-----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, Qkr7axdZQetWw4oAZVFRcwFLLQwL/sRmIpHgNJoeIShPJQz0n5qD+cAKLDRf/yCY E8wt65hy7awhBr5tzDplBg== 0000950137-00-001153.txt : 20000323 0000950137-00-001153.hdr.sgml : 20000323 ACCESSION NUMBER: 0000950137-00-001153 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 19991231 FILED AS OF DATE: 20000322 FILER: COMPANY DATA: COMPANY CONFORMED NAME: ILLINOIS SUPERCONDUCTOR CORPORATION CENTRAL INDEX KEY: 0000888693 STANDARD INDUSTRIAL CLASSIFICATION: INSTRUMENTS FOR MEAS & TESTING OF ELECTRICITY & ELEC SIGNALS [3825] IRS NUMBER: 363688459 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-22302 FILM NUMBER: 575521 BUSINESS ADDRESS: STREET 1: 451 KINGSTON CT CITY: MOUNT PROSPECT STATE: IL ZIP: 60056 BUSINESS PHONE: 8473919400 MAIL ADDRESS: STREET 1: 451 KINGSTON COURT CITY: MT PROSPECT STATE: IL ZIP: 60056 10-K 1 FORM 10-K 1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 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, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________ to __________ COMMISSION FILE NUMBER 0-22302 ILLINOIS SUPERCONDUCTOR CORPORATION (Exact name of registrant as specified in its charter) DELAWARE 36-3688459 (State or other jurisdiction (I.R.S. Employer of incorporation) Identification No.) 451 KINGSTON COURT MT. PROSPECT, ILLINOIS 60056 (847) 391-9400 (Address and telephone number of principal executive offices) Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: Title of each class --------------------------- Common Stock, par value $0.001 per share Preferred Stock Purchase Rights Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- Indicate by check mark if disclosure of delinquent filers pursuant to 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. [ ] On January 31, 2000, 21,374,027 shares of the registrant's Common Stock were outstanding. The aggregate market value on January 31, 2000 of the registrant's Common Stock held by non-affiliates of the registrant was $48,612,837. DOCUMENTS INCORPORATED BY REFERENCE Certain portions of the registrant's definitive proxy statement for the annual meeting of stockholders to be held on May 17, 2000 are incorporated by reference in Part III of this Form 10-K (the "2000 Proxy Statement"). ================================================================================ 2 TABLE OF CONTENTS PART I Item 1. Business...........................................................................................1 Item 2. Properties........................................................................................19 Item 3. Legal Proceedings.................................................................................19 Item 4. Submission of Matters to a Vote of Security Holders...............................................22 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.............................22 Item 6. Selected Financial Data...........................................................................26 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.............27 Item 7a. Quantitative and Qualitative Disclosures About Market Risk........................................30 Item 8. Financial Statements and Supplementary Data.......................................................31 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure..............57 PART III Item 10. Directors and Executive Officers of the Registrant................................................58 Item 11. Executive Compensation............................................................................58 Item 12. Security Ownership of Certain Beneficial Owners and Management....................................58 Item 13. Certain Relationships and Related Transactions....................................................58 PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K...................................59
3 A NOTE CONCERNING FORWARD-LOOKING STATEMENTS Because Illinois Superconductor Corporation wants to provide investors with more meaningful and useful information, this Annual Report on Form 10-K ("Form 10-K") contains, and incorporates by reference, certain "forward-looking statements" (as such term is defined in Section 21E of the Securities Exchange Act of 1934, as amended) that reflect the Company's current expectations regarding the future results of operations, performance and achievements of the Company. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The Company has tried, wherever possible, to identify these forward-looking statements by using words such as "anticipates," "believes," "estimates," "expects," "plans," "intends" and similar expressions. These statements reflect the Company's current beliefs and are based on information currently available to it. Accordingly, these statements are subject to certain risks, uncertainties and contingencies, which could cause the Company's actual results, performance or achievements to differ materially from those expressed in, or implied by, such statements. These factors include, among others, the following: the Company's history of net losses and the lack of assurance that the Company's earnings will be sufficient to cover fixed charges in the future; the degree to which the Company is leveraged and the restrictions imposed on the Company under its existing debt instruments, which may adversely affect the Company's ability to finance its future operations, to compete effectively against better capitalized competitors and to withstand downturns in its business or the economy generally; the Company's inability to honor redemption rights of holders of its debt instruments in the event of the Company's failure to comply with its obligations under those debt instruments, including its obligation to increase its authorized capital stock at its annual meeting of stockholders to be held prior to June 30, 2000; the fact that the Company's Common Stock is not currently listed on a national securities exchange or the Nasdaq Stock Market, which may have a material adverse effect on the liquidity of the Common Stock and the Company's ability to obtain additional funding as needed; demand for, and acceptance of, the Company's products; continued downward pressure on the prices charged for the Company's products due to competition of rival manufacturers of filters for the wireless telecommunications market; the timing and receipt of customer orders; the Company's ability to attract and retain key personnel; and the effects of legal proceedings and other factors described in this Form 10-K, including those described under the heading "Risk Factors," or in other filings of the Company with the Securities and Exchange Commission. The Company undertakes no obligation to release publicly the results of any revisions to any such forward-looking statements that may be made to reflect events or circumstances after the date of this Form 10-K or to reflect the occurrence of unanticipated events. 4 PART I ITEM 1. BUSINESS GENERAL The Company uses its patented and proprietary high temperature superconductor ("HTS") materials, radio frequency ("RF") filter designs and cryogenic technologies to develop, manufacture and market high performance products designed to enhance the quality, capacity, coverage and flexibility of cellular, Personal Communications Services ("PCS") and other wireless telecommunications services. Superconductor materials, when cooled below a critical temperature, are able to transmit an electric current with either no or minimal loss of energy. Because of this minimal energy loss, superconductors are attractive for a wide range of commercial applications. RF filters refine the radio signals by passing radio waves through a series of resonators (poles), which allow certain frequencies to pass while rejecting other frequencies. The more poles in the RF filter, the more effective the RF filter. Each pole, however, has electrical resistance which causes the loss (insertion loss) of desired radio waves. Therefore, the more poles in a conventional RF filter, the greater the insertion loss. The advantage of using superconductors in RF filters is that more poles can be added without significant increases in insertion loss. Adding superconductors does not, however, change the fundamental fact that filter performance depends upon the number of poles. The Company's highest performing RF filters have more than 30 poles, which the Company believes is significantly greater than any other commercially available filter. Filters can be designed with a variety of structures including stripline, microstrip, cavity, dielectric, and waveguide. The Company is able to produce RF filters using any of these technologies, but has primarily focused on cavity filters because of their high performance and tuning flexibility. The Company uses its proprietary thick-film superconducting technology for its RF filters. The Company believes that relative to other superconducting materials technologies, thick-film provides for higher RF filter performance and lower distortion levels. The Company also believes that its thick-film superconductor technology is unique in its ability to handle high-powered transmit applications while maintaining very low levels of intermodulation distortion. In addition, thick-film technology does not require "clean" rooms for manufacturing, which reduces the cycle time and cost of production. Superconductors become superconducting at temperatures of roughly -200(Degree) C. These temperature levels can be maintained using commercially available mechanical cooling systems. The Company has developed cryogenic packaging systems for its RF filters which are highly reliable over longer durations and minimize operating costs. The Company was founded in 1989 by ARCH Development Corporation, an affiliate of the University of Chicago, to commercialize superconductor technologies initially developed by Argonne National Laboratory. The Company was incorporated in Illinois on October 18, 1989 and reincorporated in Delaware on September 24, 1993. The Company's facilities and principal executive offices are located at 451 Kingston Court, Mt. Prospect, Illinois 60056 and its telephone number is (847) 391-9400. BUSINESS STRATEGY The Company's objective is to be the global leader in supplying high performance RF filter products to the growing wireless telecommunications market. Key elements of the Company's strategy include the following: - Offering the Highest Performance RF Filter Systems in the Industry. The Company's proprietary thick-film and RF filter design technology permits the Company to build RF filters with a high level of adjacent band interference rejection coupled with a low level of desired signal loss. The Company believes that its success will depend upon maintaining its technological leadership. - Supplying Price Competitive Products. The Company has been able to continually reduce its product cost, which has permitted the Company to more competitively price its products. Currently, the price for the Company's superconducting filters is approaching that of conventional filters. The Company's lowest price product currently sells for less than $14,000 per cell site. The Company believes that with superior 5 performance and competitive pricing it can become the dominant RF filter manufacturer in the world. In 1998, the Company reduced product costs by 40%, and in 1999 the Company reduced product costs by an additional 30%. The Company believes that it can continue to achieve further cost reductions in the coming years due to the design and development of new products. - Providing Solutions for Different Market Needs. The Company has successfully expanded its product line in response to a wide variety of customer needs in a cost-effective manner. The Company recently announced the introduction of an expanded family of superconductor-based receiver front-end products based upon its proprietary ATP(TM)Technology, which combines the industry's superconductor-based filter with a unique failure-proof feature that ensures continued operation even in the event of a loss of electric power. This allows the fastest total-system footprint of any superconducting filter solution on the market. The Company has achieved this broad product portfolio through flexible designs which can quickly be adapted to different customer needs. By addressing the varied needs of the market at a reasonable price, the Company aims to provide real value to its customers. - Superior Customer Support. The Company strives to exceed its customers' expectations for quality and responsiveness by minimizing service interruptions. Because of its superior quality and customer support, the Company was awarded Motorola's superior quality award in 1998. - Best in Class Reliability. To insure maximum customer retention, the Company aims to provide the highest level of reliability to its customers. To achieve this, the Company introduced its proprietary ATP(TM) technology which insures that its RF filters continue to operate even when there is a cooling system or power failure. In addition, the Company has chosen its cooler vendor based on superior reliability and offers such features as redundant alarms and remote diagnostics. - Focusing on Fast Growing Commercial Markets. The Company has focused on the fast growing wireless telecommunications market and has deferred at this time pursuing other commercial applications of its proprietary technology. This focus has minimized overhead costs and allowed the Company to be first to market with new RF products and a broader product portfolio than its competitors. - Building Long-Term Relationships with Customers. Becoming the preferred RF filter vendor with customers will allow the Company to focus on expanding its business with new customers and in new markets. To date, the Company has established strong relationships with seven of the largest wireless operators in the United States. These customers have placed repeated orders in multiple markets. The Company has received orders from multiple wireless telecommunications service providers located in the United States, Canada and Asia, including many of the largest wireless operators in the United States. The Company's RF filters are now installed in over 300 cell sites in market areas across the United States. The Company is an approved vendor for one of the world's largest cellular system equipment manufacturers and is pursuing similar relationships with other OEMs. Being an approved vendor allows cellular and PCS service providers in the U.S. and abroad to purchase the Company's products directly from the OEM, for use in both new and existing cell sites. RECENT DEVELOPMENTS On November 5, 1999, the Company entered into and closed a letter agreement (the "Letter Agreement") with Elliott Associates, L.P. ("Elliott Associates"), Westgate International, L.P. and Alexander Finance, L.P. (collectively, the "Investors") in connection with a financing transaction by which the Company issued to the Investors for $1 million the Company's senior convertible notes plus warrants for 400,000 shares of the Company's Common Stock. The Investors also received, under the Letter Agreement, the right, but not the obligation, to invest, until August 5, 2000, up to an additional $5 million on the same terms, of which they invested $1 million in December, 1999. 2 6 The effect of the Letter Agreement and related matters may have been an acquisition of control of the Company by the Investors and/or their designees to the Company's board of directors, from the board of directors of the Company as previously constituted. The Letter Agreement granted the Investors the right to designate for selection as members of the Company's board of directors up to two-thirds of the Company's board of directors, and affords the Investors the right to accelerate certain convertible securities held by the Investors in the event that, with certain exceptions, and after specified periods, such selections are not appointed or elected as directors. On November 5, 1999, the board of directors accepted the resignations of board members Messrs. Robert Mitchum and Terry Parker, expanded the board to six members and, effective November 8, 1999, appointed Messrs. Mark Brodsky and Samuel Perlman of Elliott Associates and Dr. George Calhoun of Davinci Solutions, LLC, each a designee of the Investors, to the Company's board of directors. Mr. Howard Hoffmann, who was designated by the Investors in July 1998 to be a director of the Company, has served on the board since that time and continues to serve as a director. On November 24, 1999, the Company announced the appointments of Dr. Calhoun to the position of Chief Executive Officer, Mr. Dennis M. Craig to the position of President and Mr. Brodsky to the position of Chairman of the Board. These appointments filled the vacancy created by the departure of Dr. Ted Laves, who resigned. The terms of the Letter Agreement are described below in greater detail under "Risk Factors - Substantial Number of Shares Eligible for Future Issuance on Conversion of Notes and Warrant and Option Exercise; Low Conversion and Exercise Prices; Dilution." RISK FACTORS The following factors, in addition to the other information contained elsewhere herein, should be considered carefully in evaluating the Company and its business. Uncertain Market Acceptance of Superconducting Telecommunications Products The Company's RF filter products, which are based on the Company's HTS technology, have not been sold in very large quantities and a sufficient market may not develop for the Company's products. The Company's customers establish demanding specifications for performance and reliability. The Company's RF filter products may not continue to meet product performance and reliability criteria set by cellular and PCS service providers. Also, the Company's products may not operate reliably on a long-term basis, the Company may be unable to manufacture adequate quantities of any products it develops at commercially acceptable costs or on a timely basis, or the Company's current or future products may not achieve market acceptance. The Company has experienced, and may continue to experience, quarterly fluctuations in its results of operations as its RF filter products attempt to gain market acceptance while being subject to the lengthy purchase processes of customers. Failure to successfully develop, manufacture and commercialize products on a timely and cost-effective basis will have a material adverse effect on the Company's business, operating results and financial condition. Limited Operating History; History of Losses; and Uncertainty of Financial Results The Company was founded in October 1989 and through 1996 was engaged principally in research and development ("R&D"), product testing, manufacturing, marketing and sales activities. The Company has only recently begun to generate significant revenues from the sale of its RF filter products. Prior to the commencement of these sales, the majority of the Company's revenues were derived from R&D contracts, primarily from the U.S. government. The Company does not expect revenues to increase dramatically until it ships a significantly larger amount of its RF products. Accordingly, the Company has only a limited operating history upon which an evaluation of the Company and its prospects can be based. The Company must be considered in light of the risks, expenses and difficulties frequently encountered by companies in their early stages of product commercialization. 3 7 The Company has incurred substantial net losses in each year since its inception. The Company expects to continue to incur operating losses through at least the end of 2000 as it continues to devote significant financial resources to its product development, manufacturing, marketing and sales efforts. Even if the Company is able to overcome the significant remaining manufacturing and marketing hurdles necessary to sell large quantities of its RF filter products, the Company may never achieve a profitable level of operations or, if profitability is achieved, it may not be sustained. The Company's customers are highly concentrated. The loss of an individual customer may have a material adverse effect on the Company's business. The wireless telecommunications market is currently experiencing an increasing rate of consolidation among the largest wireless operators, which may cause a significant disruption and/or delay in the sales of the Company's products. In order to continue to grow revenues, the Company may be required to further reduce the prices of its products. In the event of further price reductions, the Company may not be able to reduce product costs sufficiently to achieve acceptable product margins. Future Capital Needs and Delisting of Common Stock To date, the Company has financed its operations primarily through public and private equity and debt financings. The Company believes that it will require substantial additional funds during the second quarter of 2000 to carry on its operations, including the financing of its product development, manufacturing, marketing and sales activities. In addition, the Company's outstanding debt instruments contain certain restrictions which may adversely impair the Company's ability to obtain additional financing. See "Substantial Leverage; Restrictions Contained in Debt Instruments" below. If additional funds are raised by issuing other equity or convertible debt securities, further dilution to existing or future stockholders is likely to result. If adequate funds are not available on acceptable terms when needed, the Company would be required to substantially delay, scale-back or eliminate the manufacturing, marketing or sales of one or more of its products and research and development programs, or may be required to obtain funds through arrangements with collaborative partners or others that may require the Company to relinquish rights to certain of its technologies, product candidates or potential products that the Company would not otherwise relinquish. This would materially adversely affect the Company's business, operating results and financial condition. Inadequate funding also could impair the Company's ability to compete in the marketplace. The Company regularly examines opportunities to expand its technology base and product line through means such as licenses, joint ventures and acquisitions of assets or ongoing businesses, and may issue securities in connection with such transactions. However, no commitments to enter into any such transactions have been made at this time, and any such discussions may not result in any such transaction being concluded. In addition, the Company currently has no unreserved authorized shares of its Common Stock, $0.001 par value per share (the "Common Stock"), available for future issuance in connection with financings. The Company plans to request that its stockholders approve a substantial increase in the number of authorized shares at the next annual meeting of the Company's stockholders, scheduled to be held on May 17, 2000. Failure to obtain this approval would limit the Company's ability to raise sufficient funds to support its business plans. In addition, if the stockholders fail to approve the increase, the Investors would have the right to have their outstanding Notes (as defined below under the caption "Substantial Number of Shares Eligible for Future Issuance on Conversion of Notes and Warrant and Option Exercise; Low Conversion and Exercise Prices; Dilution") redeemed for an amount equal to the greater of (i) the outstanding principal amount at the time such Notes are tendered to the Company (the "Tender Date"), plus accrued and unpaid cash interest on the tendered Notes (at February 29, 2000, such interest would have been $589,981) or (ii) the average closing bid price per share of the Common Stock for the 5 trading days preceding the Tender Date multiplied by the number of shares the Investors would have received if they had been able to convert the outstanding aggregate principal amount of such Notes into shares of Common stock at a conversion price of $0.25 as provided under the terms of the Notes (at February 29, 2000, such amount would have been $772,438,511). The Company, at this time, does not have sufficient liquid assets to comply with such a redemption demand. See "- Substantial Number of Shares Eligible for Future Issuance on Conversion of Notes and Warrant and Option Exercise; Low Conversion and Exercise Prices; Dilution." The Common Stock is not listed on the Nasdaq Stock Market. Instead, the Common Stock trades in the over-the-counter market and is quoted on the National Association of Securities Dealers, Inc. electronic bulletin board. These 4 8 sources do not provide the same type of trading information as Nasdaq, and the over-the-counter market does not provide the same liquidity for trading as Nasdaq. This could be having a material adverse effect on the liquidity of the Common Stock and on the Company's ability to obtain additional funding. The Company has applied to have its Common Stock listed on the Nasdaq SmallCap Market. There can be no assurance, however, whether or when the application will be approved and the Common Stock listed. Substantial Leverage; Restrictions Contained in Debt Instruments The Company is substantially leveraged. The degree to which the Company is leveraged may adversely affect the Company's ability to finance its future operations, to compete effectively against better capitalized competitors and to withstand downturns in its business or the economy generally. Although the Company's outstanding Notes (as defined below under "Substantial Number of Shares Eligible for Future Sale; Dilution") currently permit, subject to certain restrictions, the Company to pay accrued interest on such securities in shares of Common Stock, the Company may not be permitted to do so in the future. If the Company is no longer permitted to pay accrued interest on the Notes in shares of Common Stock, the Company may not be successful in generating sufficient cash flows from its operations or raising additional equity or debt financing sufficient to enable it to pay such interest in cash. Payments due on long-term debt exceed $2 million in 2001 and $13.3 million in 2002. See Item 8, "Financial Statements and Supplementary Data," at Note 7. The Company's outstanding Notes also contain restrictions that may adversely affect the Company's ability to raise additional equity or debt financing. Under the Notes, the Company is not permitted, without the prior approval of the holders of the Notes, (i) to incur any additional indebtedness (other than pursuant to a working capital line of credit in an amount not to exceed $1 million or to trade creditors in the ordinary course of business) or to create any lien, pledge, or encumbrance, subject to certain exceptions, on any assets of the Company, (ii) for so long as a significant portion of the Notes remain outstanding, to engage in certain sale or merger transactions, or to engage in certain other transactions which require the approval of the Company's stockholders, or (iii) to redeem, purchase or otherwise acquire any equity or debt securities of the Company which are junior in rights or preferences to the Notes, or to pay any dividend (other than in shares of Common Stock) with respect to such securities. In addition, in the event that the Company fails to achieve break-even or positive operating income during the second quarter of 2001, the Notes may become immediately due and payable unless the holders thereof agree to modify or waive such provision. Under the Letter Agreement, the Investors have the right to designate up to two-thirds of the Company's board of directors. Volatility of Common Stock Price The market price of the Common Stock, like that of many other high-technology companies, has fluctuated significantly and is likely to continue to fluctuate in the future. Since January 1, 1999 and through March 13, 2000, the closing price of the Common Stock has ranged from a low of $0.3438 per share to a high of $29.375 per share. See Item 5. "Market for Registrant's Common Equity and Related Stockholder Matters." Announcements by the Company or others regarding the receipt of customer orders, quarterly variations in operating results, additional equity or debt financings, changes in recommendations of securities analysts, results of customer field trials, scientific discoveries, technological innovations, litigation, product developments, patent or proprietary rights, government regulation and general market conditions may have a significant impact on the market price of the Common Stock. In addition, fluctuations in the price of the Common Stock could affect the Company's ability to have the Common Stock accepted for listing on a securities market or exchange. Limited Experience in Manufacturing, Marketing and Sales For the Company to be financially successful, it must manufacture its products in substantial quantities, at acceptable costs and on a timely basis. Although the Company to date has produced limited quantities of its products for commercial installations and for use in development and customer field trial programs, production of large quantities at competitive costs presents a number of technological and engineering challenges for the Company. The Company may be unable to manufacture such products in sufficient volume. The Company has limited experience in manufacturing, and substantial costs and expenses may be incurred in connection with attempts to manufacture larger 5 9 quantities of the Company's products. The Company may be unable to make the transition to large scale commercial production successfully. The Company's marketing and sales experience to date is very limited. The Company will be required to further develop its marketing and sales force in order to effectively demonstrate the advantages of its products over more traditional products, as well as competitive superconductive products. The Company may also elect to enter into agreements or relationships with third parties regarding the commercialization or marketing of its products. If the Company enters into such agreements or relationships, it will be substantially dependent upon the efforts of others in deriving commercial benefits from its products. The Company may be unable to establish adequate sales and distribution capabilities, it may be unable to enter into marketing agreements or relationships with third parties on financially acceptable terms, and any third parties with whom it enters into such arrangements may not be successful in marketing the Company's products. To date, the Company's products have been installed in over 300 cell sites with a wide geographic dispersion. Although the Company's products have not experienced any significant reliability problems to date, the Company's products may develop quality problems in the future. Repeated or widespread quality problems could result in significant warranty expenses and/or the loss of customer confidence. The occurrence of such quality problems could have a material adverse effect on the Company's business, operating results and financial condition. Competition The wireless telecommunications equipment market is very competitive. The Company's products compete directly with products which embody existing and future competing commercial technologies. In particular, in cellular and PCS telecommunications applications, the Company competes with conventional RF component manufacturers whose products are currently in use by the Company's potential customers. Many of these companies have substantially greater financial resources, larger R&D staffs and greater manufacturing and marketing capabilities than the Company. Other emerging wireless technologies, including "smart antennas" and tower mounted amplifiers, may also provide protection from RF interference and offer enhanced range to cellular and PCS service providers at lower prices and/or superior performance, and may therefore compete with the Company's products. High performance RF filters may not become a preferred technology to address the needs of cellular and PCS service providers. Failure of the Company's products to improve performance sufficiently, reliably, or at an acceptable price or to achieve commercial acceptance or otherwise compete with conventional and new technologies will have a material adverse effect on the Company's business, operating results and financial condition. Although the market for superconductive electronics currently is small and in the early stages of development, the Company believes it will become intensely competitive, especially if products with significant market potential are successfully developed. In addition, if the superconducting industry develops, additional competitors with significantly greater resources are likely to enter the field. In order to compete successfully, the Company must continue to develop and maintain technologically advanced products, reduce production costs, attract and retain highly qualified personnel, obtain additional patent or other protection for its technology and products and manufacture and market its products, either alone or with third parties. The Company may be unable to achieve these objectives. Failure to achieve these objectives would have a material adverse effect on the Company's business, operating results and financial condition. During the fourth quarter of 1998, the Company implemented a new pricing strategy pursuant to which it reduced the prices for all of its products. Although sales of the Company's products increased significantly during the fourth quarter of 1998, such sales growth to date has not been consistently sustained over subsequent periods. Similarly, the Company may not be able to continue to reduce product costs sufficiently to achieve and maintain acceptable product margins. Management of Growth Any growth the Company experiences could cause a significant strain on its management, operational, financial and other resources. The Company's ability to manage its growth effectively will require it to implement and improve 6 10 its operational, financial, manufacturing and management information systems and expand, train, manage and motivate its employees. These demands may require the addition of new management personnel and the development of additional expertise by management. Any increase in resources devoted to product development and marketing and sales efforts could have an adverse effect on the Company's financial performance in the next several fiscal quarters. If the Company were to receive substantial orders, the Company may have to expand its current facility, which could cause an additional strain on the Company's management personnel and development resources. The failure of the Company's management team to effectively manage growth could have a material adverse effect on the Company's business, operating results and financial condition. Rapid Technological Change; Possible Pursuit of Other Market Opportunities The field of superconductivity is characterized by rapidly advancing technology. The success of the Company will depend in large part upon its ability to keep pace with advancing superconducting technology, high performance RF filter design and efficient, low cost cryogenic technologies. Rapid changes have occurred, and are likely to continue to occur, in the development of superconducting materials and processes. The Company will have to continue to improve its ability to fabricate thick-film HTS devices, design high performance RF filters and efficient cryogenic subsystems and produce significant quantities of products based on these improvements. The Company's development efforts may be rendered obsolete by the adoption of alternative solutions to current wireless operator problems or by technological advances made by others. In addition, other materials or processes, including other superconducting materials or fabrication processes, may prove more advantageous for the commercialization of high performance wireless products than the materials and processes selected by the Company. Because HTS product development is a new and emerging field, there may in the future be new opportunities that are more attractive than those initially identified by the Company for its targeted markets. As a result, the Company may elect in the future to commit its resources to such other potentially more attractive market opportunities. Such election may require the Company to limit or abandon its current focus on developing, manufacturing, marketing and selling HTS products for cellular, PCS and other telecommunications markets. The risks associated with other markets may be different from the risks associated with the cellular, PCS and other wireless telecommunications markets. Focus on Wireless Telecommunications Market; Current and Future Competitive Technologies The Company has selected the wireless telecommunications market, in particular the cellular and PCS markets, as the first principal target market for its superconductor-based products. The devotion of substantial resources to the wireless telecommunications market makes the Company vulnerable to adverse changes in this market. Adverse developments in the wireless telecommunications market, which could come from a variety of sources, including future competition, new technologies or regulatory decisions, could affect the competitive position of wireless systems. Any adverse developments in the wireless telecommunications market during the foreseeable future would have a material adverse effect on the Company's business, operating results and financial condition. The Federal Communications Commission ("FCC") has adopted rules that provide preferential licensing treatment for parties that develop new communications services and technologies. These developments and further technological advances may make available other alternatives to cellular or PCS service, thereby creating additional sources of competition. Competition to cellular or PCS technologies could adversely affect the market for the Company's products, or result in changes in the Company's development and manufacturing programs. Dependence on a Limited Number of Customers To date, the Company's marketing and sales efforts have focused on major cellular service providers in retrofit applications and, to a lesser extent, on PCS operators and cellular and PCS original equipment manufacturers. Sales to three of the Company's customers accounted for over 65% of the Company's total revenues for 1999. See "Sales and Marketing." The Company expects that if its RF filter products achieve market acceptance, a limited number of wireless service providers and OEMs will account for a substantial portion of its revenue during any period. Sales of many of the Company's RF filter products depend in significant part upon the decision of prospective customers and 7 11 current customers to adopt and expand their use of the Company's products. Wireless service providers and the Company's other customers are significantly larger than, and are able to exert a high degree of influence over, the Company. Customers' orders are affected by a variety of factors such as new product introductions, regulatory approvals, end user demand for wireless services, customer budgeting cycles, inventory levels, customer integration requirements, competitive conditions and general economic conditions. The loss of one or more of the Company's customers or the failure to attract new customers would have a material adverse effect on the Company's business, operating results and financial condition. Lengthy Sales Cycles Wireless service providers, wireless equipment OEMs and the Company's other customers are significantly larger than, and are able to exert a high degree of influence over, the Company. Prior to selling its products to these customers, the Company must generally undergo lengthy approval and purchase processes. Technical and business evaluation by potential customers can take up to a year or more for products based on new technologies such as HTS. The length of the approval process is affected by a number of factors, including, among others, the complexity of the product involved, priorities of the customers, budgets and regulatory issues affecting customers. The Company may not obtain the necessary approvals or ensuing sales of such products may not occur. The length of the Company's customers' approval process or delays could have a material adverse effect on the Company's business, operating results and financial condition. Dependence on Limited Sources of Supply Certain parts and components used in the Company's RF filter products, including substrates, vacuum components, and cryogenic refrigerators, are only available from a limited number of sources. The Company's reliance on these limited source suppliers exposes the Company to certain risks and uncertainties, including the possibility of a shortage or discontinuation of certain key components and reduced control over delivery schedules, manufacturing capabilities, quality and costs. Any reduced availability of such parts or components when required could materially impair the Company's ability to manufacture and deliver its products on a timely basis and result in the cancellation of orders, which could have material adverse effect on the Company's business, operating results and financial condition. In addition, the purchase of certain key components involves long lead times and, in the event of unanticipated increases in demand for the Company's products, the Company may be unable to manufacture products in a quantity sufficient to meet its customers' demand in any particular period. The Company has no guaranteed supply arrangements with its limited source suppliers, does not maintain an extensive inventory of parts or components, and customarily purchases parts and components pursuant to purchase orders placed from time to time in the ordinary course of business. To satisfy customer requirements, the Company may be required to stock certain long lead time parts in anticipation of future orders. The failure of such orders to materialize as forecasted could limit resources available for other important purposes or accelerate the Company's requirement for additional funds. In addition, such excess inventory could become obsolete which would adversely affect the Company's financial performance. Business disruption, production shortfalls or financial difficulties of a limited source supplier could materially and adversely effect the Company by increasing product costs or reducing or eliminating the availability of such parts or components. In such events, the inability of the Company to develop alternative sources of supply quickly and on a cost-effective basis could materially impair the Company's ability to manufacture and deliver its products on a timely basis and could have a material adverse effect on its business, operating results and financial condition. Intellectual Property and Patents The Company's success will depend in part on its ability to obtain patent protection for its products and processes, to preserve its trade secrets and to operate without infringing upon the patent or other proprietary rights of others and without breaching or otherwise losing rights in the technology licenses upon which any Company products are based. As of December 31, 1999, the Company has been issued 29 U.S. patents, has filed and is actively pursuing applications for 8 other U.S. patents, and is the licensee of 6 U.S. patents and patent applications held by others. One of the 8 12 Company's patents is jointly owned with Lucent Technologies, Inc. The Company believes that, since the discovery of HTS materials in 1986, a large number of patent applications have been filed worldwide and many patents have been granted in the U.S. relating to HTS materials. The claims in those patents often appear to overlap and there are interference proceedings pending in the United States Patent and Trademark Office (not currently involving the Company) regarding rights to inventions claimed in some of the HTS materials patent applications. The Company also believes there are a large number of patents and patent applications covering RF filter products and other products and technologies that the Company is pursuing. Accordingly, the patent positions of companies using HTS materials technologies and RF technologies, including the Company, are uncertain and involve complex legal and factual questions. The patent applications filed by the Company or by the Company's licensors may not result in issued patents or the scope and breadth of any claims allowed in any patents issued to the Company or its licensors may not exclude competitors or provide competitive advantages to the Company. In addition, patents issued to the Company or its licensors may not be held valid if subsequently challenged or others may claim rights in the patents and other proprietary technologies owned or licensed by the Company. Others may have developed or may in the future develop similar products or technologies without violating any of the Company's proprietary rights. Furthermore, the Company's loss of any license to technology that it now has or acquires in the future may have a material adverse effect on the Company's business, operating results and financial condition. Some of the patents and patent applications owned or licensed by the Company are subject to non-exclusive, royalty-free licenses held by various governmental units. These licenses permit these U.S. government units to select vendors other than the Company to produce products for the U.S. Government which would otherwise infringe the Company's patent rights which are subject to the royalty-free licenses. In addition, the U.S. Government has the right to require the Company to grant licenses (including exclusive licenses) under such patents and patent applications or other inventions to third parties in certain instances. Patent applications in the U.S. are currently maintained in secrecy until patents are issued. In foreign countries, this secrecy is maintained for a period of time after filing. Accordingly, publication of discoveries in the scientific literature or of patents themselves or laying open of patent applications in foreign countries tends to lag behind actual discoveries and filing of related patent applications. Due to this factor and the large number of patents and patent applications related to HTS materials, RF technologies and other products and technologies that the Company is pursuing, comprehensive patent searches and analyses associated with HTS materials, RF technologies and other products and technologies that the Company is pursuing are often impractical or not cost-effective. As a result, the Company's patent and literature searches cannot fully evaluate the patentability of the claims in the Company's patent applications or whether materials or processes used by the Company for its planned products infringe or will infringe upon existing technologies described in U.S. patents or may infringe upon claims in patent applications made available in the future. Because of the volume of patents issued and patent applications filed relating to HTS materials, RF technologies and other products and technologies that the Company is pursuing, the Company believes there is a significant risk that current and potential competitors and other third-parties have filed or will file patent applications for, or have obtained or will obtain, patents or other proprietary rights relating to materials, products or processes used or proposed to be used by the Company. In any such case, to avoid infringement, the Company would have to either license such technologies or design around any such patents. The Company may be unable to obtain licenses to such technologies or, if obtainable, such licenses may not be available on terms acceptable to the Company or the Company may be unable to successfully design around these third-party patents. Participation in litigation or patent office proceedings in the U.S. or other countries, which could result in substantial cost to and diversion of effort by the Company, may be necessary to enforce patents issued or licensed to the Company, to defend the Company against infringement claims made by others or to determine the ownership, scope or validity of the proprietary rights of the Company and others. The parties to such litigation may be larger, better capitalized than the Company and better able to support the cost of litigation. An adverse outcome in any such proceedings could subject the Company to significant liabilities to third parties, require the Company to seek licenses from third parties and/or require the Company to cease using certain technologies, any of which could have a material adverse effect on the Company's business, operating results and financial condition. 9 13 The Company believes that a number of patent applications, including applications filed by International Business Machines Corporation, Lucent Technologies, Inc., and other potential competitors of the Company are pending that may cover the useful compositions and uses of certain HTS materials including yttrium barium copper oxide ("YBCO"), the principal HTS material used by the Company in its present and currently proposed products. Therefore, there is a substantial risk that one or more third parties may be granted patents covering YBCO and other HTS materials and their uses, in which case the Company could not use these materials without an appropriate license. As with other patents, the Company has no assurance that it will be able to obtain licenses to any such patents for YBCO or other HTS materials or their uses or that such licenses would be available on commercially reasonable terms. Any of these problems would have a material adverse effect on the Company's business, operating results and financial condition. Government Regulations Although the Company believes that its wireless telecommunications products themselves would not be subject to licensing by, or approval requirements of, the FCC, the operation of base stations is subject to FCC licensing and the radio equipment into which the Company's products would be incorporated is subject to FCC approval. Base stations and the equipment marketed for use therein must meet specified technical standards. The Company's ability to sell its wireless telecommunications products is dependent on the ability of wireless base station equipment manufacturers and wireless base station operators to obtain and retain the necessary FCC approvals and licenses. In order for them to be acceptable to base station equipment manufacturers and to base station operators, the characteristics, quality and reliability of the Company's base station products must enable them to meet FCC technical standards. Any failure to meet such standards or delays by base station equipment manufacturers and wireless base station operators in obtaining the necessary approvals or licenses could have a material adverse effect on the Company's business, operating results and financial condition. In addition, HTS RF filters are on the U.S. Department of Commerce's export regulation list. Therefore, exportation of such RF filters to certain countries may be restricted or subject to export licenses. The Company is subject to governmental labor, safety and discrimination laws and regulations with substantial penalties for violations. In addition, employees and others may bring suit against the Company for perceived violations of such laws and regulations. Defense against such complaints could result in significant legal costs for the Company. Although the Company endeavors to comply with all applicable laws and regulations, it may be the subject of complaints in the future which could have material adverse effect on the Company's business, operating results and financial condition. The Company uses certain hazardous materials in its research, development and manufacturing operations. As a result, the Company is subject to stringent federal, state and local regulations governing the storage, use and disposal of such materials. It is possible that current or future laws and regulations could require the Company to make substantial expenditures for preventive or remedial action, reduction of chemical exposure, or waste treatment or disposal. The Company believes it is in material compliance with all environmental regulations and to date the Company has not had to incur significant expenditures for preventive or remedial action with respect to the use of hazardous materials. However, the operations, business or assets of the Company could be materially and adversely affected by the interpretation and enforcement of current or future environmental laws and regulations. In addition, although the Company believes that its safety procedures for handling and disposing of such materials comply with the standards prescribed by state and federal regulations, there is the risk of accidental contamination or injury from these materials. In the event of an accident, the Company could be held liable for any damages that result. Furthermore, the use and disposal of hazardous materials involves the risk that the Company could incur substantial expenditures for such preventive or remedial actions. The liability in the event of an accident or the costs of such actions could exceed the Company's resources or otherwise have a material adverse effect on the Company's business, results of operations and financial condition. The Company carries property and workman's compensation insurances in full force and effect through nationally known carriers which include pollution cleanup or removal and medical claims for industrial incidents. Dependence on Key Personnel The Company's success will depend in large part upon its ability to attract and retain highly qualified management, 10 14 administrative, manufacturing, marketing, sales and R&D personnel. Due to the specialized nature of the Company's business, it may be difficult to locate and hire qualified personnel. The loss of services of one of its executive officers or other key personnel, or the failure of the Company to attract and retain other executive officers or key personnel, could have a material adverse effect on the Company's business, operating results and financial condition. Business Interruptions and Dependence on a Single U.S. Facility The Company's primary operations, including engineering, manufacturing, research, distribution and general administration, are housed in a single facility in Mt. Prospect, Illinois. Any material disruption in the Company's operations, whether due to fire, flooding, natural disaster, power loss or otherwise, would have a material adverse effect on the Company's business, operating results and financial condition. The Company carries property insurance in full force and effect through a nationally known carrier which extends coverage for most material disruptions. Substantial Number of Shares Eligible for Future Issuance on Conversion of Notes and Warrant and Option Exercise; Low Conversion and Exercise Prices; Dilution Under the Letter Agreement dated November 5, 1999 and related agreements between the Company and the Investors, the Company received $2.0 million from the Investors during the fourth quarter of 1999 in exchange for: - - $2.0 million in aggregate principal amount of senior convertible notes, bearing annual interest at 10% payable in kind or, at the Company's option (or if the Company does not meet certain requirements commencing November 5, 2001), in cash, which notes (the "New Notes") are convertible, based on their principal amount plus accrued interest to the extent such interest is payable in kind, into Common Stock at a conversion price of $0.25 per share, and mature on January 2, 2001; - - five-year warrants (the "New Warrants") exercisable for an aggregate of 800,000 shares of Common Stock at an exercise price of $0.25 per share; and - - the right, but not the obligation, to invest up to an additional $4.0 million during the nine months following execution of the Letter Agreement on the same terms as the Investors' acquisition of the New Notes and New Warrants. Except for terms specified in the Letter Agreement, the New Notes and New Warrants have the same terms as the notes and warrants issued by the Company in March 1999. The Letter Agreement also reduced to $0.25 per share the conversion and exercise prices, respectively, of (i) $11.8 million in aggregate principal amount of outstanding senior convertible notes (the "Old Notes" and, together with the New Notes, the "Notes"), and (ii) warrants to acquire 4,834,782 shares (the "Old Warrants" and, together with the New Warrants, the "Warrants") held by the Investors. The Old Notes and Old Warrants originally were issued in May 1998 and March 1999 and, in the case of the Old Warrants, October 1997. As of December 31, 1999, the Company had (i), including the Warrants, outstanding warrants to purchase 6,735,681 shares of Common Stock at a weighted average exercise price of $0.7976 per share and (ii) options to purchase 1,914,847 shares of Common Stock at a weighted average exercise price of $1.83 per share (1,516,566 of which have not yet vested) issued to employees, directors and consultants pursuant to the Company's Amended and Restated 1993 Stock Option Plan, as amended, and individual agreements with management and directors of the Company. In order to attract and retain key personnel, the Company may issue additional securities, including stock options, in connection with its employee benefit plans. During the terms of the Notes and such options and warrants (including the Warrants), the holders thereof are given the opportunity to benefit from a rise in the market price of the Common Stock. The conversion of the Notes into, or the exercise of options and warrants (including the Warrants) for, Common Stock, as well as the sale or issuance by the Company of additional shares of Common Stock and/or rights to purchase 11 15 Common Stock, would likely have an adverse or dilutive effect on the market value of the Common Stock. The Company also may in the future offer equity participation in connection with the obtaining of non-equity financing, such as debt or leasing arrangements accompanied by warrants to purchase equity securities of the Company. This could also have a dilutive effect upon the holders of Common Stock. Anti-Takeover Provisions The Company has certain arrangements which may be deemed to have a potential "anti-takeover" effect in that such provisions may delay, defer or prevent a change of control of the Company. In February 1996, the Board of Directors of the Company (the "Board of Directors") adopted a stockholders rights plan (the "Rights Plan"). By causing substantial dilution to a person or group that attempts to acquire the Company on terms not approved by the Board of Directors, the Series A Rights and Series B Rights of the Rights Plan may interfere with certain acquisitions, including acquisitions that may offer a premium over market price to some or all of the Company's stockholders. Further discussion of the Rights Plan is set forth herein under the heading "Item 5. Market for Registrant's Common Equity and Related Stockholder Matters-Rights Plan." In addition, the Company's Certificate of Incorporation and By-Laws provide that (i) stockholder action may be taken only at stockholders meetings; (ii) the Board of Directors has authority to issue series of the Company's preferred stock with such voting rights and other powers as the Board of Directors may determine; (iii) prior specified notice must be given by a stockholder making nominations to the Board of Directors or raising business matters at stockholders meetings; and (d) the Board of Directors is divided into three classes, each serving for staggered three-year terms. In addition, the Company's outstanding debt instruments contain provisions which may be deemed to have a potential "anti-takeover" effect. The interests of the holders of such debt instruments could conflict with the interests of the Company's stockholders. See "Substantial Leverage; Restrictions Contained in Debt Instruments" above. WIRELESS TELECOMMUNICATIONS INDUSTRY BACKGROUND The wireless telecommunications industry has experienced significant growth, both domestically and internationally, in recent years. This growth appears to be due to the increasing popularity of wireless telecommunications, the entry of new service providers into the market as governments open up new RF spectrum, the continuing decline in the price of service and wireless telephones, and the introduction of new service features. Rapid growth has intensified RF interference while increasing wireless operators' demand for improved system quality, lower capital expenditures per customer, and co-location of multiple antennas with other RF transmitters at a single cell site. In the United States, wireless telecommunications services customers now frequently have a choice of at least four wireless service providers. Digital technologies such as Global System for Mobile Telecommunications ("GSM"), Code Division Multiple Access ("CDMA"), and Time Division Multiple Access ("TDMA") allow operators to offer such advanced features as short message service, fax, three-way conferencing and call waiting. Wireless systems are also marketed as a convenient and economical substitute for regular wireline telephone service. In addition, service providers are also trying to differentiate themselves on the basis of quality, price, coverage, and advanced service features. The rapid growth in competition in wireless telecommunications services is forcing operators to reduce costs and to seek out new cost effective solutions such as high performance filters which can reduce capital costs while increasing network capacity. Already, manufacturers and operators are beginning to plan a new and more advanced form of wireless telecommunications called Third Generation cellular or "3G." 3G is expected to provide full Internet access and video teleconferencing services. The first 3G network is expected to become commercial in Japan in 2001 and in Europe soon thereafter. Industry statistics demonstrate the rapid growth of the wireless telecommunications industry. The Cellular Telecommunications Industry Association ("CTIA") reports that as of June 1998 there were over 60 million wireless customers in the United States. Industry publications, as well as other industry sources, have estimated a total worldwide wireless customer base of approximately 207 million at the end of 1997. Several industry sources have estimated the customer base will exceed 830 million by the end of 2003. The Company anticipates that the need to provide improved service on a cost effective basis in an increasingly congested environment will lead wireless service providers to invest in new infrastructure technologies such as high performance RF filters. 12 16 The rapid growth and increased competition experienced by the wireless telecommunications industry has increased the difficulty of providing quality wireless services. Wireless service providers face the challenge of providing quality services in an environment increasingly characterized by RF interference and congestion. In addition, the rapid rate of growth and community concerns have affected the manner in which service providers locate their base stations. Many communities are objecting to the proliferation of new towers to provide wireless services. Base stations which provide the link between a wireless user and the telecommunications network are being positioned closer together and often in the same location, which results in RF interference problems. There has also been a dramatic proliferation in the use of portable hand held phones which transmit weaker signals than mobile or car-mounted phones. As a result, cellular networks which were laid out based on mobile phone power levels have, in many areas, developed coverage gaps which operators must fill in to satisfy their goals of providing seamless coverage. To lower costs, many cellular and PCS operators are sharing antenna sites with other cellular and PCS operators, and with television stations, paging operators and two-way radio transmitters. Such close proximity of radio transmitters can cause RF interference problems which degrade the quality and capacity of wireless telecommunications systems. Furthermore, in order to compete with these already broadly deployed cellular networks, new PCS service providers need to deploy coverage quickly and with the lowest possible capital investment. Recently, several wireless system operators have sold their antenna towers to third party management companies which then lease space for base stations and their antennas back to the system operator. In addition to managing the tower site for the existing system operator, these management companies lease additional space at the tower site to other wireless providers, including television stations, paging operators and two-way radio transmitters. The Company believes that the activities of these management companies will facilitate an increase in the co-location of multiple wireless providers over time. The Company believes that this trend may lead to an increase in the demand for high performance filters as concerns over RF interference and congestion increase. THE COMPANY'S SOLUTION The Company's products are designed to address the high performance RF front-end needs of domestic and international commercial wireless telecommunication systems by providing the following advantages: - - GREATER NETWORK CAPACITY AND UTILIZATION. The Company's RF front-end products can increase the capacity and utilization of a wireless base station by up to 18%. In some cases, capacity increases because channels which were previously unusable due to interference are recovered. In other cases, system utilization increases because of lower levels of blocked and dropped calls, and increases in the ability of the system to permit weak signals to be processed with acceptable call quality. In CDMA systems, increased capacity frequently results from lowering the system's noise floor. - - REDUCED CDMA CELL SITE BREATHING. Coverage for CDMA digital systems decreases as the number of users increases. To maintain network coverage, an operator can increase the number of cell sites, add radio carriers, or use the Company's high performance RF filters with cooled low noise amplifiers ("LNAs"). - - IMPROVED BASE STATION RANGE. Based upon comparative field trials in multiple rural locations in the United States, and as confirmed by computer propagation models conducted by customers of the Company, the Company's RF front-end systems (high performance filter and cryogenically-cooled LNA) can extend the uplink range of a wireless system by up to 30%. Greater range can reduce a service operator's capital expenditure per customer in lower density areas by filling in coverage gaps in existing systems or by reducing the number of required cell sites for new system deployments. This is true for both analog and digital systems. - - IMPROVED FLEXIBILITY IN LOCATING BASE STATIONS. The Company's RF front-end products can allow wireless telecommunications service providers to co-locate base stations near other RF transmitters. The 13 17 Company's products allow the base station radio to better tolerate RF interference while reducing out-of-band signals that could interfere with other nearby wireless telecommunications operators. - - IMPROVED CALL QUALITY. The Company's RF filter products improve call quality by reducing dropped and blocked calls. During commercial installations and field trials, the Company's RF filter products have frequently demonstrated a 20 to 40 percent reduction in dropped calls caused by out-of-band interference and base station front-end overloading. During these commercial installations and field trials, the Company's RF filter products have also demonstrated a similar reduction in blocked calls experienced in urban cellular locations. The Company's RF filter products also frequently improve audio fidelity by reducing noise and interference. - - SIMPLER TRANSMITTER SYSTEM DESIGNS. The Company believes that its line of RF transmit filters can allow for simpler, less costly transmitters, particularly for digital systems. These RF transmit filters should improve system performance while diminishing system costs. - - IMPROVED DIGITAL SYSTEM CAPACITY. The Company believes that its recently introduced line of transmit combiners allow increased capacity and range in CDMA systems as system loading increases. CDMA systems appear unable to offer multi-carrier systems without the use of a combiner, but traditional combiners reduce the power transmitted from the base station antenna. The Company's filter technology allows operators to use combiners with lower loss of desired signals. PRODUCTS Recently the Company introduced the ATP(TM) Classic, an expansion of its product line offering All Temperature Performance (ATP(TM)). ATP(TM), which was first introduced in late 1998, is a unique and proprietary technology that provides all the benefits of a superconducting filter when the system is operating normally, and continues to provide good quality performance, equivalent to conventional technology, when the product is not cryogenically cool. The ATP(TM) feature essentially eliminates any concerns about loss of cell site operation in the event of power or cooling system failure. In addition, these products resume superconducting performance automatically when power is restored, without the need for any mechanical bypass circuitry or backup filters. This not only means greater peace of mind for the operators when installing ATP(TM), but also means that, for new cell sites, ATP(TM) products can serve as the only front-end filter system, eliminating the cost and space associated with conventional filters bought with the base station equipment. The Company currently offers six basic product lines within two product families to address the needs of cellular and PCS service providers. The SpectrumMaster(R) product family represents a line of superconducting filters designed primarily to improve the RF performance of cellular and PCS systems in high interference environments, including urban areas and those sites near airports. These RF performance improvements serve to maximize the capacity and coverage of existing systems. The RangeMaster(R) product family combines the interference rejection and low insertion loss advantages of a superconducting filter with a cooled low noise amplifier (LNA). Products in the RangeMaster(R) family are designed to serve two principal needs of cellular and PCS operators: (i) range extension for those sites located in rural, suburban or small city environments and (ii) increased capacity for digital cellular and PCS sites located in all areas. Each of the product lines within a family provides different filter performance levels to meet the different needs of system operators. All of the Company's currently offered products can be supplied in domestic and international frequencies for both cellular (800 MHz) and PCS (1900 MHz) applications. The Company has also produced duplexer and combiner products that are offered in a PowerMaster(TM) product family. The PowerMaster(TM) product family incorporates the Company's filter technologies into RF transmitter products. The PowerMaster(TM) duplexer was designed to allow the co-location of multiple wireless systems at a single site. The PowerMaster(TM) combiner was designed to improve the range and capacity of multi-carrier CDMA systems. 14 18 The Company believes that products in its SpectrumMaster(R) family offer the world's highest performance commercial front-end R.F. filters for the wireless telecommunications market. SpectrumMaster(R) improves the RF performance of cellular and PCS systems in high interference environments, including urban areas and those sites near airports. These RF performance improvements allow a service provider to maximize the capacity and coverage of cell sites in its system. SpectrumMaster(R) is available in two models; the Ultra and the Extreme. The SpectrumMaster(R) Ultra is a high performance filter with 16 filter poles for very noisy RF environments. SpectrumMaster(R) Ultra provides superior rejection of unwanted signals over conventional filters, while losing very little of the desired signals and providing an extremely linear filter response for digital CDMA systems. The SpectrumMaster(R) Ultra has been shown in testing to improve the uplink capacity of a cellular CDMA system by lowering the noise floor at the base station receiver and allowing more simultaneous calls to be supported. The SpectrumMaster(R) Extreme has been developed for the even higher performance levels required by third generation (3G) systems. A SpectrumMaster(R) Extreme filter was shipped to Japan for testing with 3G systems under development there. The SpectrumMaster(R) Extreme filter provides an unprecedented 19dB per 100 kHz of rejection from the edge of its passband. The Company sold its first SpectrumMaster(R) product to cellular service providers in the second half of 1996 and sales of SpectrumMaster(R) have continued to grow since then. RangeMaster(R) products combines the interference rejection and low insertion loss advantages of a superconducting filter with a cooled low noise amplifier (LNA). RangeMaster(R) products lower the noise seen by a base station receiver and improve its sensitivity, or ability to hear weaker signals. This enables these products to meet the need of cellular and PCS operators to extend the range of those cell sites that have difficulty in hearing the lower power transmissions of portable phones. RangeMaster(R) products have also been shown to improve the capacity of digital systems, especially those incorporating CDMA. Capacity improvements of 30% to 50% have been recorded for both the uplink (mobile phone to base station path) and downlink (base station to mobile phone path) during testing at PCS frequencies. RangeMaster(R) is available in four models: (i) the ATP(TM) 150 is designed primarily for rural and suburban range extension, (ii) the ATP(TM) Classic provides filter rejection performance, and is intended for either range extension or capacity improvement at higher interference sites, (iii) the RangeMaster(R) Ultra is designed for either range extension or capacity improvement situations at severe interference sites, and the Company believes, provides the best filter performance available commercially in the U.S. today, and (iv) the RangeMaster(R) Extreme is designed for both range and capacity improvements for 3G systems being developed internationally. Several RangeMaster(R) Extreme units have been shipped to OEMs in Japan for evaluation with 3G systems under development there. For the fiscal years ended December 31, 1999, 1998 and 1997, sales to customers within the United States accounted for approximately 93.9%, 93.3% and 84.6% of the Company's revenues. Sales to customers within Japan accounted for most of the balance of the Company's revenues in such fiscal years. TECHNOLOGY The Company possesses proprietary technology in three areas: the design of high performance RF cavity filters, thick-film superconducting materials fabrication and cryogenic packaging. The Company's products are based on its proprietary RF cavity filter designs. The Company believes that cavity filter technology provides superior filter performance with low intermodulation distortion when compared with alternative technologies, such as RF stripline filter technology (which the Company is also capable of using). The Company has been able to use its cavity filter technology to offer filters with over 30 poles. The more poles in a filter, the better its rejection of unwanted signals. The Company believes its products are superior to other RF filters with regard to rejection of unwanted signals. The Company is able to offer RF cavity filters with superior filtering, low loss of unwanted signals, and high power handling because of its proprietary thick-film superconducting fabrication technology. The Company's thick-film fabrication technology allows the Company to utilize a variety of filter technologies including cavity and strip line designs. The Company's superconducting technology is simple and relatively inexpensive to manufacture and offers superconducting yields consistently above 96%. The Company believes the electrical performance of the 15 19 Company's products is superior to any alternative superconducting technology currently available for RF filters. The Company's thick-film superconducting technology can handle up to 70 watts of continuous power at 800 Mhz. High-temperature superconductors become superconducting at -200(Degree) C. This temperature can be attained using widely available mechanical refrigerators. The Company has developed proprietary technologies which provide an efficient, low cost cryogenic package with a long life cycle and minimum power consumption. Together, the Company believes that its technological excellence in filter design, superconducting materials and cryogenic packaging provide it with a unique and well-protected technology advantage over its competitors. SALES AND MARKETING The Company has focused its sales and marketing effort on U.S. wireless service providers for retrofit applications. To date, the Company has sold its products to many of the largest cellular operators in the United States as well as to numerous mid-size and smaller U.S. wireless operators. The Company has also sold or leased filters to two major international operators and has successfully tested its PCS RangeMaster(R) product with two of the largest U.S. PCS operators. The Company has also tested its PowerMasterTM line with two major OEMs and is discussing specifications with others. The Company has been named as an approved vendor to one of the largest OEMs, allowing cellular and PCS operators throughout the world the opportunity to purchase the Company's products directly from the OEM. The Company's marketing and sales personnel work directly with both PCS service providers and PCS OEMs to enhance the probability of sales success in this rapidly growing market. The Company has continued technical discussions with multiple PCS OEM's regarding integrating the Company's RF filter products into such OEM's PCS product line. To date, the Company's PowerMasterTM PCS transmit filter/duplexer has been tested in the laboratories of two PCS equipment OEMs. During 1999, sales to three of the Company's customers, ALLTEL Corporation, Cellular One and Cellular 2000, accounted for approximately 50%, 11% and 7% of the Company's total revenues, respectively. MANUFACTURING The Company's state-of-the-art manufacturing process provides predictable product yields and can be easily expanded to meet increased customer demand. Superconducting component yields are now consistently above 96%, with low scrap levels. Manufacturing costs were reduced by 50% during 1997 due to volume, design and yield efficiencies, and reduced by another 40% in 1998 due to redesign and resourcing efforts, and 30% in 1999. The Company has focused its manufacturing efforts on maintaining control of key technologies while avoiding the cost and complexities of vertical integration. The Company's manufacturing operations consist primarily of the manufacture of superconducting components from raw materials, and the assembly, tuning, testing and quality verification of the Company's products. All of these activities occur at the Company's manufacturing facility in Mt. Prospect, Illinois, which began operations during 1996. The Company believes that the manufacture of its RF filter products requires only moderate capital investments and is scaleable. The Company also believes that capacity can be rapidly expanded to meet growing demand without the need for large, upfront capital investments. The Company purchases all of the components for its filter products, except for superconducting components, from third party suppliers. The Company believes it has access to adequate supplies of these purchased components, most of which are produced according to the Company's proprietary designs and specifications. The Company is using its just-in-time manufacturing capability to maximize quality, insure flexibility, limit management complexity and minimize inventory cost. RESEARCH AND DEVELOPMENT The Company's R&D efforts have been focused on developing and improving RF filter products for wireless telecommunications systems. As a result of such efforts, filter performance has been improved, product size has been reduced, production costs have been lowered, product reliability has been increased, and product packaging 16 20 has been streamlined. The Company expects to continue to invest in R&D to further improve and adapt its filter products to meet and exceed market expectations. The Company also intends to develop related products that are synergistic with its core filter offerings and which utilize the Company's core technical competencies in RF filter design, superconducting materials, and cryogenic cooling systems. The Company's total R&D expenses during 1997, 1998 and 1999 were approximately $4,132,000, $2,935,000 and $1,757,000, respectively. INTELLECTUAL PROPERTY AND PATENTS The Company regards certain elements of its product design, fabrication technology and manufacturing process as proprietary and protects its rights in them through a combination of patents, trade secrets and non-disclosure agreements. The Company also has obtained exclusive and non-exclusive licenses for technology developed with or by its research partners, Argonne National Laboratory ("Argonne") and Northwestern University, and expects to continue to obtain licenses from such research partners and others. The Company believes that its success will depend in part upon the protection of its proprietary information, its patents and licenses of key technologies from third parties, and its ability to operate without infringing on the proprietary rights of others. As of December 31, 1999, the Company has been issued 29 U.S. patents, has filed and is actively pursuing applications for 8 other U.S. patents, and is the licensee of 6 patents and patent applications held by others. Such patents and patent applications relate to various aspects of the Company's superconductor technology, the design of HTS filters, methods for packaging and cooling, and system implementation techniques. One of the Company's patent applications has been filed jointly with Lucent Technologies, Inc. and relates to superconducting filters. Additional inventions are the subject of a group of patent applications currently under preparation. Furthermore, the Company expects to pursue foreign patent rights on certain of its inventions and technologies critical to its products. In 1994, the Company purchased from Ceramic Process Systems two additional patents and the related technical know-how covering a process for producing yttrium barium copper oxide ("YBCO") powder and manufacturing YBCO electrical fibers. In 1994, the Company also purchased technology relating to the fabrication of HTS thick-film components from the University of Birmingham (UK). This thick-film technology complements the Company's existing patented processes for making thick-film superconducting components. Through collaborative relationships with Argonne and Northwestern University, the Company has licensed patents and patent applications issued or filed in the United States and in certain foreign countries arising under or related to such collaborative relationships. These licenses primarily relate to the processing and composition of HTS materials, including the preferential orientation of HTS materials and the processing of YBCO on a variety of metals, as well as design technology for some of the Company's current and proposed products. The Company's licenses from ARCH Development Corporation and Northwestern University continue for the lives of the patent rights licensed thereby, subject to termination on certain events, and permit the Company to retain rights to its patentable improvements to the licensed technology. Certain of the Company's research has been funded in part by Small Business Innovation Research and other government contracts. Although the U.S. Government has or will have certain rights in the technology developed with this funding, the Company does not believe that these rights will have a material impact on the Company's current RF filter products. COMPETITION The market for wireless telecommunications products is very competitive. The Company views its competition as (i) conventional RF filter products, (ii) RF products based on new technologies and (iii) other superconductor-based RF products. The Company's RF filter products compete against conventional RF filter products produced by such companies as Celwave, certain divisions of the Allen Telecom Group, Inc., Filtronic Comtek, Sinclair Radio Labs, Inc., K&L Microwave, Inc., Wacom Technology Corp., EMR Corp. and TX-RX Systems, Inc., among others. 17 21 Although these conventional RF filter products are generally less expensive than the Company's products, the Company believes its RF filter products are superior on a cost/benefit basis. Other competitive RF products based on other technologies may provide competition in the future to the Company's RF filter products. In addition to competitive RF filter products, other companies including, Hazeltine Corp., Metawave Communications Corporation, Allen Telecom Group, Inc., Repeater Technologies, Inc. and Array Com, Inc., among others, are developing products based on "smart antenna," digital signal processing technologies, microcells and repeaters which are also aimed at reducing interference problems or providing range extension by means other than RF filtering. Furthermore, various vendors are offering tower mounted amplifiers ("TMAs") which provide similar range extension benefits to the Company's filters with cooled LNAs. TMAs are generally less expensive than the Company's products but require greater maintenance costs due to their location on top of the operator's antenna tower. Various filter companies appear to be experimenting with cooled dielectric filters or with filters that combine dielectric materials and superconducting technology. K&L Microwave, Inc. has been experimenting with a cooled dielectric filter design. In addition, COM DEV International, Ltd., a Canadian corporation, has published research in which a dielectric material is mounted on a superconducting ground plane. The Company does not believe that either of these efforts currently pose a competitive threat but cannot exclude them as competition to the Company's product lines at some point in the future. Two other companies, Conductus, Inc. and Superconducting Technologies, Inc., are currently marketing superconducting filters to the wireless telecommunications marketplace. In addition, a number of large multinational companies are engaged in R&D programs that could lead to the commercialization of superconducting filters for the wireless telecommunications marketplace. These companies include, among others, E.I. DuPont de Nemours & Co., Fujitsu Corporation, NEC Corporation, Kyocera Corporation, and Matsushita Electric Industrial Co., Ltd. The Company believes that all of these companies are working on RF stripline filters using epitaxial thin-film superconducting technology. None of these filters are expected to be commercially implemented in the near future. The Company believes that RF stripline superconducting filters, while smaller, are technically unable to provide equivalent rejection of unwanted signals, competitively low levels of intermodulation distortion, as large a number of filter poles, or similar levels of power handling. The Company believes that it competes on the basis of product performance, price, breadth of product portfolio, customer support, quality, reliability and focus on the wireless telecommunications market. Many of the Company's competitors have substantially greater financial resources, larger R&D staffs and greater manufacturing and marketing capabilities than the Company. GOVERNMENT REGULATIONS Although the Company believes that its wireless telecommunications products themselves are not licensed or governed by approval requirements of the Federal Communications Commission ("FCC"), the operation of base stations is subject to FCC licensing and the radio equipment into which the Company's products would be incorporated is subject to FCC approval. Base stations and the equipment marketed for use therein must meet specified technical standards. The Company's ability to sell its RF filter products is dependent on the ability of wireless base station equipment manufacturers and of wireless base station operators to obtain and retain the necessary FCC approvals and licenses. In order to be acceptable to base station equipment manufacturers and to base station operators, the characteristics, quality, and reliability of the Company's base station products must enable them to meet FCC technical standards. The Company uses certain hazardous materials in its research, development and manufacturing operations. As a result, the Company is subject to stringent federal, state and local regulations governing the storage, use and disposal of such materials. It is possible that current or future laws and regulations could require the Company to make substantial expenditures for preventive or remedial action, reduction of chemical exposure, or waste treatment or disposal. The Company believes it is in material compliance with all environmental regulations and to date the Company has not had to incur significant expenditures for preventive or remedial action with respect to the use of hazardous materials. 18 22 EMPLOYEES As of January 31, 2000, the Company had a total of 31 employees, ten of whom hold advanced degrees. Of the employees, ten are engaged in manufacturing and production, ten are engaged in research, development and engineering, and 11 are engaged in general management, marketing, sales, finance and administration. The Company also periodically employs a number of consultants and independent contractors. The Company considers its relations with its employees to be satisfactory. ITEM 2. PROPERTIES The Company maintains its corporate headquarters in a 35,000 square foot building located in Mt. Prospect, Illinois under a lease which expires in October 2004. This facility also houses the Company's manufacturing, research, development, engineering and marketing activities. The Company believes that this facility is adequate and suitable for its current needs and that additional space would be available on commercial terms as necessary to meet any future needs. ITEM 3. LEGAL PROCEEDINGS Siegler Litigation On June 5, 1996, Craig M. Siegler filed a complaint against the Company in the Circuit Court of Cook County, Illinois, County Department, Chancery Division. The complaint alleged that, in connection with the Company's private placement of securities in November 1995, the Company breached and repudiated an oral contract with Mr. Siegler for the issuance and sale by the Company to Mr. Siegler of 370,370.37 shares of the Company's Common Stock, plus warrants (immediately exercisable at $12.96 per share) to purchase an additional 370,370.37 shares of the Company's Common Stock, for a total price of $4,000,000. The remedy sought by Mr. Siegler was a sale to him of such securities on the terms of the November 1995 private placement. On August 16, 1996, the Company's motion to dismiss Mr. Siegler's complaint was granted with leave to amend. On September 19, 1996, Mr. Siegler's motion for reconsideration was denied. On October 10, 1996, Mr. Siegler filed his First Amended Verified Complaint and Jury Demand, seeking a jury trial and money damages equal to the difference between $8,800,000 (370,370.37 shares at $10.80 per share and 370,370.37 shares at $12.96 per share) and 740,740.74 shares multiplied by the highest price at which the Company's Common Stock traded on The Nasdaq Stock Market between November 20, 1995 and the date of judgment. Mr. Siegler also preserved his claim for specific performance for purposes of appeal. On November 1, 1996, the case was transferred to the Circuit Court of Cook County, Illinois, County Department, Law Division. The Company's Answer was filed on November 21, 1996 and the parties have completed discovery. The Company filed a motion for summary judgment against Mr. Siegler, which is on hold pending the deposition of an expert retained by Mr. Siegler in the case. The Company is scheduled to take the expert's deposition in March 2000, after which the court will enter a briefing schedule on the motion for summary judgement. The Company believes that the suit is without merit and intends to continue to defend itself vigorously in this litigation. However, if Mr. Siegler prevails in this litigation and is awarded damages in accordance with the formula described above, such judgment would have a material adverse effect on the Company's financial condition, results of operations and cash flows. Note Litigation On July 10, 1997, the Company filed a complaint against Sheldon Drobny; Howard L. "Buzz" Simons, joint tenant with Aric and Corey Simons; Aaron Fischer; Stewart Shiman; Sharon D. Gonsky, d/b/a SDG Associates; 19 23 Gregg Rosenberg; Stacey Rosenberg; Merrill Weber & Co., Inc.; Drobny/Fischer Partnership, an Illinois general partnership; and Ruben Rosenberg (collectively, the "Borrowers"), and Paradigm Venture Investors, L.L.C. (the "Guarantor") in the Circuit Court of Cook County, Illinois, County Department, Law Division. The complaint seeks to enforce the terms of loans made to the Borrowers by the Company and evidenced by promissory notes dated December 13, 1996, in the aggregate principal amount of $698,508 ($680,696 of which remains unpaid as of December 31, 1999) and the guarantee by the Guarantor of the Borrowers' obligations under these promissory notes. The Borrowers' notes were issued to the Company in connection with the Borrowers' exercise of warrants to purchase shares of the Common Stock in December 1996. On September 30, 1997, the Borrowers and the Guarantor responded to the Company's complaint. Concurrently, the Borrowers filed a counterclaim alleging that they exercised the warrants in reliance on the Company's alleged fraudulent representations to certain Borrowers concerning a third-party's future underwriting of a secondary public offering of the Company's Common Stock. On February 22, 2000, the Company reached a settlement agreement with the Borrowers, whereby the Company agreed to release the Borrowers' obligations under the notes in return for the Borrowers' surrender of 210,196 warrants to purchase common stock of the Company held by them and discharge of their counterclaims. As a result of this settlement, the Company will record a charge of $822,776 to additional paid-in capital in the first quarter of 2000, reflecting the carrying amount of the notes of $680,696 and related accrued interest of $142,080, which approximates the fair value of the warrants surrendered. Lipman Litigation On January 6, 1998, Jerome H. Lipman, individually and on behalf of all others similarly situated, filed a complaint against the Company and eight of its former or current directors: Leonard A. Batterson, Michael J. Friduss, Peter S. Fuss, Edward W. Laves, Steven L. Lazarus, Tom L. Powers, Ora E. Smith and Paul G. Yovovich (collectively, the "Named Directors") in the Circuit Court of Cook County, Illinois, County Department, Chancery Division. The complaint alleged that the Named Directors breached their duties of loyalty and due care to the putative class of stockholders by selecting financing for the Company in June 1997 which supposedly entrenched the Directors and reduced the Common Stock price. The complaint also alleged that the Named Directors breached their duty of disclosure by not informing the stockholders that the selected financing would erode the Common Stock price. Mr. Lipman's complaint sought certification of a class consisting of all owners of the Company's Common Stock during the period from June 6, 1997 through November 21, 1997, excluding the Named Directors and Sheldon Drobny. The complaint also seeks an unspecified amount of compensatory and punitive damages, and attorneys' fees. The Company and the Named Directors regard the suit as without factual or legal merit. Accordingly, on February 17, 1998, the Company and the Named Directors filed a motion to dismiss Mr. Lipman's complaint. The motion presented arguments that the claims of Mr. Lipman and the putative class are barred by the business judgment rule and the plaintiff's failure to fulfill the legal prerequisites for filing an action against the Named Directors. Prior to a hearing on the Company's and the Named Directors' motion to dismiss, Mr. Lipman filed a motion on March 16, 1998, seeking both to amend his proposed putative class to include Mr. Drobny and to certify the class. On June 1, 1998, the court granted the Company's and the Named Directors' motion to dismiss the complaint. Concurrently, Mr. Lipman withdrew his motion to amend the proposed putative class and certify the class. On June 30, 1998, Mr. Lipman filed an amended complaint against the Named Directors but excluding the Company itself as a defendant. The amended complaint alleges that the Named Directors breached their duties of loyalty and due care to the putative class of stockholders by selecting financing for the Company in June 1997 and thereafter drawing two tranches of the financing. The amended complaint seeks certification of a class consisting of all owners of the Company's Common Stock during the period from May 15, 1997 through December 31, 1997, excluding the Named Directors. Mr. Lipman's amended complaint alleges that the stock owned by the putative class lost $61 million due to the financing the Named Directors selected, and seeks an unspecified amount of compensatory and 20 24 punitive damages. The Company and the Named Directors regard the amended complaint as without factual or legal merit. Accordingly, the Named Directors filed a motion to dismiss Mr. Lipman's amended complaint on July 29, 1998. The court granted the motion to dismiss in December 1998, finding that Mr. Lipman still had failed to fulfill the prerequisites for maintaining a shareholder derivative action against the Named Directors. On January 12, 1999, Mr. Lipman and two added former stockholders filed a second amended complaint against the Named Directors and again including the Company itself as a defendant. The second amended complaint alleged that the Named Directors breached their duties of loyalty and due care to the putative class and further alleged that the purported devaluation of the plaintiffs' stock resulting from the June 1997 financing was an improper "assessment" on the plaintiffs' shares for which they sought an unspecified amount of compensatory and punitive damages. In February 1999, the Company and the Named Directors filed a motion to dismiss the second amended complaint. The Court granted the motion to dismiss in April 1999, finding that (i) the plaintiffs could not assert their stock devaluation claims, except derivatively, and (ii) the plaintiffs still had failed to fulfill the prerequisites for maintaining a shareholder derivative action against the Named Directors. In May 1999, the plaintiffs filed a third amended complaint against the Company and the Named Directors. The third amended complaint reiterated the plaintiffs' previous allegations that the Named Directors breached their duties of loyalty, due care and candor to the putative class, and again alleged the plaintiffs' claims of an improper "assessment." The third amended complaint also asserted two claims of purported common law fraud and a supposed violation of the Illinois Consumer Fraud Act based on allegations that the Company and the Named Directors had selectively disclosed "material, non-public confidential information" to the non-party financier in order to obtain the financing that the Company selected in June 1997, which allegedly reduced the Common Stock price. The plaintiffs sought an unspecified amount of compensatory and punitive damages, interest and attorneys' fees. In June 1999, the Company and the Named Directors filed a motion to dismiss the third amended complaint, arguing that the plaintiffs' allegations of purported market manipulation by the financier, facilitated by supposedly improper selective disclosure, are beyond the jurisdiction of the Illinois court and fail to allege certain essential elements of common law fraud and the Illinois Consumer Fraud Act. The defendants' motion also argued that the plaintiffs still had failed to fulfill the prerequisites for asserting their stock devaluation claims as a shareholder derivative action. In August 1999, the Court granted the Company's and the Named Directors' motion, and dismissed the suit with prejudice. Thereafter the plaintiffs filed a motion for reconsideration of the dismissal; the Court denied the plaintiffs' reconsideration motion on September 23, 1999. On October 21, 1999, the plaintiff filed their notice of appeal from the dismissal orders. The Company and the named Directors regard the appeal as without merit and they intend to vigorously defend against the plaintiffs' appeal from the Circuit Court's dismissal orders. Greenwald Litigation On June 24, 1998, Jonathan Greenwald, derivatively on behalf of the Company, filed a complaint against the Company and the Named Directors in the court of Chancery of the State of Delaware in and for New Castle County. Mr. Greenwald's complaint alleges that the Named Directors breached their duties of good faith, loyalty, due care, and candor by selecting financing for the Company in 1997 which purportedly reduced the Company's stock price and was supposedly accepted to entrench the Named Directors. The complaint seeks an unspecified amount of compensatory damages, various equitable relief and attorney's fees. The Company and the Named Directors regarded the suit as without factual or legal merit. Accordingly, in January 1999, the Company and the Named Directors filed a motion to dismiss the complaint arguing that the complaint is barred by the business judgment rule and the plaintiffs' failure to fulfill the prerequisites for maintaining a shareholder derivative action against the Named Directors. In July 1999, the Court of Chancery granted the defendants' motion to dismiss the complaint finding that the plaintiffs had failed to satisfy the prerequisites for maintaining a shareholder derivative action under Delaware law. By order dated August 11, 1999, the Court of Chancery granted the Company's and the named Directors' motion to dismiss with prejudice the suit as it relates to Mr. Greenwald, the named plaintiff. 21 25 16(b) Litigation On February 26, 1999, Mark Levy, derivatively on behalf of the Company, filed a complaint against Southbrook International Investments, Ltd. ("Southbrook"), Elliott Associates, L.P. ("Elliott"), and Westgate International, L.P. ("Westgate"), and against the Company as a "nominal defendant." The complaint, filed in the United States District Court for the Southern District of New York, alleges that Southbrook, Elliott and Westgate, while having beneficial ownership of more than 10% of the Company's Common Stock, incurred liability under Section 16(b) of the Securities Exchange Act of 1934 in connection with purchases and sales of Company securities within six month periods. The complaint seeks to recover from Southbrook, Elliott and Westgate their respective profits (in unspecified amounts) from those transactions. No relief is sought against the Company as a nominal defendant. Elliott and Westgate are currently investors in the Company with substantial rights to acquire Common Stock by conversion of notes and exercise of warrants and have designated four of the five current five directors of the Company, two of whom, Messrs. Mark Brodsky and Samuel Perlman, are employed by a company that provides management services to, and is under common control with Elliott and Westgate. See "Recent Developments," above. An amended complaint dated September 2, 1999 was served on the Company. The amended complaint raises the same claims alleged in the original complaint. Pursuant to stipulation, as of the date hereof, the Company has not yet responded to the amended complaint. Motions to dismiss the action have been filed by Elliott, Westgate and Southbrook. The Company intends to defend itself vigorously in the matters described above and believes that the resolution of these matters will not have a material adverse effect on the financial condition, results of operations or cash flows of the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the quarter ended December 31, 1999. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Common Stock has been quoted since April 1999 on the Nasdaq OTC Bulletin Board under the symbol "ISCO." From 1993 until April 1999, the Common Stock was quoted on the Nasdaq National Market. The following table shows, for the periods indicated, the reported high and low sale prices for the Common Stock. HIGH LOW ---- --- FISCAL YEAR ENDING DECEMBER 31, 1998 First Quarter................................. $3.88 $0.88 Second Quarter................................ $3.25 $1.16 Third Quarter................................. $1.97 $0.81 Fourth Quarter................................ $1.78 $0.75 FISCAL YEAR ENDING DECEMBER 31, 1999 First Quarter................................. $1.69 $0.94 Second Quarter................................ $1.50 $0.47 Third Quarter................................. $1.13 $0.50 Fourth Quarter................................ $2.06 $0.33 22 26 On January 31, 2000, there were approximately 256 holders of record of the Common Stock. The Company has never paid cash dividends on the Common Stock and the Company does not expect to pay any dividends on its Common Stock in the foreseeable future. In addition, the Company's existing debt instruments limit the Company's ability to pay dividends. See "Risk Factors - Substantial Leverage; Restrictions Contained in Debt Instruments." The Company has applied to have its Common Stock listed on the Nasdaq SmallCap Market. There can be no assurance, however, whether or when the application will be approved and the Common Stock listed. 23 27 RIGHTS PLAN In February 1996, the Board of Directors of the Company adopted a stockholders rights plan (the "Rights Plan"). In connection with the adoption of the Rights Plan, the Board of Directors created one series of Preferred Stock, consisting of 10,000 shares of Series A Junior Participating Preferred Stock (the "Series A Preferred"). Each share of the Series A Preferred, when and if issued, entitles the holder thereof to receive dividends equal to 1,000 times the dividends per share declared with respect to the Common Stock. Holders of the Series A Preferred are entitled to exercise 1,000 votes per share on all matters submitted to a vote of stockholders and, except as otherwise required by law, vote together with the holders of Common Stock as a single class. In the event of liquidation, such holders would receive a preference of 1,000 times the aggregate amount to be distributed per share to the holders of Common Stock. In general, each share of the Series A Preferred is intended to have a value and voting rights equal to 1,000 shares of Common Stock, and appropriate anti-dilutive adjustments will be made in accordance with the terms of such Series A Preferred in the event of certain changes in Common Stock. Pursuant to the Rights Plan, a Series A Right is associated with, and trades with, each share of Common Stock outstanding. The record date for distribution of such Series A Rights was February 22, 1996 (the "Record Date") and, for so long as the Series A Rights are associated with the Common Stock, each new share of Common Stock issued by the Company will include one Series A Right. Each Series A Right will entitle its holder to purchase one-thousandth of a share of Series A Preferred of the Company for $200 (subject to adjustment). The Series A Rights are not exercisable until the earlier of (i) ten days after any person or group becomes the beneficial owner of 15% or more of the outstanding Common Stock or (ii) 10 business days (unless extended by the Board of Directors) after the commencement of a tender offer or exchange offer that would result in a person or group beneficially owning 15% or more of the Common Stock. If any person or group acquires 15% or more of the Common Stock outstanding (the "Shares Acquisition Date"), each holder of a Series A Right (except the acquiring party) has the right to receive, upon exercise, (i) shares of Common Stock of the Company having a market value of two times the exercise price of the Series A Right and (ii) one Series B Right (Series A Rights and Series B Rights are hereinafter collectively referred to as the "Rights"). The Board of Directors has the option, after the Shares Acquisition Date but before there has been a 50% acquisition of the Company, to exchange both (i) one share of Common Stock (or one-thousandth of a share of preferred stock) and (ii) one Series B Right, for each Series A Right (other than Series A Rights held by an acquiring party). If, after the Series A Rights become exercisable, the Company is involved in a merger or other business combination, or if the Company sells or transfers more than 50% of its assets or earning power, or if an acquiring party engages in certain "self-dealing" transactions with the Company, each Series A Right and Series B Right then outstanding (other than Rights held by an acquiring party) will be exercisable for common stock of the other party to such transaction having a market value of two times the exercise price of the Right. The Company has the right to redeem the Series A Rights for $.01 per Series A Right (the "Redemption Price") prior to the Shares Acquisition Date. The Series B Rights, once issued, are not redeemable. The Rights expire on February 9, 2006. The Rights have certain anti-takeover effects. The Rights should not interfere with any merger or business combination approved by the Board of Directors since the Series A Rights may be redeemed by the Company at the Redemption Price prior to the time that a person or group has acquired beneficial ownership of 15% or more of the Common Stock. However, by causing substantial dilution to a person or group that attempts to acquire the Company on terms not approved by the Board of Directors, the Rights may interfere with certain acquisitions, including acquisitions that may offer a premium over market price to some or all of the Company's shareholders. The Rights are not intended to prevent an acquisition of the Company on terms that are favorable and fair to all shareholders. See "Risk Factors - Anti-Takeover Provisions." RECENT SALES OF UNREGISTERED SECURITIES On March 31, 1999, the Investors purchased, for an aggregate price of $3 million, an aggregate of $3 million initial principal amount (out of a private placement of an aggregate of $3.3 million initial principal 24 28 amount) of senior convertible notes due May 15, 2002 (the "March Notes") and warrants exercisable for an aggregate of 1.2 million shares of Common Stock (out of an aggregate private placement of warrants exercisable for an aggregate of 1.32 million shares of Common Stock) ("March Warrants"). The balance of the March Notes and March Warrants were purchased by State Farm Mutual Automobile Insurance Company. Concurrently with the issuance of the March Notes, the Company amended certain terms of $5.5 million initial principal amount of senior convertible notes issued on May 15, 1998 (the "Amended May Notes"), of which $5 million in aggregate initial principal amount of such Amended May Notes were held by the Investors, and warrants exercisable for an aggregate of 2.2 million shares of Common Stock that were also issued on May 15, 1998 (the "Amended May Warrants"), of which Amended May Warrants for an aggregate of 2.0 million shares of Common Stock were held by the Investors. On November 5, 1999, the board of directors, in order to address the Company's critical lack of liquidity, approved the terms of the financing transaction described above under "Risk Factors - Substantial Number of Shares Eligible for Future Issuance on Conversion of Notes and Warrant and Option Exercise; Low Conversion and Exercise Prices; Dilution." No underwriting commissions were paid in connection with the issuance of securities referenced in this section, which were issued in reliance on the exemption from registration contained in Section 4(2) of the Securities Act of 1933 for transactions by an issuer not involving a public offering. The exemption was available because these transactions involved the Company's privately negotiated sales to a small number of institutional investors with which the Company had a pre-existing business relationship. 25 29 ITEM 6. SELECTED FINANCIAL DATA The following table presents selected financial data with respect to the Company as of and for the years ended December 31, 1995, 1996, 1997, 1998 and 1999. The selected financial data for each of the years in the five-year period ended December 31, 1999 have been derived from the audited financial statements of the Company. The information set forth below should be read in conjunction with Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Item 8., "Financial Statements and Supplementary Data."
------------ ------------ ------------ ------------ ------------ 1995 1996 1997 1998 1999 ------------ ------------ ------------ ------------ ------------ STATEMENT OF OPERATIONS DATA: Net sales ................................. $ 27,830 $ 209,822 $ 1,038,134 $ 3,242,930 $ 2,408,604 Costs and expenses: Cost of revenues ........................ 19,286 49,534 4,401,077 7,047,347 5,923,173 Research and development ................ 4,554,946 6,422,921 4,132,019 2,934,784 1,757,214 Selling and marketing ................... 469,600 1,834,640 1,918,044 1,847,680 1,581,545 General and administrative .............. 2,763,615 3,290,810 2,772,274 3,370,058 2,617,809 ------------ ------------ ------------ ------------ ------------ Operating loss .......................... (7,779,617) (11,388,083) (12,185,280) (11,956,939) (9,471,137) Other income (expense): Interest income ......................... 487,543 503,911 254,781 354,738 98,194 Interest expense ........................ (39,600) (29,602) (17,969) (10,247,919) (12,634,745) Other income, net ....................... -- -- -- -- 36,623 ------------ ------------ ------------ ------------ ------------ 447,943 474,309 236,812 (9,893,181) (12,499,928) ------------ ------------ ------------ ------------ ------------ Loss before extraordinary item .............. (7,331,674) (10,913,774) (11,948,468) (21,850,120) (21,971,065) Extraordinary item-debt extinguishment ...... -- -- -- -- (745,197) ------------ ------------ ------------ ------------ ------------ Net loss .................................... (7,331,647) (10,913,774) (11,948,468) (21,850,120) (22,716,262) Preferred Stock dividends ................... -- -- (143,302) (61,834) ------------ ------------ ------------ ------------ ------------ Net loss plus Preferred Stock dividends ..... $ (7,331,674) $(10,913,774) $(12,091,770) $(21,911,954) $(22,716,262) ============ ============ ============ ============ ============ Basic and diluted loss per common share before extraordinary item ................. $ (2.01) $ (2.41) $ (2.34) $ (1.93) $ (1.71) Extraordinary item-debt extinguishment ...... -- -- -- -- (0.06) ------------ ------------ ------------ ------------ ------------ Basic and diluted loss per common share ..... $ (2.01) $ (2.41) $ (2.34) $ (1.93) $ (1.77) ============ ============ ============ ============ ============ Weighted average number of common shares outstanding ............... 3,641,196 4,536,034 5,156,663 11,345,540 12,841,497 ============ ============ ============ ============ ============
------------ ------------ ------------ ------------ ------------ 1995 1996 1997 1998 1999 ------------ ------------ ------------ ------------ ------------ BALANCE SHEET DATA: Cash and cash equivalents ................. $ 953,093 $ 5,188,047 $ 2,766,886 $ 2,152,595 $ 723,711 Working capital ........................... 5,458,474 5,207,923 4,668,982 4,190,548 831,724 Total assets .............................. 11,105,766 13,388,496 11,534,309 10,028,088 6,039,159 Long-term debt/capital lease obligations, less current portion ...... 509,079 91,618 13,541 9,432,026 13,650,885 Stockholders' equity (net capital deficiency) .................... 9,185,379 11,520,128 10,046,569 (772,968) (9,291,712)
26 30 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Years Ended December 31, 1999 and 1998 The Company's net sales decreased $834,326, or 25.7%, from $3,242,930 in 1998 to $2,408,604 in 1999, as a result of lower unit volume and reduced selling prices of the Company's radio frequency ("RF") front-end products. Net sales in the fourth quarter of 1999 were $452,812, as compared to $1,504,497 for the fourth quarter of 1998. This decline was a result of lower unit volume in 1999 compared to 1998, when there was a large-scale deployment of the Company's products by one of the largest cellular operators in the U.S. This large-scale deployment did not reoccur in 1999. The Company anticipates its net sales to remain flat in 2000 based on forecasts of domestic expansion by cellular operators and a delayed deployment of sales to international markets. All of the net sales in 1999 and 1998 were from commercial product sales. The Company has concentrated its efforts on its commercial product research and development programs and does not expect revenues to increase dramatically unless and until it ships a significantly larger amount of its commercial products. Cost of products sold decreased to $5,923,173 from $7,047,347, a reduction of $1,124,174 or 16.0%. The cost of products sold for 1999 and 1998 consisted of direct material, labor and overhead costs associated with the products that were shipped during the period, plus approximately $649,000 and $375,000, respectively, of costs, which consisted primarily of allocated overhead costs, incurred to produce units in ending finished goods inventory that exceed net realizable value. Due to low utilization levels and excess capacity in the Company's manufacturing facility, cost of products sold exceeded net sales for 1999 and 1998. The Company expects the cost of products sold to exceed net sales until it manufactures and ships a significantly higher amount of its commercial products. The Company's internally funded research and development expenses decreased to $1,757,214 from $2,934,784, a reduction of $1,177,570 or 40.1%. These costs were lower due to the successful development of the Company's core products, increased efficiency in the Company's development processes, personnel reductions, and the focusing of development efforts on products with a greater probability of commercial sales. During 2000, the Company expects its research and development expenditures to continue on a level consistent with that of 1999. Selling and marketing expenses decreased to $1,581,545 from $1,847,680, a reduction of $266,135 or 14.4%. This decrease was due primarily to personnel reductions and decreased trade show, travel and delivery expenses. General and administrative expenses decreased to $2,617,809 from $3,370,058, a reduction of $752,249 or 22.3%. This expense reduction was primarily due to personnel reductions and lower professional fees and office supply expenses. Interest income decreased $256,544 from $354,738 in 1998 to $98,194 in 1999. This decrease is a result of lower average balances of cash and cash equivalents on hand during 1999 compared to 1998. Interest expense increased $2,368,826 from $10,247,919 in 1998 to $12,634,745 in 1999. This increase was primarily due to an increase of $2,506,954 in non-cash interest charges related to the Company's Senior Convertible Notes. See Note 7 to the Company's financial statements. An extraordinary charge of $745,197 was recorded in 1999 as a result of amendments to the terms of certain of the Company's Senior Convertible Notes issued in May 1998 and March 1999. These amendments increased the interest rate of certain of the notes issued in May 1998 from 2% to 6% and reduced the conversion prices of these 27 31 notes and the exercise prices of warrants issued in conjunction with these notes. In March 1999, the conversion price of certain of the notes issued in May 1998 was reduced from $1.50 to $1.125 per share, and the exercise price of the related warrants was reduced from $3.75 to $1.4625 per share. In November 1999, the conversion price of certain of the notes issued in both May 1998 and March 1999 and the exercise price of the related warrants were reduced from $1.125 to $0.25 per share and from $1.4625 to $0.25 per share, respectively. In addition, the exercise price of certain of the Company's G Warrants was reduced from $10.0625 to $0.25 per share. See Note 7 to the Company's financial statements. Years Ended December 31, 1998 and 1997 The Company's net sales increased $2,204,796 from $1,038,134 in 1997 to $3,242,930 in 1998, as a result of increased sales of the Company's radio frequency ("RF") front-end products. Net revenues in the fourth quarter of 1998 were $1,504,497, as compared to $282,384 for the fourth quarter of 1997. This revenue growth was the result of the increased acceptance of the Company's products by operators, price reductions that the Company implemented in October 1998 and a large scale deployment of the Company's products by one of the largest cellular operators in the U.S. All of the net sales in 1997 and 1998 were from commercial product sales. Cost of product sales was $7,047,347 for the year ended December 31, 1998, as compared to $4,401,077 for the year ended December 31, 1997. The cost of net product sales for 1998 and 1997 consisted of direct material, labor and overhead costs associated with the products that were shipped during the year, plus approximately $375,000 and $529,000, respectively, of costs, which consisted primarily of allocated overhead costs, incurred to produce units in ending finished goods inventory that exceed net realizable value. Due to low utilization levels and excess capacity in the Company's manufacturing facility, cost of net product sales exceeded net sales for the years ended December 31, 1998 and 1997. The Company's internally funded research and development expenses decreased $1,197,235 from $4,132,019 in 1997 to $2,934,784 in 1998. Research and development costs were reduced during 1998, as compared to 1997, primarily due to a reduction in personnel and operating costs during 1998. Selling and marketing expenses decreased to $1,847,680 in 1998 from $1,918,044 in 1997. This decrease was due to lower advertising, recruiting and consulting expenses during 1998 as compared to 1997. The decrease was partially offset by increased salary and freight expenses in 1998. General and administrative expenses increased $597,784 from $2,772,274 in 1997 to $3,370,058 in 1998. The increase in general and administrative expenses was due primarily to higher consultant, legal and office expenses during 1998 as compared to 1997. Interest income increased $99,957 from $254,781 in 1997 to $354,738 in 1998. This increase was due to a higher average cash, cash equivalent and investment balance during 1998. Interest expense increased $10,229,950 from $17,969 in 1997 to $10,247,919 in 1998. This increase was primarily due to $10,101,401 of non-cash interest charges related to the Company's Senior Convertible Notes. IMPACT OF YEAR 2000 The Company completed its Year 2000 readiness initiatives and did not experience any significant problems. The Company does not anticipate any significant adverse business effects related to this issue. The Company did not incur material costs related to Year 2000 remediation. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1999, the Company's cash and cash equivalents, including restricted certificates of deposit, were $1,015,286, a decrease of $1,474,656 from the December 31, 1998 balance of $2,489,942. 28 32 The continuing development of and expansion in sales of the Company's RF filter product lines will require continued commitment of substantial funds to undertake continued product development and manufacturing activities and to market and sell its RF front-end products. The actual amount of the Company's future funding requirements will depend on many factors, including: the amount and timing of future revenues, the level of product marketing and sales efforts to support the Company's commercialization plans, the magnitude of its research and product development programs, the ability of the Company to improve product margins, the cost of additional plant and equipment for manufacturing and the costs involved in protecting the Company's patents or other intellectual property. Despite the completion on November 5, 1999 of the issuance and sale of $1.0 million in principal amount of November 1999 Notes and completion on December 29, 1999 of the issuance and sale of $1.0 million in principal amount of December 1999 Notes (See Note 7 to the Company's financial statements), the Company believes that during the second quarter of 2000 it will require substantial additional funds to finance its product development, manufacturing and marketing activities and otherwise to maintain its operations. The Company's strategy to generate sufficient working capital to fund its operations and cash requirements in the future includes: increasing sales and advancing market penetration by selling its products to original equipment manufacturers and customers both domestically and in overseas markets; building strong and enduring relationships with existing customers and expanding product offerings to meet varying customer needs; and reducing product costs through redesign, economies of scale in material purchases, the refinement of manufacturing processes, and further reductions in overhead. The Company is actively seeking financing in order to obtain working capital to continue its operations according to its current operating plan through the second quarter of 2000 and beyond. Certain of the purchasers of the Company's Senior Convertible Notes have an option, but not an obligation, to make additional purchases of Senior Convertible notes in the aggregate amount of $4,000,000 on the same terms and conditions as the November 1999 and December 1999 Notes. This option expires on August 5, 2000. Additionally, the Company has entered into a factoring agreement, which expires on September 27, 2000 and is subject to renewal for successive twelve month periods, whereby the Company may assign and sell its interest, on a full recourse basis, of its present and future trade accounts receivable. The Company has pledged its receivables and inventory as collateral under the factoring agreement. The Company's Senior Convertible Notes issued in May 1998, March 1999, November 1999 and December 1999 (collectively, the "Notes") contain restrictions limiting the Company's ability to incur additional indebtedness or to pay dividends (other than in shares of Common Stock) and are secured by the Company's assets. This may adversely affect the Company's ability to raise additional equity or debt financing. In the event that the Company fails to achieve break-even or positive operating income during the second quarter of 2001, the Notes may become immediately due and payable unless the holders thereof agree to modify or waive such provision. In addition, the Company's Common Stock was de-listed from trading on the NASDAQ National Market in June 1999 due to the Company's continuing inability to meet the net tangible assets requirement for continued listing. The Common Stock is now traded in the over-the-counter market and quoted on the National Association of Securities Dealers, Inc. electronic bulletin board. This does not provide the same liquidity for the trading of securities as NASDAQ. In February 2000, the Company applied to NASDAQ for re-listing of the Company's Common Stock. However, there can be no assurance as to whether or when such re-listing will occur. If the Company is unable to re-list the Common Stock for trading on NASDAQ or another securities market or exchange this could adversely affect the Company's ability to obtain additional funding as needed, and/or the terms of any such additional funding. If the Company is unable to obtain adequate funds when needed in the future, the Company would be required to substantially delay, scale-back or eliminate the manufacturing, marketing or sales of one or more of its products or research and development programs, or may be required to obtain funds through arrangements with collaborative partners or others that may require the Company to relinquish rights to certain of its technologies, or potential products that the Company would not otherwise relinquish. In particular, if the Company does not secure adequate additional financing through its existing investors' rights to make additional purchases of the Company's Senior Convertible Notes or through new or recurring sources during the second quarter of 2000, the Company believes that it may not be able to continue as a going concern. 29 33 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company does not have any material market risk sensitive instruments. 30 34 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT AUDITORS The Board of Directors Illinois Superconductor Corporation We have audited the accompanying balance sheets of Illinois Superconductor Corporation as of December 31, 1999 and 1998, and the related statements of operations, stockholders' equity (net capital deficiency), and cash flows for each of the three years in the period ended December 31, 1999. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Illinois Superconductor Corporation at December 31, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with auditing standards generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. The accompanying financial statements have been prepared assuming that Illinois Superconductor Corporation will continue as a going concern. As more fully described in Note 3, Illinois Superconductor Corporation has incurred ongoing operating losses and does not currently have financing commitments in place to meet expected cash requirements through 2000. These conditions raise substantial doubt about Illinois Superconductor Corporation's ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 3. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty. Ernst & Young LLP Chicago, Illinois February 25, 2000 31 35 ILLINOIS SUPERCONDUCTOR CORPORATION BALANCE SHEETS
DECEMBER 31, 1999 1998 ------------ ------------ ASSETS Current assets: Cash and cash equivalents $ 723,711 $ 2,152,595 Inventories 1,092,713 1,424,427 Accounts receivable, net of allowance for doubtful accounts of $35,340 and $87,990 at December 31, 1999 and 1998, respectively 175,801 1,494,418 Prepaid expenses and other 428,475 396,926 ------------ ------------ Total current assets 2,420,700 5,468,366 Property and equipment: Leasehold improvements 4,218,511 4,218,511 Lab equipment 1,457,597 1,694,840 Manufacturing equipment 1,023,211 983,426 Office equipment 754,142 759,443 Furniture and fixtures 635,708 629,490 ------------ ------------ 8,089,169 8,285,710 Less: Accumulated depreciation (5,433,808) (4,761,599) ------------ ------------ 2,655,361 3,524,111 Restricted certificates of deposit 291,575 337,347 Patents and trademarks, net 592,823 615,879 Deferred financing fees, net 78,700 82,385 ------------ ------------ Total assets $ 6,039,159 $ 10,028,088 ============ ============
See the accompanying Notes which are an integral part of the financial statements. 32 36 ILLINOIS SUPERCONDUCTOR CORPORATION BALANCE SHEETS (CONTINUED)
DECEMBER 31, 1999 1998 ------------ ------------ LIABILITIES AND STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY) Current liabilities: Accounts payable $ 990,913 $ 464,752 Accrued liabilities 589,043 799,569 Current portion of other long-term debt 9,020 13,497 ------------ ------------ Total current liabilities 1,588,976 1,277,818 Senior convertible notes, net of discount 13,002,068 9,302,651 Accrued interest on senior convertible notes 638,743 129,375 Other long-term debt, less current portion 10,074 -- Deferred occupancy costs 91,010 91,212 Stockholders' equity (net capital deficiency): Preferred Stock; 100,000 shares authorized; No shares issued and outstanding at December 31, 1999 and 1998 -- -- Common stock ($.001 par value); 60,000,000 and 30,000,000 shares authorized and 15,753,001 and 12,557,045 shares issued and outstanding at December 31, 1999 and 1998, respectively 15,753 12,557 Additional paid-in capital 74,249,643 60,055,321 Notes receivable from stockholders (680,696) (680,696) Accumulated deficit (82,876,412) (60,160,150) ------------ ------------ Total stockholders' equity (net capital deficiency) (9,291,712) (772,968) ------------ ------------ Total liabilities and stockholders' equity (net capital deficiency) $ 6,039,159 $ 10,028,088 ============ ============
See the accompanying Notes which are an integral part of the financial statements. 33 37 ILLINOIS SUPERCONDUCTOR CORPORATION STATEMENTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1999 1998 1997 ------------ ------------ ------------ Net sales $ 2,408,604 $ 3,242,930 $ 1,038,134 Costs and expenses: Cost of sales 5,923,173 7,047,347 4,401,077 Research and development 1,757,214 2,934,784 4,132,019 Selling and marketing 1,581,545 1,847,680 1,918,044 General and administrative 2,617,809 3,370,058 2,772,274 ------------ ------------ ------------ Total costs and expenses 11,879,741 15,199,869 13,223,414 ------------ ------------ ------------ Operating loss (9,471,137) (11,956,939) (12,185,280) Other income and (expense): Interest income 98,194 354,738 254,781 Non-cash interest expense on Senior convertible notes (Note 7) (12,608,355) (10,101,401) -- Other interest expense (26,390) (146,518) (17,969) Other income, net 36,623 -- -- ------------ ------------ ------------ (12,499,928) (9,893,181) 236,812 ------------ ------------ ------------ Loss before extraordinary item (21,971,065) (21,850,120) (11,948,468) Extraordinary item - debt extinguishment (745,197) -- -- ------------ ------------ ------------ Net loss (22,716,262) (21,850,120) (11,948,468) Preferred Stock dividends -- (61,834) (143,302) ------------ ------------ ------------ Net loss plus Preferred Stock dividends $(22,716,262) $(21,911,954) $(12,091,770) ============ ============ ============ Basic and diluted loss per common share before extraordinary item $ (1.71) $ (1.93) $ (2.34) Extraordinary item - debt extinguishment (0.06) -- -- ------------ ------------ ------------ Basic and diluted loss per common share $ (1.77) $ (1.93) $ (2.34) ============ ============ ============ Weighted average number of common shares outstanding 12,841,497 11,345,540 5,156,663 ============ ============ ============
See the accompanying Notes which are an integral part of the financial statements. 34 38 ILLINOIS SUPERCONDUCTOR CORPORATION STATEMENTS OF STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY) YEARS ENDED DECEMBER 31, 1999, 1998, AND 1997
SERIES B CONVERTIBLE SERIES C CONVERTIBLE SERIES G CONVERTIBLE PREFERRED STOCK PREFERRED STOCK PREFERRED STOCK COMMON STOCK ---------------------------------------------------------------------------------------- NUMBER NUMBER NUMBER NUMBER OF OF OF OF SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT ---------------------------------------------------------------------------------------- Balance as of December 31, 1996 -- $ -- -- $ -- -- $ -- 5,023,352 $ 5,023 Exercise of stock options; $.184 - $18.25 per share -- -- -- -- -- -- 17,821 18 Exercise of warrants; $1.4679 - $13.50 per share -- -- -- -- -- -- 138,820 139 Payment of stockholder notes receivable -- -- -- -- -- -- -- -- Issuance of preferred stock, net of offering costs 600 3,000,000 600 3,000,000 700 3,500,000 -- -- Preferred stock dividends -- 13,534 -- 38,424 -- 30,206 19,940 20 Conversion of preferred stock to common stock (505) (2,525,000) -- -- -- -- 801,992 802 Net loss -- -- -- -- -- -- -- -- ---------------------------------------------------------------------------------------- Balance as of December 31, 1997 95 488,534 600 3,038,424 700 3,530,206 6,001,925 6,002 Additional offering costs related to issuance of preferred stock -- -- -- -- -- -- -- -- Exercise of stock options; $. 18 - $.23 per share -- -- -- -- -- -- 33,942 34 Payment of stockholder notes receivable -- -- -- -- -- -- -- -- Preferred stock dividends -- 260 -- 24,377 -- 37,197 -- -- Conversion of preferred stock to common stock (95) (488,794) (600) (3,062,801) (700) (3,567,403) 6,521,178 6,521 Discount on issuance of senior convertible notes (Note 7) -- -- -- -- -- -- -- -- Net loss -- -- -- -- -- -- -- -- ---------------------------------------------------------------------------------------- Balance as of December 31, 1998 -- -- -- -- -- -- 12,557,045 12,557 Exercise of stock options; $.18 - $.23 per share -- -- -- -- -- -- 17,250 17 Conversion of senior convertible notes to common stock -- -- -- -- -- -- 3,178,706 3,179 Discount on issuance of senior convertible notes (Note 7) -- -- -- -- -- -- -- -- Additional discount on amendments to certain senior convertible notes (Note 7) -- -- -- -- -- -- -- -- Net loss -- -- -- -- -- -- -- -- ---------------------------------------------------------------------------------------- Balance as of December 31, 1999 -- $ -- -- $ -- -- $ -- 15,753,001 $ 15,753
See the accompanying Notes which are an integral part of the financial statements. 35 39 ILLINOIS SUPERCONDUCTOR CORPORATION STATEMENTS OF STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY) YEARS ENDED DECEMBER 31, 1999, 1998, AND 1997 (CONTINUED)
NOTES ADDITIONAL RECEIVABLE PAID-IN FROM ACCUMULATED CAPITAL STOCKHOLDERS DEFICIT TOTAL -------------------------------------------------------------- Balance as of December 31, 1996 $ 39,019,421 $ (1,142,754) $(26,361,562) $ 11,520,128 Exercise of stock options; $.184 - $18.25 per share 70,170 -- -- 70,188 Exercise of warrants; $1.4679 - $13.50 per share 796,908 -- -- 797,047 Payment of stockholder notes -- 444,246 -- 444,246 receivable Issuance of preferred stock, net of offering costs (336,572) -- -- 9,163,428 Preferred stock dividends (82,184) -- -- -- Conversion of preferred stock to common stock 2,524,178 -- -- -- Net loss -- -- (11,948,468) (11,948,468) -------------------------------------------------------------- Balance as of December 31, 1997 41,991,941 (698,508) (38,310,030) 10,046,569 Additional offering costs related to issuance of preferred stock (143,400) -- -- (143,400) Exercise of stock options; $. 18 - $.23 per share 7,387 -- -- 7,421 Payment of stockholder notes receivable -- 17,812 -- 17,812 Preferred stock dividends (61,834) -- -- -- Conversion of preferred stock to common stock 7,112,477 -- -- -- Discount on issuance of senior convertible notes (Note 7) 11,148,750 -- -- 11,148,750 Net loss -- -- (21,850,120) (21,850,120) -------------------------------------------------------------- Balance as of December 31, 1998 60,055,321 (680,696) (60,160,150) (772,968) Exercise of stock options; $.18 - $.23 per share 3,769 -- -- 3,786 Conversion of senior convertible notes to common stock 849,554 -- -- 852,733 Discount on issuance of senior convertible notes (Note 7) 1,904,000 -- -- 1,904,000 Additional discount on amendments to certain senior convertible notes (Note 7) 11,436,999 -- -- 11,436,999 Net loss -- -- (22,716,262) (22,716,262) -------------------------------------------------------------- Balance as of December 31, 1999 $ 74,249,643 $ (680,696) $(82,876,412) $ (9,291,712)
See the accompanying Notes which are an integral part of the financial statements. 36 40 ILLINOIS SUPERCONDUCTOR CORPORATION STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 1999 1998 1997 ------------ ------------ ------------ OPERATING ACTIVITIES Net loss $(22,716,262) $(21,850,120) $(11,948,468) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation 953,971 1,107,360 1,533,705 Amortization 28,434 14,881 6,994 Extraordinary item 745,197 -- -- Non-cash interest expense on senior convertible notes (Note 7) 12,608,355 10,101,401 -- Loss on available-for-sale securities -- 4,963 -- Gain on sale of property and equipment (30,662) -- -- Write-off of capitalized patent costs 57,741 61,333 -- Changes in operating assets and liabilities: Accounts receivable 1,318,617 (907,917) (455,749) Inventories 331,714 301,714 (1,072,445) Prepaid expenses and other (31,549) 86,864 (35,876) Accounts payable 526,161 (252,673) (411,584) Accrued liabilities (210,526) 341,659 92,778 Deferred occupancy costs (202) (200) 15,599 ------------ ------------ ------------ Net cash used in operating activities (6,419,011) (10,990,735) (12,275,046) INVESTING ACTIVITIES Sales of available-for-sale securities -- 495,350 -- (Increase) decrease in restricted certificates of deposit 45,772 42,653 (30,000) Payments of patent costs (63,119) (112,607) (199,647) Proceeds from sale of property and equipment 58,006 -- -- Acquisitions of property and equipment (85,450) (108,417) (310,956) ------------ ------------ ------------ Net cash (used in) provided by investing activities (44,791) 316,979 (540,603) FINANCING ACTIVITIES Proceeds from issuance of preferred stock - net of offering costs -- (143,400) 9,163,428 Exercise of stock options 3,786 7,421 70,188 Exercise of warrants -- -- 797,047 Payments on stockholder notes receivable -- 17,812 444,246 Proceeds from issuance of senior convertible notes 5,300,000 10,350,000 -- Payment of deferred financing fees (247,349) (94,247) -- Payments on other long-term debt (21,519) (78,121) (80,421) ------------ ------------ ------------ Net cash provided by financing activities 5,034,918 10,059,465 10,394,488 ------------ ------------ ------------ Decrease in cash and cash equivalents (1,428,884) (614,291) (2,421,161) Cash and cash equivalents at beginning of period 2,152,595 2,766,886 5,188,047 ------------ ------------ ------------ Cash and cash equivalents at end of period $ 723,711 $ 2,152,595 $ 2,766,886 ============ ============ ============ Supplemental cash flow information: Cash paid for interest $ 26,390 $ 8,994 $ 17,969 ============ ============ ============
See the accompanying Notes which are an integral part of the financial statements 37 41 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS 1. DESCRIPTION OF BUSINESS Illinois Superconductor Corporation (the "Company") uses its patented and proprietary high-temperature superconducting materials technologies to develop and manufacture radio frequency front-end products designed to enhance the quality, capacity, coverage and flexibility of cellular, PCS and other wireless telecommunications services. The Company has historically marketed its products to cellular, PCS and wireless telecommunications service providers located primarily in the United States and expects to begin to market its products to these same types of telecommunications service providers located in certain international markets. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Cash and Cash Equivalents Cash and cash equivalents consist of demand deposits, time deposits, money market funds, and commercial paper which have maturities of three months or less from the date of purchase. Management believes that the financial institutions in which it maintains such deposits are financially sound and, accordingly, minimal credit risk exists with respect to these deposits. Inventories Inventories are stated at the lower of cost (determined on a first in, first out basis) or market. Patents and Trademarks Patents and trademarks represent costs, primarily legal fees and expenses, incurred in order to prepare and file patent applications related to various aspects of the Company's superconductor technology and to its current and proposed products. Patents and trademarks are recorded at cost and are amortized using the straight-line method over the shorter of their estimated useful lives or 17 years. The recoverability of the carrying values of patents and trademarks is evaluated on an ongoing basis. During 1999 and 1998, the Company wrote off $57,741 and $61,333, respectively, of patent-related costs. Total capitalized patent and trademark costs are $647,084 and $655,678 at December 31, 1999 and 1998, respectively. Capitalized patent costs related to pending patents are $218,143 and $315,177 at December 31, 1999 and 1998, respectively. Patents and trademarks are net of accumulated amortization of $54,261 and $39,799 at December 31, 1999 and 1998, respectively. Property and Equipment Property and equipment are stated at cost, less accumulated depreciation, and are depreciated over the estimated useful lives of the assets using accelerated methods. Leasehold improvements are amortized using the straight-line method over the shorter of the useful life of the asset or the term of the lease. Amortization of leasehold improvements is included in depreciation expense. The useful lives assigned to property and equipment for the purpose of computing book depreciation are as follows: 38 42 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Lab equipment 5 years Manufacturing equipment 3 to 5 years Office equipment 3 to 5 years Furniture and fixtures 5 years Leasehold improvements Life of lease Income Taxes Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Revenue Recognition and Product Warranty Revenues from product sales are generally recognized at the time of shipment and are recorded net of estimated returns and allowances. The Company has, under certain conditions, granted customers the right to return product during a specified period of time after shipment. In these situations, the Company establishes a liability for estimated returns and allowances at the time of shipment. The Company has established a program which, in certain situations, allows customers or prospective customers to field test the Company's products for a specified period of time. Revenues from field test arrangements are recognized upon customer acceptance of the products. The Company warrants its products against defects in materials and workmanship typically for an eighteen-month period from the date of shipment, except for superconducting materials contained in the products, which are warranted for ten years from the date of shipment. A provision for estimated future costs related to warranty expenses is recorded when revenues are recognized. At December 31, 1999 and 1998, respectively, the Company has accrued $282,250 and $30,000 for warranty costs. Returns and allowances were not significant in any period reported. Advertising Costs Advertising costs are charged to expense in the period incurred. Advertising expense for the years ended December 31, 1999, 1998 and 1997, was approximately $26,000, $18,000 and $176,000, respectively. Research and Development Costs Research and development costs related to both present and future products are charged to expense in the period incurred. Net Loss Per Common Share Basic and diluted net loss per common share are computed based upon the weighted average number of common shares outstanding. Approximately 64.9 million common shares issuable as of December 31, 1999 upon the exercise of options and warrants and conversion of the Company's Senior Convertible Notes (Note 7) are not included in the per share calculations since the effect of their inclusion would be antidilutive. 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 amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. 39 43 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Description of Certain Concentrations and Risks The Company operates in a highly competitive and rapidly changing industry. Product revenues are currently concentrated with a limited number of customers, and the supply of certain materials is concentrated among a few providers. The development and commercialization of new technologies by any competitor could adversely affect the Company's results of operations. Long Lived Assets The Company records impairment losses on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets' carrying amount. Reclassifications Certain amounts in the financial statements of prior years have been reclassified to conform to the 1999 presentation. 3. GOING CONCERN AND MANAGEMENT'S PLANS The Company has incurred, and continues to incur, losses from operations and has a net capital deficiency. For the years ended December 31, 1999 and 1998, the Company incurred net losses of $22,716,262 and $21,850,120, respectively. At December 31, 1999, the Company has a net capital deficiency of $9,291,712, and its available resources are not presently sufficient to fund its expected cash requirements through the end of 2000. These conditions raise substantial doubt about the Company's ability to continue as a going concern. During 1999, the Company implemented a strategy to reduce its losses from operations and cash used in operating activities. The Company's strategy includes a reduction of the employee workforce, increasing the efficiency of the Company's research and development processes, focusing development efforts on products with a greater probability of commercial sales, reducing professional fees and discretionary expenditures, and negotiating favorable payment arrangements with suppliers and service providers. These efforts have already resulted in a $4.6 million and $5.9 million reduction of the Company's net cash used in operations in 1999 compared to 1998 and 1997 levels, respectively. The Company's business strategy in the future also includes advancing relationships with customers in overseas markets and introducing expanded product offerings to meet varying customer needs. Despite the recently completed issuance of $2,000,000 aggregate principal amount of senior convertible notes in the fourth quarter of 1999, the Company believes that during the second quarter of 2000 it will require substantial additional funding to finance its operations. The Company is actively seeking financing in order to obtain working capital to continue its operations according to its current operating plan through the second quarter of 2000 and beyond. If the Company is unable to obtain adequate funds when needed in the future, the Company would be required to substantially delay, scale-back or eliminate the marketing or sales of one or more of its products or research and development programs, or may be required to obtain funds through arrangements with collaborative partners or others that may require the Company to relinquish rights to certain of its technologies, product candidates or potential products that the Company would not otherwise relinquish. This would materially and adversely affect the Company's business, financial condition, results of operations and cash flows. 40 44 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 4. INVENTORIES Inventories consist of the following: DECEMBER 31, 1999 1998 ---------- ---------- Raw materials $735,787 $1,083,605 Work-in-process -- 60,456 Finished product 356,926 280,366 ---------- ---------- $1,092,713 $1,424,427 ========== ========== Cost of product sales for the years ending December 31, 1999 and 1998 includes approximately $649,000 and $375,000, respectively, of costs in excess of the net realizable value of finished goods inventory. 5. CAPITAL STOCK The Company has an authorized class of undesignated preferred stock consisting of 100,000 shares. Preferred stock may be issued in series from time to time with such designations, relative rights, priorities, preferences, qualifications, limitations and restrictions thereof, to the extent that such are not fixed in the Company's certificate of incorporation, as the Board of Directors determines. On February 9, 1996, the Board of Directors adopted a shareholder rights plan (the "Rights Plan"). In conjunction with the adoption of the Rights Plan, the Company created one series of preferred stock, consisting of 10,000 shares of Series A Junior Participating Preferred Stock ("Series A Preferred"). Each share of Series A Preferred would entitle the holder to receive dividends equal to 1,000 times the dividends per share declared with respect to the Company's common stock and, in the event of liquidation, such holders would receive a preference of 1,000 times the aggregate amount to be distributed per share to the holders of the Company's common stock. Pursuant to the Rights Plan, a Series A Right is associated with, and trades with, each share of common stock outstanding. The record date for distribution of such Series A Rights was February 22, 1996, and for so long as the Series A Rights are associated with the common stock, each new share of common stock issued by the Company will include a Series A Right. Each Series A Right will entitle its holder to purchase one one-thousandth of a share of Series A Preferred for $200, subject to adjustment as defined in the Rights Plan. The Series A Rights are not exercisable until the earlier of (i) 10 days after any person or group becomes the beneficial owner of 15% or more of the Company's outstanding common stock, or (ii) 10 business days (unless extended by the Board of Directors) after the commencement of a tender offer or exchange offer that would result in a person or group beneficially owning 15% or more of the Company's outstanding common stock. 41 45 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 5. CAPITAL STOCK (CONTINUED) If any person or group ("Acquiring Party") acquires 15% or more of the Company's outstanding common stock ("Shares Acquisition Date"), each holder of a Series A Right, except the Acquiring Party, has the right to receive upon exercise (i) shares of the Company's common stock having a market value equal to two times the exercise price of the Series A Right, and (ii) one Series B Right (Series A Rights and Series B Rights are hereinafter collectively referred to as the "Rights"). The Board of Directors has the option, after the Shares Acquisition Date but before there has been a 50% acquisition of the Company, to exchange one share of common stock (or one one-thousandth of a share of preferred stock) and one Series B Right for each Series A Right (other than Series A Rights held by the Acquiring Party). If, after the Series A Rights become exercisable, the Company is involved in a merger or other business combination, or if the Company sells or transfers more than 50% of its assets or earning power, or if an acquiring party engages in certain "self-dealing" transactions with the Company, as defined in the Rights Plan, each Right then outstanding (other than Rights held by the Acquiring Party) will be exercisable for common stock of the other party to such transaction having a market value of two times the exercise price of the Right. The Company has the right to redeem each Series A Right for $0.01 prior to the Shares Acquisition Date. The Series B Rights, once issued, are not redeemable. The Rights expire on February 9, 2006. On November 14, 1995, the Company completed the private placement and issuance of 356,473 Units, which raised $3,581,282, net of related expenses. Each Unit consisted of one share of common stock and one detachable common stock purchase warrant. Each warrant had a term of two years and was exercisable for the purchase of one share of common stock at $13.00 per share. Warrants for 15,700 of these shares were exercised prior to December 23, 1996. The remaining 340,773 warrants were redeemed by the Company on December 23, 1996. In conjunction with the redemption, the Company issued 340,773 shares of its common stock in exchange for $3,287,304 in cash plus $1,142,754 of notes. The notes bear interest at 8.25% per annum, were due on April 30, 1997, and are guaranteed by an affiliate of a stockholder. Payments made during 1998 and 1997 on the notes receivable totaled $17,812 and $444,246, respectively. The remaining balance due of $680,696 was forgiven as part of a settlement agreement and will be charged to additional paid-in capital in the first quarter of 2000 (Note 11). On June 6, 1997, the Company issued 600 shares of Series B Convertible Preferred Stock ("Series B Stock") for $5,000 per share, or $3,000,000. In connection with the sale, the Company issued warrants to purchase 62,500 shares of common stock at $14.8125 per share expiring on June 6, 2001. On each of August 29, 1997 and October 29, 1997, the Company issued 300 shares of Series C Convertible Preferred Stock ("Series C Stock") for $5,000 per share, or $3,000,000 in aggregate. In addition, on October 29, 1997, the Company issued 700 shares of Series G Convertible Preferred Stock ("Series G Stock") for $5,000 per share, or $3,500,000. In connection with the sale of Series G Stock, the Company issued warrants to purchase an aggregate of 34,782 shares of common stock at an original exercise price of $10.0625 per share, expiring on October 29, 2001. On November 5, 1999, in conjunction with certain amendments to the Company's senior convertible notes (Note 7), these outstanding warrants were amended to reduce the exercise price to $0.25 per share. Total proceeds for the above issuances, net of related expenses, was $9,020,028. None of the Preferred Stock has voting rights. The Series B Stock was convertible into common stock at a conversion price equal to the lessor of (a) $11.85, or (b) 101% of the average of the lowest per share market value for the five consecutive trading days during the 60 trading days immediately preceding the date of the conversion. The Series C Stock and Series G Stock was convertible into common stock at a conversion price equal to the lessor of (a) $8.05 or (b) 101% of the average of the lowest per share market value for the five consecutive trading days during the 60 trading days immediately proceeding the date of conversion. The conversion ratio was subject to adjustment. Dividends on the Series B, Series C and Series G Convertible Preferred Stock were payable at the rate of 5% per annum, and were payable in cash or shares of common stock, at the option of the Company. 42 46 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 5. CAPITAL STOCK (CONTINUED) During 1997, $2,525,000 (505 shares) of Series B Convertible Preferred Stock were converted into 801,992 shares of common stock. Accrued dividends thereon of $61,138 were also converted into 19,940 shares of common stock. During 1998, $475,000 (95 shares) of Series B Convertible Preferred Stock were converted into 270,671 shares of common stock. Accrued dividends thereon of $13,794 were also converted into 7,860 shares of common stock. In addition, $3,000,000 (600 shares) of Series C Convertible Preferred Stock were converted into 2,611,299 shares of common stock. Accrued dividends thereon of $62,801 were also converted into 54,646 shares of common stock. In addition, $3,500,000 (700 shares) of Series G Convertible Preferred Stock were converted into 3,509,125 shares of common stock. Accrued dividends thereon of $67,403 were also converted into 67,577 shares of common stock. On June 9, 1999, the stockholders of the Company approved an increase in the number of shares of authorized common stock from 30,000,000 to 60,000,000. At December 31, 1999, authorized but unissued shares of common stock have been reserved for future issuance as follows: Warrants outstanding (Note 6) (1) 6,525,485 Options outstanding (Note 6) 1,914,847 Options reserved for future issuance under the 1993 Stock Option Plan (Note 6) 553,493 Shares currently issuable upon conversion of senior convertible notes (Note 7)(2) 35,253,174 ---------- 44,246,999 ========== (1) Excludes 210,196 warrants outstanding at December 31, 1999 that were surrendered to the Company in February 2000 (Note 11). (2) As of December 31, 1999, the Company's senior convertible notes, plus interest paid-in-kind, were convertible into approximately 55,886,000 shares of the Company's common stock. However, conversions were limited by agreement with the holders to 35,253,174 shares as of that date because the Company does not currently have enough authorized shares of common stock. 6. STOCK OPTIONS AND WARRANTS On August 19, 1993, the Board of Directors adopted the 1993 Stock Option Plan (the "Plan") for employees, consultants, and directors who are not also employees of the Company (outside directors). The maximum number of shares issuable under the Plan, as amended in 1999, is 2,511,486. The Plan is administered by a committee (the "Committee") consisting of two or more outside directors appointed by the board of directors of the Company. 43 47 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 6. STOCK OPTIONS AND WARRANTS (CONTINUED) For employees and consultants, the Plan provides for granting of Incentive Stock Options (ISOs) and Nonstatutory Stock Options (NSOs). In the case of ISOs, the exercise price shall not be less than 100% (110% in certain cases) of the fair value of the Company's common stock, as determined by the Committee, on the date of grant. In the case of NSOs, the exercise price shall not be less than 85% (110% in certain cases) of the fair value of the Company's common stock, as determined by the Committee, on the date of grant. The term of options granted to employees and consultants will be for a period not to exceed 10 years (five years in certain cases). Options granted under the Plan generally vest over a four year period (one-fourth of options granted vest after one year from the grant date and the remaining options vest ratably each month thereafter). In addition, the Committee may authorize option grants with vesting provisions that are not based solely on employees' rendering of additional service to the Company. For outside directors, NSOs only will be granted with an exercise price of 100% of the fair value of the stock, as determined by the Committee, on the date of grant. The Plan provides that each outside director will be automatically granted 10,000 NSOs on the date of their initial election to the board of directors. On the date of the annual meeting of the stockholders of the Company, each outside director who is elected, reelected, or continues to serve as a director, shall be granted not less than 3,000 nor more than 10,000 NSOs, except for those outside directors who are first elected to the Board of Directors at the meeting or three months prior. The options granted vest ratably over three years and expire after ten years from the grant date. The Company entered into stock option agreements with certain employees and a consultant prior to the adoption of the Plan. These stock options expire 10 years from the date of grant. Exercise prices were determined by the Board of Directors and represented estimated fair values of the Company's common stock at the grant date. On May 10, 1999, the Board of Directors granted to each employee of the Company (other than the executive officers of the Company) (collectively, the "Non-Executive Employees") the option to (i) reduce the exercise prices of up to a maximum of 15,000 of the unexercised stock options previously granted to such Non-Executive Employee under the Plan to $.5625 per share (the closing price of the Company's Common Stock on May 10, 1999) and (ii) cause all of such stock options not otherwise scheduled to become fully vested on or before May 10, 2000 to become fully vested on such date. As a result thereof, an aggregate of 279,550 stock options previously granted under the Plan were amended as described in the preceding sentence. In addition, on May 10, 1999 the Board of Directors granted to the executive officers and certain Non-Executive Employees of the Company additional non-statutory stock options to purchase an aggregate of 343,575 shares of the Company's Common Stock under the Plan. Such stock options become fully vested on the first anniversary of the date of grant, have exercise prices of $.5625 per share and expire 10 years from the date of grant. The Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related Interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under Financial Accounting Standards Board No. 123, Accounting for Stock-Based Compensation (FASB 123) requires the use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, since the exercise price of the Company's employee stock option grants has equaled the market price of the underlying stock on the date of grant, no compensation expense is recognized. 44 48 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 6. STOCK OPTIONS AND WARRANTS (CONTINUED) Pro forma information regarding net income and earnings per share is required under FASB 123, and has been determined as if the Company had accounted for its stock options granted subsequent to December 31, 1994 under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for the years ended December 31, 1999, 1998 and 1997: risk-free interest rate of 6.0%, 5.6% and 6.3%, respectively; a dividend yield of 0%; volatility factor of the expected market price of the Company's common stock of 1.68, .96 and .74, respectively; and expected life of the options of 4.0 years. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information is as follows:
YEAR ENDED DECEMBER 31, 1999 1998 1997 ------------ ------------ ------------- Pro forma net loss $(23,522,352) $(22,863,252) $(13,063,962) Pro forma basic and diluted loss per common share $ (1.83) $ (2.02) $ (2.53)
The table below summarizes all option activity during the three year period ended December 31, 1999:
EXERCISE OPTIONS PRICE OUTSTANDING PER SHARE -------------------------------- Outstanding at December 31, 1996 796,258 $ .18 - 27.00 Granted 121,000 2.00 - 19.00 Exercised (17,821) .18 - 18.25 Forfeited (216,104) 6.75 - 27.00 --------- Outstanding at December 31, 1997 683,333 .18 - 26.50 Granted 780,900 1.03 - 2.00 Exercised (33,942) .18 - .23 Forfeited (236,314) .23 - 26.50 --------- Outstanding at December 31, 1998 1,193,977 .18 - 26.50 Granted 1,935,125 .45 - 1.31 Exercised (17,250) .18 - .23 Forfeited (1,197,005) .48 - 26.50 --------- Outstanding at December 31, 1999 1,914,847 $ .18 - 26.50 =========
45 49 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 6. STOCK OPTIONS AND WARRANTS (CONTINUED) The weighted-average exercise price of options outstanding at December 31, 1999, 1998 and 1997, was $1.83, $6.71 and $12.92, respectively. The weighted-average exercise price of options granted, exercised, and forfeited during 1999 was $0.59, $0.22 and $4.70, respectively. The weighted-average fair value of options granted during 1999, 1998 and 1997 was $0.53, $1.09, $7.94, respectively. Following is additional information with respect to options outstanding at December 31, 1999:
EXERCISE EXERCISE EXERCISE EXERCISE EXERCISE PRICE FROM PRICE FROM PRICE FROM PRICE FROM PRICE FROM $0.18 TO $0.48 TO $0.66 TO $6.75 TO $15.50 TO $0.45 $0.56 $2.00 $11.75 $26.50 --------------------------------------------------------------- OUTSTANDING AT DECEMBER 31, 1999: Number of options 301,725 1,093,535 356,000 71,639 91,948 Weighted-average exercise price $ 0.45 $ 0.51 $ 1.34 $ 9.76 $ 17.78 Weighted-average remaining contractual life in years 9.90 9.19 8.73 4.43 5.94 EXERCISABLE AT DECEMBER 31, 1999: Number of options 1,725 156,342 85,063 69,839 85,312 Weighted-average exercise price $ 0.18 $ 0.56 $ 1.69 $ 9.80 $ 17.72
The total number of unvested options outstanding at December 31, 1999 was 1,516,566, all of which will vest based on employees' continued service to the Company. On February 15, 2000, the Board of Directors of the Company granted to certain executive level employees (i) an aggregate of 440,000 Deferred Stock Units and (ii) an aggregate of 585,000 NSOs under the Plan. The NSOs have an exercise price of $4.1875 per share (the closing price of the Company's common stock on February 15, 2000). The Deferred Stock Units represent the right to receive an equivalent number of restricted shares of the Company's common stock. Both the Deferred Stock Units and the NSOs vest at the rate of 10%, 20%, 30% and 40% on the first, second, third and fourth anniversary, respectively, of the date of grant. The executive level employees have the right to defer receipt of the common stock subject to the Deferred Stock Units to a later date as elected by the employee. 46 50 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 6. STOCK OPTIONS AND WARRANTS (CONTINUED) In December 1991 and January 1992, the Company issued common stock purchase warrants for 34,063 and 74,938 shares, respectively, to preferred stockholders in conjunction with short-term loans from the stockholders. These warrants have an exercise price of $1.4679 per share and expire 10 years from the date of issue. Warrants for 19,869, 34,063 and 13,625 of these shares were exercised during 1997, 1996, and 1995, respectively. In connection with the July 1992 issuance of Series B convertible preferred stock, the Company issued common stock purchase warrants for 213,780 shares to the Series B convertible preferred stockholders. These warrants have an exercise price of $2.29 (71,260 shares), $2.75 (71,260 shares), and $3.21 (71,260 shares) per share and expire upon the seventh anniversary of issuance. Warrants for 96,437 of these shares (36,107 shares at $2.29 per share, 36,107 shares at $2.75 per share and 24,223 shares at $3.21 per share) were exercised during 1996. Warrants for 54,337 of these shares (17,779 shares at $2.29 per share, 17,779 shares at $2.75 per share, and 18,779 shares at $3.21 per share) were exercised during 1997. The remaining 63,006 unexercised warrants expired in 1999. The Company issued warrants to purchase 470,589 shares of common stock in connection with the July 1993 issuance of Series C Preferred Stock. These warrants are exercisable at $9.56 per share. Warrants for 64,614 and 69,020 of these shares were exercised during 1997 and 1996, respectively. On February 22, 2000, 210,196 of these warrants were surrendered to the Company as part of a settlement agreement (Note 11). The remaining 126,759 warrants expire in November 2000. On June 6, 1997, the Company issued warrants to purchase 62,500 shares of common stock in connection with the issuance of Series B Convertible Preferred Stock (Note 5). These warrants have an exercise price of $14.8125 per share and expire on June 6, 2001. On October 29, 1997, the Company issued warrants to purchase 34,782 shares of common stock in connection with the issuance of Series G Convertible Preferred Stock (Note 5). These warrants had an original exercise price of $10.0625 per share and expire on October 29, 2001. On November 5, 1999, in conjunction with certain amendments to the Company's senior convertible notes (Note 7), these outstanding warrants were amended to reduce the exercise price to $0.25 per share. On May 15, 1998, the Company issued warrants to purchase 4,140,000 shares of common stock in connection with the issuance of the Company's senior convertible notes (Note 7). Of the original warrants issued, 3,800,000 of these warrants have an exercise price of $0.25 per share and 340,000 of these warrants have an exercise price of $3.75 per share. These warrants expire on May 15, 2001. On March 31, 1999, the Company issued warrants to purchase 1,320,000 shares of common stock in connection with the issuance of the Company's senior convertible notes (Note 7). Of the original warrants issued, 1,200,000 of these warrants have an exercise price of $0.25 per share and 120,000 of these warrants have an exercise price of $1.4625 per share. These warrants expire on March 31, 2002. 47 51 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 6. STOCK OPTIONS AND WARRANTS (CONTINUED) On November 5, 1999 and December 29, 1999, the Company issued warrants to purchase an aggregate total of 800,000 shares of common stock in connection with the issuance of the Company's senior convertible notes (Note 7). These warrants have an exercise price of $0.25 per share and expire on November 5, 2004. During the period from January 1, 2000 to February 25, 2000, 2,200,000 warrants issued in connection with the issuance of the Company's senior convertible notes (Note 7) were exercised at an exercise price of $0.25 per share. 7. LONG-TERM DEBT On May 15, 1998, the Company issued and sold $10,350,000 in aggregate principal amount of senior convertible notes due May 15, 2002 (the "May 1998 Notes") and issued warrants (the "May 1998 Warrants") to purchase 4,140,000 shares of the Company's common stock. The May 1998 Notes (based upon the terms at their time of issue) bear interest at 2% per annum, payable in cash or shares of Common Stock, at the Company's option (unless the Company does not meet certain requirements commencing November 5, 2001, in which case interest must be paid in cash). The May 1998 Notes mature on May 15, 2002 and (based upon the terms at their time of issue) are convertible (based on the principal amount, plus accrued and unpaid interest, if any) into shares of the Company's common stock at a fixed conversion price of $1.50 per share. On and after May 15, 2000, the Company may redeem all or a portion of the May 1998 Notes at a redemption price equal to the principal amount plus accrued interest thereon, if any, under certain conditions. The May 1998 Warrants (based upon the terms at their time of issue) have an exercise price of $3.75 per share and expire on May 15, 2001. Since the May 1998 Notes were issued with a non-detachable conversion feature that was "in-the-money" at the date of issuance, a portion of the proceeds equal to the intrinsic value of the conversion feature (equal to $9,918,750, and calculated as the difference between the conversion price and the quoted market price of the Company's common stock on the date of issuance, multiplied by the number of shares into which the May 1998 Notes are convertible) was allocated to additional paid-in capital, thus creating a discount to the debt. This discount was recognized as a charge to interest expense using the effective interest method over the period from the date of issuance to the date that the May 1998 Notes first became convertible (August 15, 1998 for up to one-half of the original principal amount and November 15, 1998 for the remaining principal amount). In addition, a portion of the proceeds equal to the fair value of the May 1998 Warrants issued in conjunction with the May 1998 Notes (equal to $1,230,000, and calculated using a Black-Scholes valuation model) was allocated to additional paid-in capital, thus creating an additional discount to the debt. This discount is being recognized as a charge to interest expense using the effective interest method over the four year term of the May 1998 Notes. On March 31, 1999, the Company issued and sold $3,300,000 in aggregate initial principal amount of senior convertible notes due May 15, 2002 (the "March 1999 Notes") and issued warrants (the "March 1999 Warrants") to purchase 1,320,000 shares of the Company's common stock. The March 1999 Notes bear interest at 6% per annum, payable in kind or in cash, at the Company's option (unless the Company fails to meet certain requirements commencing November 5, 2001, in which case interest must be paid in cash). Holders of the March 1999 Notes may convert the principal amount, plus accrued interest not paid in cash, if any, into shares of the Company's common stock at a fixed conversion price of $1.125 per share (based upon the terms at their time of issue). On and after May 15, 2000, the Company may redeem all or a portion of the March 1999 Notes at a redemption price equal to the principal amount plus accrued interest thereon, if any, under certain conditions. The March 1999 Warrants (based upon the terms at their time of issue) have an exercise price of $1.4625 per share and expire on March 31, 2002. 48 52 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 7. LONG-TERM DEBT (CONTINUED) Concurrently with the issuance of the March 1999 Notes, the Company amended certain terms of $5,500,000 in aggregate principal amount of the May 1998 Notes (the "Amended Notes") and May 1998 Warrants exercisable for an aggregate of 2,200,000 shares of the Company's common stock (the "Amended Warrants") issued in connection therewith (the "March 1999 Amendments"). The Amended Notes, as so amended, bear interest at the rate of 6% per annum, payable in cash or shares of the Company's common stock, at the Company's option (unless the Company fails to meet certain requirements commencing November 5, 2001, in which case interest must be paid in cash), and the fixed conversion price for the Amended Notes was reduced from $1.50 to $1.125 per share. The exercise price of the Amended Warrants was reduced from $3.75 to $1.4625 per share and the expiration date was extended from May 15, 2001 to March 31, 2002. A portion of the proceeds of the March 1999 Notes equal to the fair value of the March 1999 Warrants issued in conjunction with the March 1999 Notes (equal to $300,000 and calculated using a Black-Scholes valuation model) was allocated to additional paid-in capital, thus creating a discount to the debt. This discount is being recognized as a charge to interest expense using the effective interest method over the three year term of the March 1999 Notes. In addition, the increase in fair value of the Amended Warrants as a result of the decrease in exercise price (equal to $41,000 and calculated using a Black-Scholes valuation model) was allocated to additional paid-in capital, thus creating an additional discount on the Amended Notes. This discount is being recognized as a charge to interest expense using the effective interest method over the remaining three year term of the Amended Notes. On November 5, 1999, the Company issued and sold $1,000,000 in aggregate principal amount of senior convertible notes due January 2, 2001 (the "November 1999 Notes") and issued warrants (the "November 1999 Warrants") to purchase 400,000 shares of the Company's common stock. The November 1999 Notes bear interest at 10% per annum, payable in kind or in cash, at the Company's option (unless the Company does not meet certain requirements commencing November 5, 2001, in which case interest must be paid in cash). Holders of the November 1999 Notes may convert the principal amount, plus accrued interest not paid in cash, if any, into shares of the Company's common stock at a fixed conversion price of $0.25 per share. The November 1999 Warrants have an exercise price of $0.25 per share and expire on November 5, 2004. Concurrently with the issuance of the November 1999 Notes, the Company amended certain terms of $11,800,000 in aggregate principal amount of the March 1999 Notes, the Amended Notes and the May 1998 Notes (the "Further Amended Notes") and certain terms of the March 1999 Warrants, the Amended Warrants and the May 1998 Warrants previously exercisable for an aggregate of 4,800,000 shares of the Company's common stock (the "Further Amended Warrants") issued in connection therewith ("the "November 1999 Amendments"). The Further Amended Notes were amended to reduce their fixed conversion price to $0.25 per share and to provide that interest on the Further Amended Notes can be paid in cash or shares of the Company's common stock, at the Company's option until November 5, 2000, after which interest must be paid in cash if the Company fails to meet certain requirements. The exercise price of the Further Amended Warrants was reduced to $0.25 per share. Since the November 1999 Notes were issued with a non-detachable conversion feature that was "in-the-money" at the date of issuance, a portion of the proceeds equal to the intrinsic value of the conversion feature (calculated as the difference between the conversion price ($0.25 per share) and the quoted market price of the Company's common stock on the date of issuance ($0.46875 per share) multiplied by the number of shares into which the November 1999 Notes are convertible (4,000,000 shares)) must be allocated to additional paid-in capital, thus creating a discount to the debt. This discount, which was limited to $844,000 because the intrinsic value of the beneficial conversion feature cannot exceed the amount allocated to the convertible instrument, was recognized as a charge to interest expense during the fourth quarter of 1999 since the November 1999 Notes are immediately convertible into common stock. In addition, a portion of the proceeds of the November 1999 Notes equal to the fair value of the November 1999 Warrants issued in conjunction with the November 1999 Notes (equal to $156,000 and calculated using a Black-Scholes valuation model) was allocated to additional paid-in capital, thus creating an additional discount to the debt. This additional discount will be recognized as a charge to interest expense using the effective interest method over the fourteen month term of the November 1999 Notes. 49 53 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 7. LONG-TERM DEBT (CONTINUED) Since the Further Amended Notes were amended to reduce the non-detachable conversion feature so that they were "in-the-money" on November 5, 1999, a portion of the principal amount equal to the intrinsic value of the conversion feature (calculated as the difference between the amended conversion price ($0.25 per share) and the quoted market price of the Company's common stock on the amendment date ($0.46875) multiplied by the number of shares into which the Further Amended Notes are convertible (47,200,000)) must be allocated to additional paid-in capital, thus creating a discount to the debt. This discount, which was limited to $10,264,000 because the intrinsic value of the beneficial conversion feature cannot exceed the amount allocated to the convertible instrument, was recognized as a charge to interest expense during the fourth quarter of 1999 since the Further Amended Notes are immediately convertible into common stock. In addition, the increase in fair value of the Further Amended Warrants as a result of the decrease in exercise price (equal to $1,132,000 and calculated using a Black-Scholes valuation model) was allocated to additional paid-in capital, thus creating an additional discount on the Further Amended Notes. This additional discount will be recognized as a charge to interest expense using the effective interest method over the remaining term of the Further Amended Notes. The March 1999 Amendments and the November 1999 Amendments were accounted for and reported in the same manner as a debt extinguishment. This resulted in a $745,197 charge, which is shown as an extraordinary item in the Company's Statements of Operations for the year ended December 31, 1999. On December 29, 1999, the Company issued and sold $1,000,000 in aggregate principal amount of senior convertible notes due January 2, 2001 (the "December 1999 Notes") and issued warrants (the "December 1999 Warrants") to purchase 400,000 shares of the Company's common stock. The December 1999 Notes bear interest at 10% per annum, payable in kind or in cash, at the Company's option (unless the Company does not meet certain requirements commencing November 5, 2001, in which case interest must be paid in cash). Holders of the December 1999 Notes may convert the principal amount, plus accrued interest not paid in cash, if any, into shares of the Company's common stock at a fixed conversion price of $0.25 per share. The December 1999 Warrants have an exercise price of $0.25 per share and expire on November 5, 2004. Since the December 1999 Notes were issued with a non-detachable conversion feature that was "in-the-money" at the date of issuance, a portion of the proceeds equal to the intrinsic value of the conversion feature (equal to $500,000, and calculated as the difference between the conversion price ($0.25 per share) and the quoted market price of the Company's common stock on the date of issuance ($0.375 per share) multiplied by the number of shares into which the December 1999 Notes are convertible (4,000,000 shares)) was allocated to additional paid-in capital, thus creating a discount to the debt. This discount was recognized as a charge to interest expense since the notes are immediately convertible into common stock. In addition, a portion of the proceeds of the December 1999 Notes equal to the fair value of the December 1999 Warrants issued in conjunction with the December 1999 Notes (equal to $104,000 and calculated using a Black-Scholes valuation model) was allocated to additional paid-in capital, thus creating an additional discount to the debt. This additional discount will be recognized as a charge to interest expense using the effective interest method over the twelve month term of the December 1999 Notes. During 1999, $200,000 in aggregate principal amount of the Amended Notes and $725,000 in aggregate principal amount of the Further Amended Notes, plus accrued interest, were converted into 186,314 shares and 2,992,392 shares, respectively, of common stock. The Company recognized $12,608,355 and $10,101,401 of non-cash interest charges during 1999 and 1998, respectively as a result of amortizing the debt discount and the deferred financing fees related to the Company's senior convertible notes. 50 54 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 7. LONG-TERM DEBT (CONTINUED) All of the Company's assets are pledged as security to certain of the purchasers of the senior convertible notes. Additionally, the Note Purchase Agreements contain several covenants which limit the Company's ability to incur additional indebtedness and to create any further lien, pledge, or encumbrance on any assets of the Company. Payments due on long-term debt, including interest accrued on the senior convertible notes, during each of the five years subsequent to December 31, 1999 and in the aggregate are as follows: 2000 $ 9,020 2001 2,025,025 2002 13,348,792 2003 -- 2004 -- Thereafter -- ------------ $ 15,382,837 ============ During the period from January 1, 2000 to February 25, 2000, $2,470,222 in aggregate principal amount of Further Amended Notes, $500,000 in aggregate principal amount of Amended Notes, $300,000 in aggregate principal amount of March 1999 Notes, and $500,000 in aggregate principal amount of May 1998 Notes were converted into 11,341,526 shares of common stock. It is not practicable to estimate the fair value of the Notes at December 31, 1999 because a quoted market price for such securities is not available, the Company has not yet developed a valuation model necessary to make such an estimate, and the cost of obtaining an independent valuation would be prohibitive. 8. INCOME TAXES The Company has net operating loss and research and development credit carryforwards for tax purposes of approximately $60,584,000 and $1,075,000, respectively, at December 31, 1999. The net operating loss carryforwards expire in the following years: YEAR AMOUNT ---- ----------- 2005 $ 7,000 2006 638,000 2007 974,000 2008 1,658,000 2009 3,973,000 2010 8,199,000 2011 11,953,000 2012 11,922,000 2013 11,146,000 2014 10,114,000 ----------- $60,584,000 =========== 51 55 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 8. INCOME TAXES (CONTINUED) Significant components of the Company's deferred tax assets and liabilities are as follows: DECEMBER 31, 1999 1998 ------------ ------------ Deferred tax assets: Net operating loss carryforward $ 23,023,000 $ 19,140,000 Research and development tax credit carryforwards 1,075,000 1,050,000 Deferred compensation 3,000 27,000 Accrued liabilities 130,000 -- Accounts receivable 13,000 33,000 Inventories 324,000 223,000 ------------ ------------ Total deferred tax assets 24,568,000 20,473,000 Deferred tax liabilities: Patent costs (225,000) (234,000) Property and equipment (29,000) (101,000) ------------ ------------ (254,000) (335,000) ------------ ------------ Net deferred tax assets 24,314,000 20,138,000 Valuation allowance (24,314,000) (20,138,000) ------------ ------------ Net deferred tax assets $ -- $ -- ============ ============ The valuation allowance increased during 1999 and 1998 by $4,176,000 and $4,313,000, respectively, due primarily to the increase in the net operating loss carryforward. Based on the Internal Revenue Code and changes in the ownership of the Company, utilization of the net operating loss carryforwards will be subject to annual limitations. 9. LEASES The Company leases its manufacturing and office space. Under the terms of the lease, which expires October 2004, the Company is responsible for all real estate taxes and operating expenses. The lease provides for a security deposit ($200,000 at December 31, 1999) that is secured by a certificate of deposit owned by the Company. 52 56 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 9. LEASES (CONTINUED) Future minimum payments under the operating lease consist of the following at December 31, 1999: YEAR AMOUNT ----------- ----------- 2000 $ 231,300 2001 249,900 2002 249,900 2003 249,900 2004 208,300 Thereafter -- ---------- $1,189,300 ========== Rent expense totaled $227,535, $229,786 and $226,938, for the years ended December 31, 1999, 1998, and 1997, respectively. 10. 401(k) PLAN The Company has a 401(k) plan covering all employees who meet prescribed service requirements. The plan provides for deferred salary contributions by the plan participants and a Company contribution. Company contributions, if any, are at the discretion of the Board of Directors and are not to exceed the amount deductible under applicable income tax laws. No Company contribution was made for the years ended December 31, 1999, 1998, and 1997. 11. LITIGATION Siegler Litigation On June 5, 1996, Craig M. Siegler filed a complaint against the Company in the Circuit Court of Cook County, Illinois, County Department, Chancery Division. The complaint alleged that, in connection with the Company's private placement of securities in November 1995, the Company breached and repudiated an oral contract with Mr. Siegler for the issuance and sale by the Company to Mr. Siegler of 370,370.37 shares of the Company's Common Stock, plus warrants (immediately exercisable at $12.96 per share) to purchase an additional 370,370.37 shares of the Company's Common Stock, for a total price of $4,000,000. The remedy sought by Mr. Siegler was a sale to him of such securities on the terms of the November 1995 private placement. On August 16, 1996, the Company's motion to dismiss Mr. Siegler's complaint was granted with leave to amend. On September 19, 1996, Mr. Siegler's motion for reconsideration was denied. On October 10, 1996, Mr. Siegler filed his First Amended Verified Complaint and Jury Demand, seeking a jury trial and money damages equal to the difference between $8,800,000 (370,370.37 shares at $10.80 per share and 370,370.37 shares at $12.96 per share) and 740,740.74 shares multiplied by the highest price at which the Company's Common Stock traded on The Nasdaq Stock Market between November 20, 1995 and the date of judgment. Mr. Siegler also preserved his claim for specific performance for purposes of appeal. On November 1, 1996, the case was transferred to the Circuit Court of Cook County, Illinois, County Department, Law Division. The Company's Answer was filed on November 21, 1996, and the parties have completed discovery. 53 57 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 11. LITIGATION (CONTINUED) The Company filed a motion for summary judgment against Mr. Siegler, which is on hold pending the deposition of an expert retained by Mr. Siegler in the case. The Company is scheduled to take the expert's deposition in March 2000, after which the court will enter a briefing schedule on the motion for summary judgement. The Company believes that the suit is without merit and intends to continue to defend itself vigorously in this litigation. However, if Mr. Siegler prevails in this litigation and is awarded damages in accordance with the formula described above, such judgment would have a material adverse effect on the Company's financial condition, results of operations and cash flows. Note Litigation On July 10, 1997, the Company filed a complaint against Sheldon Drobny; Howard L. "Buzz" Simons, joint tenant with Aric and Corey Simons; Aaron Fischer; Stewart Shiman; Sharon D. Gonsky, d/b/a SDG Associates; Gregg Rosenberg; Stacey Rosenberg; Merrill Weber & Co., Inc.; Drobny/Fischer Partnership, an Illinois general partnership; and Ruben Rosenberg (collectively, the "Borrowers"), and Paradigm Venture Investors, L.L.C. (the "Guarantor") in the Circuit Court of Cook County, Illinois, County Department, Law Division. The complaint seeks to enforce the terms of loans made to the Borrowers by the Company and evidenced by promissory notes dated December 13, 1996, in the aggregate principal amount of $698,508 ($680,696 of which remains unpaid as of December 31, 1999) and the guarantee by the Guarantor of the Borrowers' obligations under these promissory notes. The Borrowers' notes were issued to the Company in connection with the Borrowers' exercise of warrants to purchase shares of the Common Stock in December 1996. On September 30, 1997, the Borrowers and the Guarantor responded to the Company's complaint. Concurrently, the Borrowers filed a counterclaim alleging that they exercised the warrants in reliance on the Company's alleged fraudulent representations to certain Borrowers concerning a third-party's future underwriting of a secondary public offering of the Company's Common Stock. On February 22, 2000, the Company reached a settlement agreement with the Borrowers, whereby the Company agreed to release the Borrowers obligations under the notes in return for the Borrowers' surrender of 210,196 warrants to purchase common stock of the Company held by them and discharge of their counterclaims. As a result of this settlement, the Company will record a charge of $822,776 to additional paid-in capital in the first quarter of 2000, reflecting the carrying amount of the notes of $680,696 and related accrued interest of $142,080, which approximates the fair value of the warrants surrendered. Lipman Litigation On January 6, 1998, Jerome H. Lipman, individually and on behalf of all others similarly situated, filed a complaint against the Company and eight of its former or current directors: Leonard A. Batterson, Michael J. Friduss, Peter S. Fuss, Edward W. Laves, Steven L. Lazarus, Tom L. Powers, Ora E. Smith and Paul G. Yovovich (collectively, the "Named Directors") in the Circuit Court of Cook County, Illinois, County Department, Chancery Division. The complaint alleged that the Named Directors breached their duties of loyalty and due care to the putative class of stockholders by selecting financing for the Company in June 1997 which supposedly entrenched the Directors and reduced the Common Stock price. The complaint also alleged that the Named Directors breached their duty of disclosure by not informing the stockholders that the selected financing would erode the Common Stock price. Mr. Lipman's complaint sought certification of a class consisting of all owners of the Company's Common Stock during the period from June 6, 1997 through November 21, 1997, excluding the Named Directors and Sheldon Drobny. The complaint also seeks an unspecified amount of compensatory and punitive damages, and attorneys' fees. 54 58 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 11. LITIGATION (CONTINUED) The Company and the Named Directors regard the suit as without factual or legal merit. Accordingly, on February 17, 1998, the Company and the Named Directors filed a motion to dismiss Mr. Lipman's complaint. The motion presented arguments that the claims of Mr. Lipman and the putative class are barred by the business judgment rule and the plaintiff's failure to fulfill the legal prerequisites for filing an action against the Named Directors. Prior to a hearing on the Company's and the Named Directors' motion to dismiss, Mr. Lipman filed a motion on March 16, 1998, seeking both to amend his proposed putative class to include Mr. Drobny and to certify the class. On June 1, 1998, the court granted the Company's and the Named Directors' motion to dismiss the complaint. Concurrently, Mr. Lipman withdrew his motion to amend the proposed putative class and certify the class. On June 30, 1998, Mr. Lipman filed an amended complaint against the Named Directors but excluding the Company itself as a defendant. The amended complaint alleges that the Named Directors breached their duties of loyalty and due care to the putative class of stockholders by selecting financing for the Company in June 1997 and thereafter drawing two tranches of the financing. The amended complaint seeks certification of a class consisting of all owners of the Company's Common Stock during the period from May 15, 1997 through December 31, 1997, excluding the Named Directors. Mr. Lipman's amended complaint alleges that the stock owned by the putative class lost $61 million due to the financing the Named Directors selected, and seeks an unspecified amount of compensatory and punitive damages. The Company and the Named Directors regard the amended complaint as without factual or legal merit. Accordingly, the Named Directors filed a motion to dismiss Mr. Lipman's amended complaint on July 29, 1998. The court granted the motion to dismiss in December 1998, finding that Mr. Lipman still had failed to fulfill the prerequisites for maintaining a shareholder derivative action against the Named Directors. On January 12, 1999, Mr. Lipman and two added former stockholders filed a second amended complaint against the Named Directors and again including the Company itself as a defendant. The second amended complaint alleged that the Named Directors breached their duties of loyalty and due care to the putative class and further alleged that the purported devaluation of the plaintiffs' stock resulting from the June 1997 financing was an improper "assessment" on the plaintiffs' shares for which they sought an unspecified amount of compensatory and punitive damages. In February 1999, the Company and the Named Directors filed a motion to dismiss the second amended complaint. The Court granted the motion to dismiss in April 1999, finding that (i) the plaintiffs could not assert their stock devaluation claims, except derivatively, and (ii) the plaintiffs still had failed to fulfill the prerequisites for maintaining a shareholder derivative action against the Named Directors. In May 1999, the plaintiffs filed a third amended complaint against the Company and the Named Directors. The third amended complaint reiterated the plaintiffs' previous allegations that the Named Directors breached their duties of loyalty, due care and candor to the putative class, and again alleged the plaintiffs' claims of an improper "assessment." The third amended complaint also asserted two claims of purported common law fraud and a supposed violation of the Illinois Consumer Fraud Act based on allegations that the Company and the Named Directors had selectively disclosed "material, non-public confidential information" to the non-party financier in order to obtain the financing that the Company selected in June 1997, which allegedly reduced the Common Stock price. The plaintiffs sought an unspecified amount of compensatory and punitive damages, interest and attorneys' fees. In June 1999, the Company and the Named Directors filed a motion to dismiss the third amended complaint, arguing that the plaintiffs' allegations of purported market manipulation by the financier, facilitated by supposedly improper selective disclosure, are beyond the jurisdiction of the Illinois court and fail to allege certain essential elements of common law fraud and the Illinois Consumer Fraud Act. The defendants' motion also argued that the plaintiffs still had failed to fulfill the prerequisites for asserting their stock devaluation claims as a shareholder derivative action. In August 1999, the Court granted the Company's and the Named Directors' motion, and dismissed the suit with prejudice. 55 59 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) 11. LITIGATION (CONTINUED) Thereafter the plaintiffs filed a motion for reconsideration of the dismissal; the Court denied the plaintiffs' reconsideration motion on September 23, 1999. On October 21, 1999, the plaintiff filed their notice of appeal from the dismissal orders. The Company and the named Directors regard the appeal as without merit and they intend to vigorously defend against the plaintiffs' appeal from the Circuit Court's dismissal orders. Greenwald Litigation On June 24, 1998, Jonathan Greenwald, derivatively on behalf of the Company, filed a complaint against the Company and the Named Directors in the court of Chancery of the State of Delaware in and for New Castle County. Mr. Greenwald's complaint alleges that the Named Directors breached their duties of good faith, loyalty, due care, and candor by selecting financing for the Company in 1997 which purportedly reduced the Company's stock price and was supposedly accepted to entrench the Named Directors. The complaint seeks an unspecified amount of compensatory damages, various equitable relief and attorney's fees. The Company and the Named Directors regarded the suit as without factual or legal merit. Accordingly, in January 1999, the Company and the Named Directors filed a motion to dismiss the complaint arguing that the complaint is barred by the business judgment rule and the plaintiffs' failure to fulfill the prerequisites for maintaining a shareholder derivative action against the Named Directors. In July 1999, the Court of Chancery granted the defendants' motion to dismiss the complaint finding that the plaintiffs had failed to satisfy the prerequisites for maintaining a shareholder derivative action under Delaware law. By order dated August 11, 1999, the Court of Chancery granted the Company's and the named Directors' motion to dismiss with prejudice the suit as it relates to Mr. Greenwald, the named plaintiff. 16(b) Litigation On February 26, 1999, Mark Levy, derivatively on behalf of the Company, filed a complaint against Southbrook International Investments, Ltd. ("Southbrook"), Elliott Associates, L.P. ("Elliott"), and Westgate International, L.P. ("Westgate"), and against the Company as a "nominal defendant." The complaint filed in the United States District Court for the Southern District of New York, alleges that Southbrook, Elliott and Westgate, while having beneficial ownership of more than 10% of the Company's common stock, incurred liability under Section 16(b) of the Securities Exchange Act of 1934 in connection with purchases and sales of Company securities within six month periods. The complaint seeks to recover from Southbrook, Elliott and Westgate their respective profits (in unspecified amounts) from those transactions. No relief is sought against the Company as a nominal defendant. Elliott and Westgate are currently investors in the Company with substantial rights to acquire Company common stock by conversion of notes and exercise of warrants and have designated four of the current five directors of the Company, two of whom, Messrs. Mark Brodsky and Samuel Perlman, are employed by a company that provides management services to, and is under common control with, Elliott and Westgate. An amended complaint dated September 2, 1999 was served on the Company. The amended complaint raises the same claims alleged in the original complaint. Pursuant to stipulation, as of the date hereof, the Company has not yet responded to the amended complaint. Motions to dismiss the action have been filed by Elliott, Westgate and Alexander. 56 60 ILLINOIS SUPERCONDUCTOR CORPORATION NOTES TO FINANCIAL STATEMENTS (CONTINUED) The Company intends to defend itself vigorously in the matters described above and believes that the resolution of these matters will not have a material adverse effect on the financial condition, results of operations, or cash flows of the Company. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 57 61 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information in response to this item is incorporated by reference from the "Election of Directors," "Executive Officers," and "Section 16(a) Beneficial Ownership Reporting Compliance" sections of the 2000 Proxy Statement. ITEM 11. EXECUTIVE COMPENSATION Information in response to this item is incorporated by reference from the section of the 2000 Proxy Statement captioned "Executive Compensation and Certain Transactions." ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information in response to this item is incorporated by reference from the section of the 2000 Proxy Statement captioned "Security Ownership of Management and Principal Stockholders." ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information in response to this item is incorporated by reference from the section of the 2000 Proxy Statement captioned "Executive Compensation and Certain Transactions" and "Interests of Certain Persons in the Matters to be Acted Upon at the Meeting." 58 62 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this Form 10-K: 1. The following financial statements of the Company, with the report of independent auditors, are filed as part of this Form 10-K: Report of Independent Auditors Balance Sheets as of December 31, 1999 and 1998 Statements of Operations for the Years Ended December 31, 1999, 1998, and 1997 Statements of Stockholders' Equity (Net Capital Deficiency) for the Years Ended December 31, 1999, 1998, and 1997 Statements of Cash Flows for the Years Ended December 31, 1999, 1998 and 1997 Notes to Financial Statements 2. The following financial statement schedules of the Company are filed as part of this Form 10-K: Schedule II Valuation and Qualifying Accounts All other financial schedules are omitted because such schedules are not required or the information required has been presented in the aforementioned financial statements. 3. Exhibits are listed in the Exhibit Index to this Form 10-K. (b) The following current reports on Form 8-K were filed during the quarterly period ended December 31, 1999: 1. On November 15, 1999, the Company filed with the Securities and Exchange Commission a Current Report on Form 8-K, reporting on the entering into and closing of the Letter Agreement. 2. On November 30, 1999, the Company filed with the Securities and Exchange Commission a Current Report on Form 8-K, reporting on changes in its senior management effective on November 24, 1999. 3. On December 30, 1999, the Company filed with the Securities and Exchange Commission a Current Report on Form 8-K, reporting on an additional $1.0 million investment in the Company by the Investors. 59 63 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, on the 22nd day of March, 2000. ILLINOIS SUPERCONDUCTOR CORPORATION By: /s/ GEORGE CALHOUN -------------------------------- George Calhoun Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the 22nd day of March, 2000.
SIGNATURE TITLE --------- ----- Chief Executive Officer and Director /s/ GEORGE CALHOUN (Principal Executive Officer and Director) ------------------------------------------- George Calhoun /s/ CYNTHIA QUIGLEY Chief Financial Officer ------------------------------------------- (Principal Financial Officer) Cynthia Quigley Controller and Treasurer /s/ KENNETH E. WOLF (Principal Accounting Officer) ------------------------------------------- Kenneth E. Wolf /s/ MARK D. BRODSKY Director ------------------------------------------- Mark D. Brodsky /s/ HOWARD HOFFMANN Director ------------------------------------------- Howard Hoffmann /s/ SAMUEL PERLMAN Director ------------------------------------------- Samuel Perlman /s/ THOMAS L. POWERS Director ------------------------------------------- Thomas L. Powers
60 64 ILLINOIS SUPERCONDUCTOR CORPORATION SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
Balance at beginning of Balance at end Year Additions Deductions of year ------------ ----------- ---------- -------------- YEAR ENDED DECEMBER 31, 1999: Deducted from asset accounts: Valuation allowance on deferred tax assets $20,138,000 $ 4,176,000 $ 0 $24,314,000 Allowance for doubtful accounts $ 87,990 $ 0 $ 52,650 $ 35,340 Reserve of obsolete inventory $ 587,000 $ 266,724 $ 0 $ 853,724 YEAR ENDED DECEMBER 31, 1998: Deducted from asset accounts: Valuation allowance on deferred tax assets $15,825,000 $ 4,313,000 $ 0 $20,138,000 Allowance for doubtful accounts $ 68,775 $ 19,215 $ 0 $ 87,990 Reserve for obsolete inventory $ 0 $ 587,000 $ 0 $ 587,000 YEAR ENDED DECEMBER 31, 1997: Deducted from asset accounts: Valuation allowance on deferred tax assets $11,010,000 $ 4,815,000 $ 0 $15,825,000 Allowance for doubtful accounts: $ 0 $ 68,775 $ 0 $ 68,775
61 65 EXHIBIT INDEX EXHIBIT NUMBER DESCRIPTION OF EXHIBITS ------ ----------------------- 3.1 Certificate of Incorporation of the Company, incorporated by reference to Exhibit 3.1 to the Company's Registration Statement on Form S-3/A, filed with the Securities and Exchange Commission ("SEC") on August 13, 1998, Registration No. 333-56601 (the "August 1998 S-3"). 3.2 By-Laws of the Company, incorporated by reference to Exhibit 3.2 to Amendment No. 3 to the Company's Registration Statement on Form S-1, filed with the SEC on October 26, 1993, Registration No. 33-67756 (the "IPO Registration Statement"). 3.3 Certificate of Amendment of Certificate of Incorporation of the Company, incorporated by reference to Exhibit 3.3 to the IPO Registration Statement. 3.4 Certificate of Amendment of Certificate of Incorporation of the Company, incorporated by reference to Exhibit 4.3 to the Company's Registration Statement on Form S-3/A, filed with the SEC on July 1, 1999, Registration No. 333-77337. 4.1 Specimen stock certificate representing Common Stock, incorporated by reference to Exhibit 4.1 to the IPO Registration Statement. 4.2 Form of Series B Warrants, incorporated by reference to Exhibit 4.2 to the IPO Registration Statement. 4.3 Form of Series C Warrants, incorporated by reference to Exhibit 4.3 to the IPO Registration Statement. 4.4 Form of Representative Warrant, incorporated by reference to Exhibit 4.4 to the IPO Registration Statement. 4.5 Rights Agreement dated as of February 9, 1996 between the Company and LaSalle National Trust, N.A., incorporated by reference to the Exhibit to the Company's Registration Statement on Form 8-A, filed with the SEC on February 12, 1996. 4.6 Convertible Preferred Stock Purchase Agreement dated as of June 6, 1997, by and between the Company and Southbrook International Investments, Ltd., incorporated by reference to Exhibit 4.3 to the Company's Registration Statement on Form S-3, filed with the SEC on June 23, 1997, Registration No. 333-29797 (the "June 1997 S-3"). 4.7 Registration Rights Agreement dated as of June 6, 1997, by and between the Company and Southbrook International Investments, Ltd., incorporated by reference to Exhibit 4.5 to the June 1997 S-3. 4.8 Warrant dated June 6, 1997 issued to Southbrook International Investments, Ltd., incorporated by reference to Exhibit 4.5 to the June S-3. 4.9 Certificate of Designation, Preferences and Rights relating to the Company's Series C Convertible Preferred Stock, incorporated by reference to Exhibit 4.9 to the Company's Registration Statement on Form S-3, filed with the SEC on September 22, 1997, Registration No. 333-36089. 4.10 Certificate of Designation, Preferences and Rights relating to the Company's Series G Convertible Preferred Stock, incorporated by reference to Exhibit 4.8 to the Company's Registration Statement on Form S-3, filed with the SEC on December 8, 1997, Registration No. 333-41731 (the "December 1997 S-3"). 62 66 4.11 Convertible Preferred Stock Purchase Agreement dated as of October 29, 1997, by and between the Company and Elliott Associates, L.P. and Westgate International, L.P., incorporated by reference to Exhibit 4.9 to the December 1997 S-3. 4.12 Registration Rights Agreement dated as of October 29, 1997, by and between the Company and Elliott Associates, L.P. and Westgate International, L.P., incorporated by reference to Exhibit 4.10 to the December 1997 S-3. 4.13 Agreement dated as of October 29, 1997, by and between the Company and Brown Simpson Strategic Growth Fund, L.P. and Southbrook International Investments, Ltd., incorporated by reference to Exhibit 4.11 to the December 1997 S-3. 4.14 Form of 2% Senior Convertible Note due May 15, 2002, incorporated by reference to Exhibit 4.2 to the August 1998 S-3. 4.15 Form of Warrant dated May 15, 1998, incorporated by reference to Exhibit 4.3 to the August 1998 S-3. 4.16 Securities Purchase Agreement dated as of May 15, 1998, by and between the Company and Elliott Associates, L.P., Westgate International, L.P., Alexander Finance, LP, State Farm Mutual Automobile Insurance Company, Spring Point Partners, L.P. and Spring Point Offshore Fund, incorporated by reference to Exhibit 4.5 to the August 1998 S-3. 4.17 Registration Rights Agreement dated as of May 15, 1998, by and between the Company and Elliott Associates, L.P., Westgate International, L.P., Alexander Finance, LP, State Farm Mutual Automobile Insurance Company, Spring Point Partners, L.P. and Spring Point Offshore Fund, incorporated by reference to Exhibit 4.6 to the August 1998 S-3. 4.18 Form of 6% Senior Convertible Note due May 15, 2002 incorporated by reference to Exhibit 4.18 to the Company's Annual Report on Form 10-K for the year ended December 31, 1998. 4.19 Form of Warrant dated March 31, 1999 incorporated by reference to Exhibit 4.19 to the Company's Annual Report on Form 10-K for the year ended December 31, 1998. 4.20 Securities Purchase Agreement dated as of March 31, 1999, by and between the Company and Elliott Associates, L.P., Westgate International, L.P., Alexander Finance, LP and State Farm Mutual Automobile Insurance Company, incorporated by reference to Exhibit 4.20 to the Company's Annual Report on Form 10-K for the year ended December 31, 1998. 4.21 Registration Rights Agreement dated as of March 31, 1999, by and between the Company and Elliott Associates, L.P., Westgate International, L.P., Alexander Finance, LP and State Farm Mutual Automobile Insurance Company, incorporated by reference to Exhibit 4.21 to the Company's Annual Report on Form 10-K for the year ended December 31, 1998. 4.22 Amendment to Securities Purchase Agreement dated as of March 31, 1999, by and between the Company and Elliott Associates, L.P., Westgate International, L.P., Alexander Finance, LP, State Farm Mutual Automobile Insurance Company, Spring Point Partners, L.P. and Spring Point Offshore Fund, incorporated by reference to Exhibit 4.22 to the Company's Annual Report on Form 10-K for the year ended December 31, 1998. 10.1 1993 Amended and Restated Stock Option Plan, as amended, incorporated by reference to Exhibit B to the Company's Proxy Statement filed with the SEC on May 6, 1997.* 63 67 10.2 Form of Amended and Restated Director Indemnification Agreement, incorporated by reference to Exhibit 10 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1998. * 10.3 Third Amended and Restated Registration Rights Agreement dated as of July 14, 1993, as amended, incorporated by reference to Exhibit 10.4 to the IPO Registration Statement. 10.4 Public Law Agreement dated February 2, 1990 between Illinois Department of Commerce and Community Affairs and the Company, incorporated by reference to Exhibit 10.5 to the IPO Registration Statement. 10.5 Public Law Agreement dated December 30, 1991 between Illinois Department of Commerce and Community Affairs and the Company, amended as of June 30, 1992, incorporated by reference to Exhibit 10.6 to the IPO Registration Statement. 10.6 Representative Warrant Agreement, incorporated by reference to Exhibit 10.7 to the IPO Registration Statement. 10.7 Subcontract and Cooperative Development Agreement dated as of June 1, 1993 between American Telephone and Telegraph Company and the Company, incorporated by reference to Exhibit 10.9 to the IPO Registration Statement. 10.8 Intellectual Property Agreement dated as of June 1, 1993 between American Telephone and Telegraph Company and the Company, incorporated by reference to Exhibit 10.10 to the IPO Registration Statement. 10.9 License Agreement dated January 31, 1990 between the Company and Northwestern University, incorporated by reference to Exhibit 10.13 to the IPO Registration Statement. 10.10 License Agreement dated February 2, 1990 between the Company and ARCH Development Corporation, incorporated by reference to Exhibit 10.14 to the IPO Registration Statement. 10.11 License Agreement dated August 9, 1991 between the Company and ARCH Development Corporation, incorporated by reference to Exhibit 10.15 to the IPO Registration Statement. 10.12 License Agreement dated October 11, 1991 between the Company and ARCH Development Corporation, incorporated by reference to Exhibit 10.16 to the IPO Registration Statement. 10.13 Public Law Agreement dated August 18, 1993 between Illinois Department of Commerce and Community Affairs and the Company, incorporated by reference to Exhibit 10.17 to the IPO Registration Statement. 10.14 Form of Officer Indemnification Agreement incorporated by reference to Exhibit 10.17 to the Company's Annual Report on Form 10-K for the year ended December 31, 1998.* 10.15 Employment Agreement dated November 9, 1998 between the Company and Dennis Craig incorporated by reference to Exhibit 10.18 to the Company's Annual Report on Form 10-K for the year ended December 31, 1998.* 10.16 Employment Agreement dated April 12, 1999 between the Company and Amr Abdelmonem, incorporated by reference to the Company's Registration Statement on Form S-2A, filed with the SEC on July 9, 1999, Registration Number 333-77337. 10.17 Single-Tenant Industrial building Lease between Teachers' Retirement System of the State of Illinois, landlord, and Illinois Superconductor Corporation, tenant, dated June 24, 1994, incorporated by reference to Exhibit 10.1 to the Company's Form 10-Q for the quarterly period ending June 30, 1994. 64 68 10.18 Letter Agreement, dated November 5, 1999, by and among the Company and the Investors, incorporated by reference to Exhibit 10(a) to the Company's Current Report on Form 8-K filed with the SEC on November 15, 1999. 10.19 Letter Agreement re Modification of Covenants, dated November 5, 1999, by and among the Company and the Investors, incorporated by reference to Exhibit 10(b) to the Company's Current Report on Form 8-K filed with the SEC on November 15, 1999. 10.20 Security Agreement, dated November 5, 1999, by and among the Company and the Investors, incorporated by reference to Exhibit 10(c) to the Company's Current Report on Form 8-K filed with the SEC on November 15, 1999. 10.21 Form of Letter Agreement dated November 12, 1999, amending the Letter Agreement filed as Exhibit 10.19, incorporated by reference to Exhibit 10(f) to the Company's Current Report on Form 8-K filed with the SEC on November 15, 1999. 10.22 Form of Securities Purchase Letter Agreement dated December 28, 1999, by and among the Company, Elliott Associates, Westgate and Alexander. 23. Consent of Independent Auditors. 27. Financial Data Schedule. - ------------------ * Management contract or compensatory plan or arrangement required to be filed as an exhibit on this Form 10-K. 65 EX-10.22 2 SECURITIES PURCHASE LETTER AGREEMENT DTD 12/28/99 1 EXHIBIT 10.22 Elliott Associates, L.P., 712 Fifth Avenue New York, New York 10019 Westgate International, L.P. c/o Stonington Management Corporation 712 Fifth Avenue New York, New York 10019 Alexander Finance, L.P. 1560 Sherman Avenue Evanston, Illinois 60201 December 28, 1999 Illinois Superconductor Corporation 451 Kingston Court Mt. Prospect, Illinois 60056 RE: EXERCISE OF OPTION Ladies and Gentlemen: Reference is made to the Investment Agreement, dated as of November 5, 1999 (as amended by the letter dated November 12, 1999) (the "Investment Agreement"), by and among you (the "Company") and the undersigned (the "Investors"). Capitalized terms used herein without definition have the meaning set forth in the Investment Agreement. 1. EXERCISE OF OPTION (a) Pursuant to Section 7 of the Investment Agreement, the Investors hereby notify the Company of their exercise of the option, contained in such section, to purchase additional Notes and Warrants which shall contain the terms and provisions described in such section. (b) Pursuant to the foregoing exercise, the Investors shall purchase (the "Option Purchase") an aggregate of $1,000,000 principal amount of Notes and Warrants to purchase 400,000 shares of Common Stock, in the respective amounts set forth on Schedule I hereto, for aggregate consideration of $1,000,000 (the "Option Purchase Price"). This option exercise shall be without prejudice to the rights of the Investors, pursuant to Section 7 of the Investment Agreement, to invest up to an additional $4,000,000 in the Company. 2 2. CLOSING OF OPTION PURCHASE. (a) The closing of the Option Purchase shall take place at the offices of Kleinberg, Kaplan, Wolff & Cohen, P.C. on December 29, 1999 (the "Closing Date") at 1 p.m. Eastern Standard Time. (b) The Notes and Warrants purchased pursuant to the Option Purchase shall be deemed to be outstanding on the Closing Date for all purposes. Within fourteen days of the Closing Date, the Company shall deliver to the Investors, in physical form, the Notes and Warrants purchased by them pursuant to the Option Purchase. The delivery of payment by wire transfer to an account designated by the Company by each Investor of the portion of the Option Purchase Price applicable to it as set forth in Schedule I shall constitute a payment delivered to the Company in satisfaction of such Investor's obligation to pay its share of the Option Purchase Price hereunder. (c) In addition to the foregoing, within fourteen days of the Closing Date, the Company shall deliver in physical form, the Notes and Warrants purchased by the undersigned from the Company on November 5, 1999. (d) The Company agrees to pay the legal fees and disbursements incurred by the Investors in connection with the Option Purchase and shall pay the invoice for such fees and disbursements within seven days of the receipt thereof. 3. REPRESENTATIONS AND WARRANTIES. (a) The Company hereby restates, as of the date hereof, the representations and warranties set forth in Section 8 of the Investment Agreement, with respect to the Notes and Warrants being issued pursuant to the Option Purchase, except as set forth on Schedule 111, hereto. For purposes of the foregoing restatement of representations, (i) references to Transaction Documents shall refer only to this Agreement and, with respect to solely the consummation of the Option Purchase, the Transaction Documents referred to in the Investment Agreement, and (ii) the date referred to in Section 2.1(s) shall be deemed to refer to November 15,1999. (b) The Investors hereby restate the representations set forth in Section 9(a) of the investment agreement with respect to the Notes and Warrants being purchased pursuant to the Option Purchase. [signature page follows] 2 3 Please indicate your acceptance and agreement of the terms contained herein by countersigning this Agreement and returning a signed copy to the undersigned. Sincerely, ELLIOTT ASSOCIATES, L.P. By: ---------------------------------- WESTGATE INTERNATIONAL, L.P. By: Martley International, Inc. Attorney-in-Fact By: ----------------------------- ALEXANDER FINANCE, L.P. By: ---------------------------------- Bradford T. Whitmore President: Bun Partners, Inc. its General Partner AGREED TO AND ACCEPTED ILLINOIS SUPERCONDUCTOR CORPORATION By: -------------------------------- 3 4
SCHEDULE I PRINCIPAL AMOUNT AMOUNT OF PURCHASER PURCHASE PRICE OF NOTES PURCHASED WARRANTS PURCHASED - --------- -------------- ------------------ ------------------ Elliott Associates, L.P. $277,778 $277,778 111,111 Westgate International, L.P. $277,778 $277,778 111,111 Alexander Finance, LP $444,444 $444,444 177,778
5 Schedule II to Agreement Dated December 28, 1999 ------------------------------------------------ The Company generally incorporates information from its SEC filings as disclosures for these schedules. The Company further notes that: 2.1(c): The 3rd Quarter 1999 10-Q has the Company's current capitalization prior to giving effect to these transactions. Additional holders of 5% of the Company's Common Stock, if any, may be disclosed in Schedules 13D or 13G filed with the Securities and Exchange Commission. Options have continued to be granted. 2.1 d): As recognized in Section 12 of the Investment Agreement, additional shares must be authorized and a charter amendment is necessary to authorize such shares. 2.1(e)/(f): See 2.1(d) above with respect to the need for a charter amendment. The factoring agreement with Franklin Capital will be in breach if a lien is created on the inventory and accounts without the prior written consent of the factor. The Company will not list shares of its Common Stock, and will register such shares as and when required by the Registration Rights Agreement as modified by Section 5 of the Investment Agreement. The Company will reflect the Option Purchase in a Form 8-K filing and a Form S-2 supplemental filing. 2.1 (g): To the Company's knowledge, there is no pending litigation except (i) as disclosed the SEC filings, and (ii) Steve Levy v. Illinois Superconductor Corporation, filed in Delaware Chancery Court on or about December 14, 1999. 2.1(h):See 2.1(e)/f, above. 2.1 (i): The Company has not recently reviewed the voluminous schedules previously delivered and the company does not now make or update such representations and schedules. 2.1 (k): The Disclosure Materials also include the Company's Annual Report on Form 10-Q for the year ended December 31, 1998, its Quarterly Reports on Form 10-K for the quarters ended March 31, June 30, 1999 and September 30, 1999, and its Current Reports on Form 8-K filed in 1999. Elliott and Grace have been updated on the Company's financial and business situation, including at a meeting with those investors during their due diligence in connection with their November, 1999 investment in the Company, and as a result of affiliates of Elliott having joined the Company's board of directors in November, 1999. That information, including the written handouts from the aforementioned due diligence meeting, is incorporated by reference. 5 6 2.1(l) The obligations to Franklin Capital under the factoring agreement are pari passu with the notes held by Elliott and Grace, including the 6% Notes, but may in certain respects have a senior lien. 2.1(p): Registration under Form S-3 may no longer be available to the Company. A registration under Form S-2 may be available. 2.1(s): See SEC filings. Elliott and Grace are aware of the terms of the factoring agreement with Franklin Factor. 6 EX-23 3 CONSENT OF INDEPENDENT AUDITORS 1 EXHIBIT 23 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statements (Form S-8 No. 33-88716, Form S-8 No. 333-06003, Form S-3 No. 333-02846, Form S-3 No. 333-29797, Form S-3 No. 333-36089, Form S-3 No. 333-41731 and Form S-3 No. 333-56601) of Illinois Superconductor Corporation and in the related Prospectuses of our report, dated February 25, 2000, with respect to the financial statements and schedule of Illinois Superconductor Corporation included in this Annual Report (Form 10-K) for the year ended December 31, 1999. /s/ ERNST & YOUNG LLP Chicago, Illinois March 17, 2000 EX-27 4 FINANCIAL DATA SCHEDULE
5 12-MOS DEC-31-1999 JAN-01-1999 DEC-31-1999 723,711 0 211,141 35,340 1,092,713 2,420,700 8,089,169 5,433,808 6,039,159 1,588,976 13,659,905 0 0 15,753 (9,307,465) 6,039,159 2,408,604 2,408,604 5,923,173 5,923,173 5,956,568 (52,650) 12,634,745 (21,971,065) 0 (21,971,065) 0 (745,197) 0 (22,716,262) (1.77) (1.77)
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