have completed one year of service with the Company are eligible to participate in the Savings Plan. The Company did not make any contributions to the Savings Plan in 1997, and 18 made contributions of $23,000 and $10,000 to the Savings Plan related to 1996 and 1995, respectively. 8. INCOME TAXES: The components of the Company's income tax provision (benefit) are as follows:
YEAR ENDED DECEMBER 31 1997 1996 1995 - --------------------------------------------------------------------------------- Current U.S. federal $585,000 $484,000 $875,000 U.S. state 15,000 57,000 5,000 International 223,000 292,000 270,000 Deferred (78,000) (867,000) (370,000) --------------------------------------------- $745,000 $ (34,000) $780,000 --------------------------------------------- ---------------------------------------------
The variance of the 1997 and 1996 effective tax rate from the U.S. statutory tax rate was primarily due to losses incurred by the Company's French subsidiary for which no tax benefit has been recorded because of the uncertainty of their realization, offset by the generation of research and experimentation credits. The variance of the 1995 effective tax rate from the U.S. statutory tax rate was primarily due to utilization of $1,730,000 of net operating loss carryforwards ("NOLs") and $26,000 of state research and experimentation credits. Components of the Company's deferred tax assets and liabilities are as follows:
DECEMBER 31 1997 1996 - --------------------------------------------------------------------------- Deferred tax assets: Patent settlement $ -- $ 418,000 Research and experimentation credits 881,000 560,000 French subsidiary NOL carryforwards 226,000 119,000 AMT carryforwards 195,000 -- Other, primarily certain accrued expenses 239,000 296,000 Valuation allowance (226,000) (119,000) ------------------------- 1,315,000 1,274,000 Deferred tax liabilities: Depreciation -- (37,000) ------------------------- Net deferred tax assets $1,315,000 $1,237,000 ------------------------- -------------------------
The Company has established a valuation allowance to offset its deferred tax asset related to its French subsidiary's NOL carryforwards due to the uncertainty of their realization. The NOL carryforwards expire from 2000 to 2002. The Company expects its future taxable income will be sufficient to realize its other deferred tax assets, therefore there is no valuation allowance offsetting them. Available research and experimentation credits at December 31, 1997, represent federal and state amounts of approximately $632,000 and $249,000, respectively, with expiration dates ranging from 2007 to 2012. The Company's AMT credit carryforwards do not expire. Domestic and international components of income (loss) before income taxes are as follows:
YEAR ENDED DECEMBER 31 1997 1996 1995 - ---------------------------------------------------------------------------------- AVECOR Cardiovascular Inc. $1,663,000 $(1,088,000) $3,351,000 AVECOR Cardiovascular Ltd. 409,000 487,000 725,000 ---------------------------------------------- $2,072,000 $ (601,000) $4,076,000 ---------------------------------------------- ----------------------------------------------
Undistributed earnings of the Company's foreign subsidiary are indefinitely reinvested in foreign operations. Accordingly, no provision has been made for income taxes that might be payable upon remittance. 9. PATENT MATTERS: In March 1997, the Company filed suit in U.S. District Court for the District of Minnesota, seeking to invalidate a newly issued U.S. patent held by a competing manufacturer of blood oxygenators and other medical devices, and requesting a determination that the Company's Affinity oxygenator does not infringe the competitor's patent. The Company filed suit in response to a December 1996 letter from the competitor, alleging that the Affinity oxygenator infringes certain claims under the competitor's patent, and requesting discussion regarding a possible license agreement. The Company reviewed the subject patent and concluded, based on an opinion from its patent counsel, that none of the claims in the patent are infringed by the Affinity oxygenator, and that the patent is, in any event, invalid. On October 6, 1997, the Magistrate Judge of the United States District Court vacated a previous order and granted a stay in the proceedings, including the suspension of discovery, pending the outcome of the competitor's request for re-issuance of the aforementioned patent. The expense and effort potentially required to bring this action, as well as the outcome of any counterclaim successfully brought against the Company by the competitor, could have a material adverse effect on the Company's business, financial condition and results of operations. In 1996, the Company reached an agreement with COBE Laboratories Inc. (COBE) to settle COBE's patent suit against the Company. The terms of the settlement with COBE provided for the Company to make net payments totaling $2,200,000. Two net payments of $1,100,000 were made in August 1996 and August 1997, respectively. The net settlement costs of $2,200,000 and the associated legal costs were recognized as a charge to operations in 1996. 10. QUARTERLY DATA (UNAUDITED): Quarterly net sales, gross profit, net income (loss) and net income (loss) per share data are presented on page 20. 11. NEW ACCOUNTING STANDARD: In June 1997, the Financial Accounting Standards Board issued Statement 130, "Reporting Comprehensive Income," a new standard requiring the reporting and display of "comprehensive income" (defined as the change in equity of a business enterprise during a period from sources other than those resulting from investments by owners and distributors to owners) and its components in a full set of general purpose financial statements. The new standard will be effective for the Company's annual financial statements in 1998. The Company's cumulative translation adjustment is considered a component of "comprehensive income," however the Company has not evaluated what other components of its changes in equity would be components of "comprehensive income." 19 REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and Board of Directors of AVECOR Cardiovascular Inc.: We have audited the accompanying consolidated balance sheets of AVECOR Cardiovascular Inc. as of December 31, 1997 and 1996, and the related consolidated statements of operations, changes in shareholders' equity and cash flows for each of the three years in the 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 consolidated financial position of AVECOR Cardiovascular Inc. as of December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. /s/ Coopers & Lybrand L.L.P MINNEAPOLIS, MINNESOTA MARCH 16, 1998 QUARTERLY OPERATING DATA The following table sets forth certain unaudited operating data for the four quarters in 1997 and 1996. In the opinion of management, the data include all adjustments, consisting of only normal recurring adjustments, necessary to present fairly the information set forth therein.
FIRST SECOND THIRD FOURTH (UNAUDITED) QUARTER QUARTER QUARTER QUARTER - ------------------------------------------------------------------------------------ (IN THOUSANDS, EXCEPT PER SHARE DATA) 1997 Net sales $12,043 $11,961 $11,273 $11,587 Gross profit 4,983 5,061 4,785 4,461 Net income 387 403 365 172 Diluted earnings per share $.05 $.05 $.05 $.02 1996 Net sales $10,293 $11,145 $11,315 $11,648 Gross profit 4,342 4,702 4,534 4,837 Net income (loss) 211 (1,876) 628 470 Diluted earnings (loss) per share $.03 $(.24) $.08 $.06
The summation of quarterly diluted earnings (loss) per share may not equate to the calculation for the year as quarterly calculations are prepared on a discrete basis. All earnings per share calculations are presented per the definition of "diluted earnings per share" from FASB Statement No. 128. COMMON STOCK INFORMATION The Company's Common Stock is currently traded on the Nasdaq National Market under the symbol AVEC. The quotations set forth below reflect the high and low closing prices for the Company's Common Stock on the Nasdaq National Market for each of the identified periods, excluding adjustments for retail mark-ups, mark-downs or commissions.
1997 HIGH LOW - ----------------------------------------------------------------------------------- First Quarter $13 3/8 $10 3/4 Second Quarter 12 1/4 8 3/4 Third Quarter 12 3/8 9 7/8 Fourth Quarter 12 6 1996 HIGH LOW - ------------------------------------------------------------------------------------ First Quarter $17 1/4 $10 1/2 Second Quarter 14 1/8 12 Third Quarter 15 7/8 11 5/8 Fourth Quarter 14 7/8 10 7/8
SHAREHOLDERS. As of March 1, 1998, there were approximately 300 holders of record and approximately 3,800 beneficial shareholders of the Company's Common Stock. DIVIDENDS. The Company has not declared or paid any cash dividends on its Common Stock since its inception, and the Board of Directors currently intends to retain all earnings for use in the business for the foreseeable future. Under terms of the note payable used to finance the Company's U.S. manufacturing facility in January 1997, no dividends may be paid to shareholders while the note payable is outstanding. The bank note payable will fully mature in February 2002. 20
CORPORATE INFORMATION AVECOR CARDIOVASCULAR, INC. CORPORATE HEADQUARTERS AVECOR Cardiovascular Inc. 7611 Northland Drive Minneapolis, Minnesota 55428 (612) 391-9000 FORM 10-K Shareholders may receive a copy of the Company's Annual Report on Form 10-K, as filed with the Securities and Exchange Commission, without charge by writing to: Investor Relations AVECOR Cardiovascular Inc. 7611 Northland Drive Minneapolis, Minnesota 55428 STOCK TRANSFER AGENT For change of name, address, or to replace lost stock certificates, contact: Norwest Bank Minnesota, N.A. P.O. Box 738 161 N. Concord Exchange South St. Paul, Minnesota 55075-0738 (612) 450-4064 INDEPENDENT ACCOUNTANTS Coopers & Lybrand L.L.P. Minneapolis, Minnesota GENERAL COUNSEL Oppenheimer Wolff & Donnelly LLP Minneapolis, Minnesota INVESTOR RELATIONS COUNSEL Swenson NHB Investor Relations Minneapolis, Minnesota (612) 371-0000 ANNUAL MEETING The Annual Meeting of Shareholders will be held on Thursday, May 7, 1998, at 3:30 p.m. at the Minneapolis Marriott City Center Hotel, 30 South Seventh Street, Minneapolis, Minnesota. DIRECTORS ANTHONY BADOLATO Chairman of the Board and Chief Executive Officer EDWARD E. STRICKLAND Independent Financial Consultant DAVID W. STASSEN President Sulzer Spine-Tech, Inc. J. GORDON WRIGHT Founder and Managing Director Caledonian Medical Limited OFFICERS ANTHONY BADOLATO Chairman of the Board and Chief Executive Officer WILLIAM S. HAWORTH Vice President - Engineering GREGORY J. MELSEN Vice President - Finance, Treasurer and Chief Financial Officer ALLAN R. SECK Vice President - Marketing and Sales
AVECOR CARDIOVASCULAR INC. 7611 NORTHLAND DRIVE MINNEAPOLIS, MINNESOTA 55428 (612) 391-9000 EX-23.1 4 EXHIBIT 23.1 CONSENT OF COOPERS & LYBRAND EXHIBIT 23.1 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statements of AVECOR Cardiovascular Inc. on Form S-8 (File Nos. 33-55184, 33-55166, 33-90460, 333-29143 and 333-29145) of our reports dated March 16, 1998, or our audits of the consolidated financial statements and financial statement schedule of AVECOR Cardiovascular Inc. as of December 31, 1997 and 1996, and for the years ended December 31, 1997, 1996 and 1995, which reports are included or incorporated by reference in this Annual Report on Form 10-K. We also consent to the reference to our firm as "experts" in the above-mentioned registration statements on Form S-8. /s/ COOPERS & LYBRAND L.L.P. COOPERS & LYBRAND L.L.P. Minneapolis, Minnesota March 30, 1998 EX-27.1 5 EXHIBIT 27.1 FDS
5 12-MOS DEC-31-1997 JAN-01-1997 DEC-31-1997 1,215,000 3,727,000 8,611,000 (334,000) 10,634,000 25,498,000 22,785,000 (6,096,000) 42,759,000 5,294,000 4,694,000 80,000 0 0 32,538,000 42,759,000 46,864,000 46,864,000 27,574,000 27,574,000 0 0 383,000 2,072,000 745,000 1,327,000 0 0 0 1,327,000 .17 .17
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