-----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, NF5ZnRninePLxKyCkZVIs8wmN3EDgtkVlfrGf8yolMVvfoiuxxh6Jl2zemdc86+d XhJesfBxwOck7bgALFyNkQ== 0000912057-97-011355.txt : 19970401 0000912057-97-011355.hdr.sgml : 19970401 ACCESSION NUMBER: 0000912057-97-011355 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19970331 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: SPINE TECH INC CENTRAL INDEX KEY: 0000889842 STANDARD INDUSTRIAL CLASSIFICATION: ORTHOPEDIC, PROSTHETIC & SURGICAL APPLIANCES & SUPPLIES [3842] IRS NUMBER: 061258314 STATE OF INCORPORATION: MN FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-26116 FILM NUMBER: 97570649 BUSINESS ADDRESS: STREET 1: 7375 BUSH LAKE ROAD CITY: MINNEAPOLIS STATE: MN ZIP: 55439 BUSINESS PHONE: 6126279631 MAIL ADDRESS: STREET 1: 7375 BUSH LAKE ROAD CITY: MINNEAPOOLIS STATE: MN ZIP: 55439 10-K 1 10-K SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (Mark One) /X/ Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Fiscal Year Ended December 31, 1996 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 0-26116 SPINE-TECH, INC. - -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Minnesota 06-1258314 - -------------------------------------------------------------------------------- (State or other jurisdiction of (I.R.S. employer incorporation or organization) identification no.) 7375 Bush Lake Road Minneapolis, Minnesota 55439 - -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip code) (612) 832-5600 - -------------------------------------------------------------------------------- (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.01 per share 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. / / The aggregate market value of the Common Stock held by non-affiliates of the registrant as of March 18, 1997 was $275,467,702, based on the closing sale price for the Company's Common Stock on that date. For purposes of determining this number, all officers and directors of the registrant are considered to be affiliates of the registrant. This number is provided only for the purpose of this report on Form 10-K and does not represent an admission by either the registrant or any such person as to the status of such person. As of March 18, 1997 the registrant had 10,068,812 shares of Common Stock issued and outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1996 are incorporated by reference in Part II. Portions of the registrant's Proxy Statement dated March 28, 1997 for the annual meeting of shareholders to be held May 8, 1997 are incorporated by reference in Part III. FORWARD-LOOKING STATEMENTS The information presented in this Annual Report on Form 10-K under the headings "Item 1. Business," "Item 2. Properties" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" contains forward-looking statements within the meaning of the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934, as amended. Such statements are subject to risks and uncertainties, including those discussed under "Forward Looking Statements" in Item 7 and "Risk Factors" on pages 11-16 of this Annual Report on Form 10-K, that could cause actual results to differ materially from those projected. Because actual results may differ, readers are cautioned not to place undue reliance on these forward-looking statements. Certain forward-looking statements are indicated below by an asterisk. ITEM 1. BUSINESS THE COMPANY Spine-Tech, Inc. (the "Company") was incorporated in Minnesota in 1988, and began full-time operations in 1991. The Company designs, manufacturers and markets an innovative series of spinal implants, instruments and procedures based on the Company's BAK-TM- technology for the treatment of degenerative conditions of the human spine. The Company's spinal implants are designed to facilitate fusion of spinal vertebrae in order to reduce spinal instability that can cause chronic, disabling back pain. The Company conducted a clinical trial of the BAK/L-TM-, for use in the lumbar region of the spine, starting in April 1992. Based upon data from the clinical trial, the Company submitted a Pre-Market Approval Application ("PMA") to the United States Food and Drug Administration (the "FDA"), which included data on 942 patients. On May 23, 1996, the Orthopaedic and Rehabilitation Devices Advisory Panel reviewed the Company's PMA and voted to recommend approval of the BAK/L. On September 23, 1996, the FDA approved the BAK/L for marketing in the United States. The BAK system consists of the BAK spinal implants and customized surgical instruments and techniques that facilitate the surgical placement of the implants between the vertebrae. The BAK implants are hollow, threaded cylinders made of a titanium alloy that are implanted in the disc space between two or more vertebrae. The implants are packed with bone graft to facilitate growth of the vertebrae bones through holes in the walls of the implants. Fusion is achieved when adjoining vertebrae grow together. In most procedures performed in the lumbar spine, two BAK devices are implanted, side by side. The BAK devices may be implanted between two adjoining vertebrae (one-level) or between three consecutive vertebrae (two-level). Implantation of the BAK device can be performed using an open surgical technique from an anterior (front) or posterior (back) approach. 2 As part of the multi-center clinical trial of the BAK/L, certain surgeons perfected the techniques and instruments necessary to implant the BAK/L using a minimally invasive laparoscopic technique through the abdomen. In December 1996, the Company assembled the data from this portion of the multi-center clinical trial and submitted it to the FDA in a Supplemental Pre-Market Approval Application. As of December 2, 1996, the cut-off date for data analyses, a total of 240 patients had been enrolled in the laparoscopic BAK study and had complete history and hospitalization data forms. The series is comprised of a total of 215 one-level and 25 two-level patients. The laparoscopic study was performed at 10 centers. The laparoscopic surgical approach for implantation of the BAK/L for the treatment of one-level degenerative disc disease showed comparable rates of operative and post-operative complications, as well as secondary surgery rates, as those documented in the FDA approved BAK/L open anterior one-level series. OTHER PRODUCTS In addition to the BAK/L, the Company has developed the BAK/C-TM-, based upon the BAK technology to treat degenerative disc disease in the cervical (neck) area of the spine. The BAK/C system is a series of implantable devices and customized instruments specifically designed and sized to facilitate fusion of vertebrae in the cervical spine. Either one or two BAK/C devices are implanted anteriorally in the disc space between two or three vertebrae. The implants provide stability for fusion to occur through and around the implants, similar to the BAK/L implants. In November 1994, the FDA granted approval for the BAK/C Investigational Device Exemption ("IDE") clinical study. The study is a randomized study comparing BAK/C implants to non-instrumental cervical fusion procedures. The Company is currently enrolling patients in the study and as of December 1, 1996, approximately 250 procedures had been performed. There can be no assurance that the Company will achieve results in this study sufficient to obtain required marketing clearance or physician acceptance in the United States or internationally, which could have a material adverse effect on the Company's future operating results. The Company also developed its BAK/T-TM- implants and instruments, specifically designed for use in the thoracic region of the spine. Fusion procedures to treat degenerative disc disease and other spinal conditions in the thoracic spine have rarely been attempted due to the difficulty of surgical access to the disc site through the chest cavity due to the highly invasive nature of the procedure. Instead of making a large incision in the front of the patient's chest, spreading the patient's ribs and moving the patient's organs, the surgeon makes four small punctures in the patient's side and inserts the instruments in between the patient's ribs using a small television camera called a thoracoscope for visualization on a monitor. The surgeon can visualize and access the patient's spine from the side (laterally) and implant the BAK/T implants through a trocar inserted through one of the punctures. The Company believes that the BAK/T may enable surgeons to treat degenerative disc disease in the thoracic spine with reduced trauma and recovery time as compared to current open surgical alternatives.* On September 27, 1995, the FDA granted conditional approval to begin Phase I of the BAK/T IDE clinical study. The Company is currently enrolling patients in the study and as of December 1, 1996, approximately 12 procedures had been performed. There can be no assurance that the Company will achieve results in this study sufficient to obtain required marketing clearance or physician acceptance in the United States or internationally, which could have a material adverse effect on the Company's future operating results. In addition to products based on the BAK technology, the Company has developed the following products: 3 CERVI-LOK SPINAL STABILIZATION SYSTEM. The Company's Cervi-Lok-Registered Trademark- system is a line of implantable metal plates and screws for stabilizing vertebrae in the cervical spine. The Cervi-Lok system utilizes a unique screw-to-plate locking mechanism that locks the screw to the plate to provide stability and helps to prevent loosening of the screw. The system also includes surgical instruments that are used to implant the devices. MINIMALLY INVASIVE DISCECTOMY INSTRUMENTS. The Company markets a line of surgical instruments for use in minimally invasive endoscopic discectomy and fusion procedures. BONE HARVESTER. The Bone Harvester is a surgical instrument that provides a less invasive technique and more convenient method for gathering autologous bone. This autologous bone may be used to fill the inner chambers of the BAK implants for spinal fusion. In addition, the autologous bone may be used in other surgical techniques which require bone for creating fusion or filling boney defects. The Bone Harvester is sold as a disposable sterile kit for one-time use. The main components within the kit are a clear plastic T-handle and a cutting head. The cutting head is designed to morselize and gather bone into the T-handle. MARKETING AND DISTRIBUTION The Company's sales and marketing strategy is to focus its efforts on orthopaedic and neurological spine surgeons through a combination of direct marketing, comprehensive training and on-going surgical support. The Company markets its products domestically through a network of 25 direct sales representatives, all with successful experience selling medical/surgical specialty devices, four regional sales managers and seven independent agent groups. The Company believes there are more than 4,000 orthopaedic and neurological spine surgeons in the United States, the majority of which are located in major metropolitan areas. Through September 23, 1996, the Company sold its principal products in the United States primarily in conjunction with its clinical trials. Beginning in June 1996 the Company began hiring the sales and marketing personnel necessary to begin to launch the BAK domestically. In September 1993, the Company entered into an exclusive agreement with Smith & Nephew Richards, Inc. ("Smith & Nephew"), a leading medical products company headquartered in the United Kingdom, for marketing and distribution of the BAK/L outside the United States for a period of up to eight years if certain quarterly minimum purchases were made. In February 1996, the Company terminated its exclusive agreement with Smith & Nephew because the required minimum purchases were not made. Through February 1997, Smith & Nephew retained limited non-exclusive rights to sell the BAK/L outside the United States. These non-exclusive rights have terminated. Since March 1996, the Company has been establishing a network of independent distributors on a country-by-country basis to market and distribute all of its products outside of the United States. Currently, the Company has distribution agreements with 19 different independent distributors who cover 28 different foreign markets. Most of these independent distributors have ordered and received product shipments and are selling products or working on mandatory registration requirements. MANUFACTURING AND QUALITY CONTROL The Company's manufacturing and quality control operations consist primarily of testing and inspection of products manufactured to the Company's specifications by outside contractors. The Company inspects each lot of implants and instruments to ensure that it complies with the Company's specifications. 4 The quality of finished products is controlled in accordance with the Company's procedures, those of the FDA's Good Manufacturing Practices ("GMP") requirements, and the requirements of foreign regulatory agencies, including ISO 9001 certification. Products requiring sterilization are sent to a certified laboratory where they are sterilized before being shipped to customers. Currently, the Company is dependent on one contract sterilizer. In the event that this relationship is terminated, the Company will have to locate a new contract sterilizer, which could result in increased cost and turn around time for sterilization of the Company's products. During much of 1995 and the first half of 1996, the Company established the systems, procedures and documentation necessary to comply with ISO 9001 Quality System Certification. This effort resulted in the Company receiving ISO 9001 Certification and CE Mark Certification. CE Mark Certification signifies that the Company conforms with the European Community Medical Device Directive requirements for the design, manufacturing, servicing and installation of its products. The Company does not conduct manufacturing operations and is dependent upon several contract manufacturers for the production of its products and expects to continue to be dependent upon such manufacturers for the foreseeable future. The Company is dependent upon these manufacturers for timely and cost-effective manufacturing services. In the event that the Company is unable to obtain contract manufacturing, or obtain such manufacturing on commercially reasonable terms, it may not be able to manufacture its products on a timely and competitive basis, or at all. PRODUCT DEVELOPMENT The Company's objective is to continue to develop innovative products for the spinal implant market. The Company's research and development department consists of six engineers with substantial design experience in the orthopaedic industry. In addition to the engineers, the department has two individuals with Ph.D. degrees in biomedical engineering and biophysics. The research and development department is continually engaged in assessing new spinal devices, materials and surgical techniques that are applicable to the Company's business strategies. The Company evaluates new technologies using sound biomechanical principles in the Company's own laboratory or at university- based research centers. The Company spent $1.2 million, $1.6 million and $1.8 million on research and development in fiscal years 1994, 1995 and 1996, respectively. The Company is investigating both genetic and biologic bone substitutes that may be used instead of harvested bone to fill the Company's BAK products. In addition, the Company is evaluating the efficacy of new implant structures, designs and procedures for use in spinal fusions, and advanced design and technique enhancements to the Company's BAK products. Furthermore, the research and development department is evaluating proprietary metallic and non-metallic implant designs to improve fusion success rates. The Company is also investigating the application of its minimally invasive technologies to discectomy procedures. THIRD-PARTY REIMBURSEMENT Spinal implants are generally purchased by hospitals upon the recommendation of spinal surgeons on staff. These hospitals bill various third- party payors for the services provided to patients. Spinal fusion procedures are considered elective surgeries and therefore most require preapproval by the payor. In 5 the United States, these payors include private insurance companies, managed care organizations, workers' compensation insurers and occasionally Medicare. Most private payors pay for the costs of the surgery and rehabilitation, and procedures that are deemed cost-effective will generally receive reimbursement by private payors.* Workers' compensation insurers are responsible for both surgical costs and patient disability costs, including lost wages. Since back pain claims represent the largest category of workers' compensation claims paid, workers' compensation insurers are motivated to reimburse for surgical procedures that reduce surgical costs and reduce or eliminate long-term disability costs. Cost-effective procedures with positive surgical outcomes enabling workers to return to work more rapidly are generally supported by workers' compensation insurers. However, no assurance can be given that the Company's products will be recommended for purchase by surgeons at prices comparable to those charged by the Company in the past, if at all, or that third-party payors will reimburse hospitals, in whole or in part, if such purchases are made. Reimbursement for BAK products may also be affected by the increasing prevalence of cost-containment measures of managed care systems. In a managed care system, a health care provider typically contracts with an employer or organization to provide comprehensive health care to covered persons for a fixed fee per person. A provider in a managed care system, generally a family practice physician, will attempt to control the costs of health care for each individual. While such cost control efforts may result in an emphasis on more cost-effective procedures and may result in fewer elective surgical procedures, the Company believes that it may benefit from this emphasis due to the cost- effective nature of its products as compared to other products in the spinal implant market.* However, there can be no assurance that these benefits will be realized by the Company. The Company must register its products in each foreign country where it intends to sell its products. In many countries the Company must also receive reimbursement approval from the foreign government authorities. The Company has received reimbursement approval in several foreign countries, and is seeking reimbursement approval in all countries where its products are sold. Lack of reimbursement approval may restrict the Company's ability to sell its products in certain foreign markets and there can be no assurance that it will receive reimbursement approval in other foreign markets. LICENSE AGREEMENTS In May 1992, the Company entered into a license agreement with Dr. Gary Michelson ("Dr. Michelson") and an affiliated company, Karlin Technology, Inc. ("Karlin"), as the owners of certain patents and patent applications relating to threaded cylindrical spinal implants, the technology which is the basis of the Company's BAK implant (the "Karlin Technology"). Pursuant to the license agreement, the Company has a co-exclusive worldwide license during the life of the patents to make, use or sell products covered by the Karlin Technology. One other party may license and develop the Karlin Technology subject to the terms and conditions of the license agreement. Sofamor Danek Inc. ("Danek"), a competitor of the Company, is the other co-licensee of the Karlin Technology. The Company also has rights to certain future instruments or methods developed by Dr. Michelson during the life of the agreement. The license agreement provides for a cross-license of certain patented technology of the Company and obligates the Company to pay Karlin a royalty based upon a percentage of the net sales price for sales of its products utilizing the Karlin Technology. Karlin is currently involved in litigation with Surgical Dynamics, Inc., a subsidiary of U.S. Surgical Corporation ("Surgical Dynamics"), regarding the patent which covers the Karlin Technology. Surgical Dynamics has filed a complaint for declaratory judgment of patent invalidity, unenforceability and non-infringement against Karlin and Danek regarding the Karlin Technology. Karlin and Danek have counterclaimed against Surgical Dynamics claiming patent infringement. The outcome of the litigation is 6 uncertain. However, under its license agreement with Dr. Michelson, if the patent is declared invalid, the Company's royalty obligations will be reduced. Furthermore, if no subsequent patent is issued to Dr. Michelson related to technology that would be utilized in the Company's products within the four quarters after the patent is declared invalid, the Company's royalty obligations will expire. See "Item 3. Legal Proceedings" for a discussion of certain claims that have been made against the Company by Dr. Michelson and Karlin in connection with the license agreement and the Karlin Technology and for more information regarding the Surgical Dynamics litigation. In January 1995, the Company entered into a license agreement with Dr. Ted Obenchain, the owner of certain patents and patent applications relating to tools and methods used in minimally invasive discectomy surgery. Pursuant to the license agreement, the Company has an exclusive worldwide right during the life of the patents to make, use or sell instruments and methods developed by Dr. Obenchain. The license agreement obligates the Company to pay Dr. Obenchain a royalty based upon a percentage of the net sales of its products utilizing the licensed technology. PATENTS AND PROPRIETARY TECHNOLOGY The Company relies heavily on proprietary technology, which it protects primarily through licensing arrangements, patents and trade secrets. In addition, the Company files patent applications to protect technology, inventions and improvements that are significant to the development of its business. The Company currently holds ten issued United States patents and has licensed three issued United States patents and one foreign patent and has pending seven United States and five foreign patent applications relating to spinal implants, instruments and surgical methods. Dr. Michelson claims to be the true inventor of the innovations claimed in one of these patents. On February 6, 1996, the Company filed a declaratory action asserting that Dr. Michelson has no rights in that patent. There can be no assurance that any pending or future patent applications will be granted or that any current or future patent, regardless of whether the Company is an owner or a licensee of such patent, will not be challenged, rendered unenforceable, invalidated or circumvented or that the rights granted thereunder or under its licensing agreements will provide competitive advantages to the Company. The Surgical Dynamics litigation is challenging the validity and enforceability of the patent that covers key aspects of the design of the Company's BAK products. The outcome of the litigation is uncertain. There can be no assurance that the patent related to the Karlin Technology will be upheld or that the Company will continue to have such patent protection for its products. The Company also relies on trade secrets and proprietary know-how that it seeks to protect, in part, through confidentiality agreements with employees, consultants and other parties. There can be no assurance that these agreements will not be breached, that the Company will have adequate remedies for any breach, or that the Company's trade secrets will not otherwise become known to or independently developed by competitors. GOVERNMENT REGULATION The manufacture and sale of the Company's products are subject to regulation by numerous governmental authorities, principally the FDA and corresponding foreign agencies. The FDA administers the Federal Food, Drug, and Cosmetic Act and the amendments thereto contained in the Safe Medical Devices Act of 1990. The Company is subject to the Federal Food, Drug, and Cosmetic Act and the regulations promulgated thereunder and is subject to inspection by the FDA for compliance therewith. The Company's products are classified by the FDA as Class I, Class II and Class III devices. Certain Class I devices, such as instruments, are exempt from "510(k) clearance" requirements. Class II 7 devices, such as laparoscopic instruments and certain implants, including the Cervi-Lok system, must secure a 510(k) clearance. The process of obtaining a 510(k) clearance typically can take a year or longer and may require the submission of laboratory or clinical data supporting assertions that the product is substantially equivalent to another medical device on the market. Class III devices require PMAs before they can be introduced to the market. The PMA approval process is more costly and burdensome than the 510(k) clearance process and generally takes a number of years. The PMA process generally requires more detailed preclinical and clinical studies pursuant to an IDE, as well as manufacturing data and other information. The PMA must report on the results of the clinical trial, the results of all relevant prototype tests, laboratory and animal studies, a complete description of the device and its components, and a detailed description of the methods, facilities and controls used for manufacturing, including the method of sterilization. In addition, the submission must include the proposed labeling, advertising literature and training methods, if applicable. After completion of the FDA's preliminary review, the FDA will determine whether the PMA is technically fileable. If the PMA is accepted for filing, the FDA begins a more in-depth review. The submission is typically sent to a scientific advisory panel composed of physicians and scientists with expertise in the particular field. The FDA scientific advisory panel issues a recommendation to the FDA that the PMA should either be approved, approved with certain conditions or denied. The FDA is not bound by the recommendations of the advisory panel. During the PMA review process, the FDA conducts an inspection of the manufacturer's facilities to ensure that they are in compliance with the applicable GMP requirements. If the FDA evaluation of both the PMA and the manufacturing facilities is favorable, the FDA will issue an "approvable" letter, which usually contains a number of conditions that must be met in order to secure final approval of the PMA. When those conditions have been fulfilled to the satisfaction of the FDA, the agency will issue a final PMA approval letter, authorizing commercial distribution of the device. An approved PMA indicates that the FDA has determined that a device has been demonstrated, through the submission of clinical data and manufacturing and other information, to be safe and effective for its intended uses. The FDA may determine in its discretion to grant marketing clearance for certain improvements in, and changes to indications of, a PMA approved product based on additional data, possibly including clinical data, submitted to the FDA in the form of a supplement to the original PMA ("PMA supplement"). The BAK/L is designated as a Class III device by the FDA. On September 23, 1996 the Company announced that the FDA had approved the Company's BAK/L for marketing in the United States. The Company is required to obtain further approval from the FDA, however, to label the BAK/L for laparoscopic implantation. The Company has submitted a PMA supplement seeking this approval. There can be no assurance that marketing clearances from the FDA will be obtained for the laparoscopic procedure on a timely basis or at all. The Company has initiated clinical trials for the BAK/C implants under an IDE approved by the FDA in November 1994, and received conditional approval for its IDE application for the BAK/T device in April 1995. Patient enrollment for a feasibility study of the BAK/T commenced in May 1995. The IDE study for each of these products is expected to take several years. These devices are classified as Class III devices requiring PMA approval. The Company plans to perform these clinical trials and submit the results in PMAs if the results merit such submissions.* There can be no assurances that the clinical results from these trials will be completed or result in a PMA, or that the marketing clearance will ever be received. The Company may apply to the FDA for approval of the BAK/C and BAK/T devices on a PMA supplement to the approved BAK/L PMA.* The availability of the use of a PMA supplement for a product is subject to the discretion of the FDA. 8 The Company markets certain other of its products pursuant to 510(k) clearances received from the FDA. Government regulations may prevent or substantially delay the marketing of the Company's proposed products, cause the Company to undertake costly procedures, and furnish a competitive advantage to the more substantially capitalized companies with which the Company competes. After approval, the FDA has required post-marketing approval surveillance programs to monitor the effects of an approved medical device. FDA approval may be withdrawn for noncompliance with regulatory standards or the occurrence of unforeseen problems following initial marketing. In addition, the extent of potentially adverse government regulations that might arise from future administrative action or legislation cannot be predicted. There can be no assurances that marketing clearances or approvals will be obtained on a timely basis, or at all. Delays in receiving, or failure to receive, such clearances could have a material adverse effect on the Company. Every company that manufactures or assembles medical devices is required to register with the FDA and adhere to GMP requirements which prescribe recordkeeping, validation and quality assurance procedures and provide for the unscheduled inspection of facilities. The Company believes that its design, manufacturing and quality control procedures comply with the FDA's GMP regulations. In addition, marketed products are subject to continuing FDA scrutiny for compliance with the FDA's requirements relating to promotional activities. Failure to comply with these requirements may result in FDA enforcement actions, including warning letters, seizure, injunction or civil penalties. The Company is also subject to regulation in each of the foreign countries where it sells its products in the areas of product standards, packaging requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements. Many of the regulations applicable to the Company's products in such countries are similar to those of the FDA. The national health or social security organizations of certain countries require the Company's products to be qualified before they can be marketed in those countries. The Company relies on its independent distributors to comply with the majority of the foreign regulatory requirements. To date, the Company has not experienced significant difficulty in complying with these regulations. The Company has implemented policies and procedures that allowed the Company to receive ISO 9001 certification. ISO 9001 standards for quality operations have been developed to ensure that companies know, on a worldwide basis, the standards of quality to which they will be held. The European Union has promulgated rules which require that medical products receive a CE mark, an international symbol of quality and compliance with applicable European medical device directives, by mid-1998. ISO 9001 certification is one of the CE mark certification requirements. The Company has received CE mark certification. There can be no assurance that the Company will be successful in maintaining certification requirements, which would prohibit the Company from selling its products in Europe. Regulations regarding the manufacture and sale of the Company's products are subject to change. The Company cannot predict what impact, if any, such changes might have on its business, financial condition or results of operations. COMPETITION Competition in the market for spinal implants is intense. To date, the market has been dominated by manufacturers of pedicle screw implants, including Danek and Acromed, Inc. The Company will also 9 likely be directly competing with other manufacturers of less invasive implantable devices, including Danek and Surgical Dynamics. In addition, several other companies active in other areas of the orthopaedic market could enter the market at any time. Many of the Company's competitors have capital resources, research and development staffs, facilities, experience in conducting clinical trials and obtaining regulatory approvals and experience in manufacturing and marketing medical devices significantly greater than those of the Company. In addition, competitors may employ litigation to gain a competitive advantage. There can be no assurance that the Company's competitors will not develop or obtain regulatory approval for spinal implants that may be more effective in treating degenerative disc disease and other spinal conditions than the Company's current or future products, and that the Company's technologies and products would not be rendered obsolete by such developments. Any product developed by the Company that gains regulatory approval will have to compete for market acceptance and market share. The Company believes that competition in the spinal implant market is based, among other things, on the ability to safely and effectively treat degenerative disc disease and other spinal conditions, the availability of devices that can be implanted using less invasive surgical procedures, product reliability, physician familiarity with the procedure, patent position, price, sales and marketing capability, third- party reimbursement policies and reputation. Both Danek and Surgical Dynamics are pursuing development of less invasive implantable technology similar to the BAK device for spinal fusion. Danek has the Karlin Technology and has indicated that it received approval in March 1995 to initiate IDE clinical trials for its implantable lumbar fusion device. Surgical Dynamics has completed an IDE clinical trial with its implantable lumbar fusion device and has received FDA approval for this product. In addition, Danek and Surgical Dynamics are both marketing their devices internationally and compete with the Company in several markets. Danek and Surgical Dynamics are involved in patent litigation related to the Karlin Technology. If the patent that covers the Karlin Technology is declared invalid or if the license agreement with the Company is terminated, the Company may be subject to increased competition since it will not be able to prevent competitors from selling similar devices. PRODUCT LIABILITY Medical device companies are subject to inherent risk of product liability. Spinal implants, specifically pedicle screw systems, have been targeted in many product liability lawsuits in recent years. Since the Company's principal products are designed to be permanently implanted in the human body, manufacturing errors or design defects could result in an unsafe condition, injury or death to the patient. Although the Company maintains liability insurance, there can be no assurance that the coverage limits of the Company's insurance policies will be adequate in the event that claims are brought. Such insurance is expensive, difficult to obtain and may not be available in the future on acceptable terms, or at all. Although the Company has never been subject to a product liability claim, one or more successful claims brought against the Company would have a material adverse effect upon its business, financial condition and results of operations. EMPLOYEES The Company had 96 employees at December 31, 1996. No employee of the Company is represented by a labor union or is subject to a collective bargaining agreement. All employees are covered by agreements containing confidentiality provisions. The Company believes it maintains good relations with its employees. 10 RISK FACTORS Certain statements made in this Annual Report on Form 10-K, including those indicated by an asterisk, are forward-looking statements that involve risks and uncertainties, and actual results may differ. Factors that could cause actual results to differ include those identified below. COMPETITION; UNCERTAINTY OF TECHNOLOGICAL CHANGE. The orthopaedic device and instrument market is highly competitive and is characterized by innovation and technological change. The Company currently competes with a number of companies that have capital resources, research and development staffs, facilities, experience in conducting clinical trials and obtaining regulatory approvals, and experience in manufacturing and marketing medical devices that are significantly greater than those of the Company. In addition, there are several companies developing new technologies, such as bone growth factors and bone growth stimulation devices, which may have application in spinal fusions. There can be no assurance that the Company's competitors will not succeed in developing technologies and products that are more effective than any that are being developed by the Company or that would render the Company's products obsolete or noncompetitive. In addition, certain of the Company's competitors may achieve patent protection, regulatory approval or product commercialization that would limit the Company's ability to compete. Both Danek and Surgical Dynamics are pursuing development of less invasive implantable technology similar to the BAK/L device for spinal fusion. Danek, the co-licensee of the Karlin Technology, has indicated that it is in IDE clinical trials for its implantable lumbar fusion device. Surgical Dynamics has indicated that it has received PMA approval from the FDA for its implantable lumbar fusion device. In addition, Danek and Surgical Dynamics are both marketing their devices internationally and compete with the Company in several global markets. Danek and Surgical Dynamics are involved in patent litigation related to the Karlin Technology. If the patent that covers the Karlin Technology is declared invalid, or if the Karlin license is terminated, the Company may be subject to increased competition since it will not be able to prevent competitors from selling similar devices. The Company's inability to compete successfully could have a material adverse effect on the Company's business, financial condition and results of operations. RELIANCE ON PATENTS AND PROPRIETARY TECHNOLOGY. The Company relies heavily on proprietary technology, which it protects primarily through licensing arrangements, patents, trade secrets and proprietary know-how. The Company holds patents and has pending patent applications that cover certain aspects of its technology. The Company is a co-licensee of certain patented technology that covers key aspects of the design of the Company's BAK products. The Company is currently in litigation with the owners of this patent regarding contractual rights under the license agreement and other matters. Also, the owners of this patent and the other co-licensee, Danek, are involved in litigation with Surgical Dynamics, a competitor of the Company, which is challenging the validity and enforceability of the patent. There can be no assurance that the patent related to such technology will be upheld or that the Company will continue to have such patent protection for its products. See "Litigation; Potential for Adverse Outcomes" below. The Company also has an exclusive license under two method patents for conducting spinal surgery through minimally invasive laparoscopic procedures. There can be no assurance that any pending or future patent applications will be granted or that any current or future patents, regardless of whether the Company is an owner or a licensee of such patent, will not be challenged, rendered unenforceable, invalidated or circumvented or that the rights granted thereunder or under its licensing agreements will provide a competitive advantage to the Company. There can also be no assurance that the Company's trade secrets or non-disclosure 11 agreements will provide meaningful protection of the Company's proprietary information. Furthermore, there can also be no assurance that others will not independently develop similar technologies or duplicate any technology developed by the Company or that the Company's technology will not infringe upon patents or other rights owned by others. The Company's inability to maintain its proprietary rights, including the patent protection of the Karlin Technology, would have a material adverse effect on its business, financial condition and results of operations. LITIGATION; POTENTIAL FOR ADVERSE OUTCOMES. The medical device market is characterized by frequent and substantial intellectual property litigation. Intellectual property litigation is complex and expensive, and the outcome of such litigation is difficult to predict. The Company is currently in litigation with Dr. Michelson and an affiliated company, Karlin, the co-owners of the patent licensed by the Company which covers key aspects of the design of the Company's BAK products. The suits against the Company allege various causes of action concerning, among other things, Dr. Michelson's and Karlin's right to co- license the technology covered by the patent to a third party and termination of the Company's license agreement. The suits further allege that Dr. Michelson is the true inventor of certain innovations claimed by the Company in a patent. Although the Company believes that these claims are without merit and intends to contest these claims vigorously, the Company expects to incur substantial legal expenses in connection with the litigation. A finding against the Company could have a material adverse effect on the Company's business, financial condition and results of operations. Surgical Dynamics has filed a complaint for declaratory judgment of patent invalidity, unenforceability and non-infringement against Karlin and Danek regarding the Karlin Technology. Karlin and Danek have counterclaimed against Surgical Dynamics claiming patent infringement. The outcome of the litigation is uncertain. There can be no assurance that the patent related to the Karlin Technology will be upheld or that the Company will continue to have such patent protection for its products. The Company is not aware of any other patent infringement charge or any violation of other proprietary rights claimed by any third party relating to the Company or the Company's products. However, no assurance can be given that the Company or its products will not become the subject of such a claim in the future. Any current or future litigation involving the Company or its products could result in substantial expense to the Company and significant diversion of effort by the Company's technical and management personnel. Litigation may also be necessary to enforce patents issued to the Company, to protect trade secrets or know-how owned by the Company or to determine the enforceability, scope and validity of the proprietary rights of others. An adverse determination in any such proceeding could subject the Company to significant liabilities to third parties, or require the Company to seek licenses from third parties or require the Company to seek licenses from third parties or pay royalties that may be substantial. Furthermore, there can be no assurance that the necessary licenses would be available to the Company on satisfactory terms, or at all. Accordingly, an adverse determination in a judicial or administrative proceeding, including rescission or termination of its license agreement with Karlin or failure to obtain the necessary licenses, could prevent the Company from manufacturing and selling certain of its products, which would have a material adverse effect on the Company's business, financial condition and results of operations. GOVERNMENT REGULATION. In the United States, the FDA regulates the sale of medical devices as well as manufacturing procedures, labeling and recordkeeping with respect to such products. The process of obtaining marketing clearances and approvals from the FDA for new products can be time consuming and expensive, and there is no assurance that such clearances or approvals will be granted or that FDA review will not involve delays that would adversely affect the Company's ability to 12 commercialize its products. The FDA requires that a new device and related instruments secure either a 510(k) clearance or an approved PMA, depending upon their classification, prior to marketing in the United States. The process of obtaining a 510(k) clearance, which is available for products demonstrated to be substantially equivalent to products which are already commercially available, typically takes several months and may require the submission of supporting laboratory or clinical data. The PMA process generally takes years and may require the submission of significant supporting data and clinical information and can be very expensive. The Company obtained PMA approval from the FDA for its BAK/L product in September 1996. The Company's BAK/C and BAK/T products must obtain PMA approval before they can be sold in the United States. No assurance can be given that the Company will ever receive FDA marketing approval for these products. Even if regulatory approvals to market a product are obtained from the FDA, such approvals may entail limitations on the indicated uses of the product. Product approvals by the FDA can also be withdrawn due to failure to comply with regulatory requirements or the occurrence of unforeseen problems following initial approval. The FDA could also limit or prevent the manufacture or distribution of the Company's products and has the power to require the recall of such products. FDA regulations depend heavily on administrative interpretation, and there can be no assurance that future interpretations made by the FDA or other regulatory bodies, with possible retroactive effect, will not adversely affect the Company. The FDA, various state agencies and foreign regulatory agencies inspect the Company from time to time to determine whether the Company is in compliance with various regulations relating to manufacturing practices, validation, testing, quality control and product labeling. A determination that the Company is in violation of such regulations could lead to imposition of civil penalties, including fines, product recall orders or product seizures, and, in extreme cases, criminal sanctions. International regulatory bodies often establish varying regulations governing products standards, packaging requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements. As a result of the Company's sales in Europe, the Company was required to be certified as ISO 9001 compliant and to receive CE mark certification. Failure to maintain CE mark certification would have a material adverse effect on the Company's business, financial condition and results of operations. The Company relies on its independent distributors to comply with the majority of the foreign regulatory requirements. The inability or failure of the independent distributors to comply with the varying regulations or the imposition of new regulations could restrict such distributors' ability to sell the Company's products and thereby materially adversely affect the Company's business, financial condition and results of operations. LIMITATIONS ON THIRD-PARTY REIMBURSEMENT. The Company's ability to sell its products depends in part on the extent to which reimbursement for the cost of such products and related treatments are available to patients under domestic and foreign governmental health programs, private health insurance, managed care organizations, workers' compensation insurers, and other similar programs. Over the past decade, the cost of health care has risen significantly, and there have been numerous proposals by legislators, regulators and third-party health care payors to curb these costs. Some of these proposals have involved limitations on the amount of reimbursement for certain surgical procedures. Certain of the Company's products are still investigational and certain payors will not provide reimbursement since these devices have not received FDA clearance. There can be no assurance that adequate third-party reimbursement will be achieved even if FDA clearance for these products is obtained. In addition, certain health care providers are moving towards a managed care system in which such providers contract to provide comprehensive health care for a fixed cost per 13 person. Managed care providers are attempting to control the cost of health care by authorizing fewer elective surgical procedures, such as spinal fusions. The Company is unable to predict what changes will be made in the reimbursement methods utilized by third-party health care payors. In addition, hospitals and other health care providers have become increasingly price competitive and, in some instances, have put pressure on medical suppliers to lower their prices. The Company's BAK implants are currently priced at a premium to pedicle screw implants in the United States. Any reproductions in coverage or price limitations by third-party payors could have a material adverse effect on the Company's business, financial condition and results of operations. LACK OF MARKET ACCEPTANCE. The Company received FDA approval for its principal product, the BAK/L (for lumbar spinal fusions), in September 1996. The Company's other spinal fusion products, the BAK/C (for cervical spinal fusions) and the BAK/T (for thoracic spinal fusions) are in various stages of clinical testing in the United States. Prior to FDA approval, the Company had very limited sales and marketing opportunities in the United States. Although various products of the Company have received marketing approval outside the United States, those products have been marketed internationally only for a limited period of time. The Company's principal products and related instrumentation are based upon innovative surgical concepts and procedures relating to interbody spinal fusion and minimally invasive surgery. A majority of the Company's BAK devices have been surgically implanted from the front rather than from the back, which is the conventional method of implanting pedicle screws. The Company believes that market acceptance of the Company's products will depend, in part, on the Company's ability to convince the medical community of the safety, efficacy and cost effectiveness of the Company's products as compared to existing fusion implants and surgical techniques. Market acceptance will further depend on the Company's ability to train surgeons in the use of its products. There can be no assurance that spine surgeons will readily adopt new device concepts and surgical techniques. Furthermore, even though the number of spinal fusion procedures has been increasing each year, there can be no assurance that this growth will continue. The Company's inability to gain market acceptance for its products and surgical techniques would have a material adverse effect on the Company's business, financial condition and results of operations. DEVELOPMENT OF DOMESTIC SALES FORCE. The Company has sold its principal products in the United States only on a limited basis and is in the process of developing a domestic sales and marketing staff. The Company plans to market and sell such products in the United States through a combination of direct sales and marketing staff and independent sales and support representatives that have been specially trained by the Company. There can be no assurance that the Company will be able to develop such a network or that these persons will be able to successfully sell the Company's products. RELIANCE ON INTERNATIONAL DISTRIBUTORS. Prior to February 1996, the Company had an exclusive international distribution agreement with Smith & Nephew for the BAK/L implant. In February 1996, the Company determined to terminate its agreement with Smith & Nephew and to establish alternative international distribution channels of independent distributors. There can be no assurance that the Company will be able to establish such alternative international distribution channels on terms acceptable to the Company, or at all. TRAINING OF MEDICAL PERSONNEL. Market acceptance of the Company's products will depend on the Company's ability to train spine surgeons and other medical personnel in the use of the Company's 14 products. The Company requires that all surgeons receive training in Company-sponsored sessions prior to using the Company's products in the United States. In addition, in the United States each surgeon receives support during surgery from medical personnel who have received the Company's training. The Company's inability to train a sufficient number of spine surgeons and other medical personnel on a timely basis, whether because of inadequate facilities, surgeon reluctance or otherwise, could have a material adverse effect on the Company's business, financial condition and results of operations. PRODUCT LIABILITY. The medical device industry has been historically litigious and the Company faces an inherent business risk of financial exposure to product liability claims in the event that the use of its products results in personal injury. Since the Company's principal products are designed to be permanently implanted in the human body, manufacturing errors or design defects could result in an unsafe condition, injury or death to the patient, and could result in a recall of the Company's products and substantial monetary damages. There can be no assurance that the Company will not experience losses due to product liability claims in the future. Although the Company currently maintains liability insurance, there can be no assurance that the coverage limits of the Company's insurance policies will be adequate. Such insurance is expensive, difficult to obtain and may not be available in the future on acceptable terms, or at all. Any claims against the Company, regardless of their merit or eventual outcome, would have a material adverse effect upon the Company's business financial condition and results of operations. DEPENDENCE ON KEY PERSONNEL. The Company's success depends in large part on its ability to attract and retain highly qualified scientific, technical, management and marketing personnel. Competition for such personnel is intense and there can be no assurance that the Company will be able to attract and retain the personnel necessary for the development and operation of its business. The loss of the services of key personnel could have a material adverse effect on the Company's business, financial condition and results of operations. DEPENDENCE ON CONTRACT MANUFACTURERS. The Company does not conduct manufacturing operations and is dependent upon several contract manufacturers for the production of its products and expects to continue to be dependent upon such manufacturers for the foreseeable future. The Company is dependent upon these manufacturers for timely and cost-effective manufacturing services. In the event that the Company is unable to obtain contract manufacturing, or obtain such manufacturing on commercially reasonable terms, it may not be able to manufacture products on a timely and competitive basis, or at all. POSSIBLE VOLATILITY OF SHARE PRICE. Market prices for securities of medical technology companies are highly volatile and the trading price of the Company's Common Stock could be subject to significant fluctuations in response to quarterly variations in operating results, announcements of technological innovations by the Company or its competitors, government regulation and other events or factors, including the various risk actors discussed above. In addition, market prices of securities of medical technology companies have from time to time experienced extreme price and volume fluctuations, which may be unrelated to the operating performance of particular companies. These broad market fluctuations may materially adversely affect the market price of the Company's Common Stock. 15 ABSENCE OF DIVIDENDS. The Company has not paid any cash dividends since its inception and does not anticipate paying cash dividends in the foreseeable future. ANTI-TAKEOVER CONSIDERATIONS. The Board of Directors of the Company has the authority, without any action by the stockholders, to fix the rights and preferences of any shares of the Company's Preferred Stock to be issued from time to time. In addition, as a Minnesota corporation, the Company is subject to certain anti-takeover provisions of the Minnesota Business Corporation Act (the "MBCA"). The Company has also adopted a Shareholder Rights Agreement. The authority of the Board with regard to the Preferred Stock, the provisions of the MBCA and the Shareholder Rights Agreement could have the effect of delaying, deferring or preventing a change in control of the Company, may discourage bids for the Company's Common Stock at a premium over the then prevailing market price of the Common Stock, and may adversely effect the market price of, and the voting and other rights of the holders of, Common Stock. ITEM 2. PROPERTIES The Company's headquarters and research facilities are located in a 42,000 square foot office building in Edina, Minnesota, which the Company acquired in November 1995 and has occupied since December of that year. Management believes that the Company's facilities are suitable and adequate for current office, research and warehouse requirements, and will meet the Company's currently anticipated needs.* ITEM 3. LEGAL PROCEEDINGS The medical device market is characterized by frequent and substantial intellectual property litigation. Intellectual property litigation is complex and expensive, and the outcome of such litigation is difficult to predict. The Company is not aware of any patent infringement charge or any violation of other proprietary rights claimed by any third party relating to the Company or the Company's products, except as set forth below. However, no assurance can be given that the Company or its products will not become the subject of such a claim in the future. Any future litigation could result in substantial expense to the Company and significant diversion of effort by its technical and management personnel. Litigation may also be necessary to enforce patents issued to the Company, to protect trade secrets or know-how owned by it or to determine the enforceability, scope and validity of the proprietary rights of others. An adverse determination in any such proceeding could subject the Company to significant liabilities to third parties, or require it to seek licenses from, and pay substantial royalties to, third parties. Furthermore, there can be no assurance that necessary licenses would be available to the Company on satisfactory terms, or at all. Accordingly, an adverse determination in a judicial or administrative proceeding or failure to obtain necessary licenses could prevent the Company from manufacturing and selling certain of its products, which would have a material adverse effect on its business, financial condition and results of operations. The Company is involved in litigation related to its license of the Karlin Technology from Dr. Michelson and Karlin, co-owners of the Karlin Technology. The litigation principally relates to the interpretation of Dr. Michelson's and Karlin's right to co-license the Karlin Technology to a third party and to the inventorship of one of the Company's patents. In December 1993, Dr. Michelson and Karlin filed a complaint against the Company and Smith & Nephew Group, an entity under common control with Smith & 16 Nephew, in United States District Court, Central District of California. In December 1994, the plaintiffs served the defendants with a second amended complaint (the "Complaint"). The Company filed an answer to the Complaint in January 1995 denying the material allegations and setting forth affirmative defenses. The Complaint alleged various causes of action, including tortious interference with prospective and contractual business relationships, unfair competition and breach of contract, and requested various types of relief, including money damages, injunctive relief and declaratory judgment. In addition, in the event the Company objected to the co-license of the Karlin Technology to a third party, the Complaint requested rescission of the license agreement. Danek, a competitor of the Company, is the other co-licensee of the Karlin Technology. The Company is not contesting the co-license of the Karlin Technology to Danek. Each of the claims relating to the Karlin Technology has been the subject of a dispositive motion resulting in an order by the court granting its dismissal in the Company's favor. On February 12, 1996, the court entered judgment finding that the Company was the prevailing party on all counts of the Complaint. Dr. Michelson and Karlin have appealed the judgment to the Ninth Circuit Court of Appeals. The parties have filed briefs and are awaiting an oral hearing before the appellate court. On June 19, 1995, the Company received a purported notice of termination of the Karlin license agreement based on alleged inadequacy in the reporting of the royalty payments due by the Company to Karlin under the license agreement. Karlin has claimed that the Company has therefore breached the license agreement. The Company denies, however, that it has breached the agreement. Under the terms of the agreement, the license agreement may not be terminated until after a final, non-appealable determination of the existence of the breach by a court of competent jurisdiction. The license agreement also provides for non-binding arbitration and the right of a breaching party to cure a breach by adopting the recommendation of the arbitrator. On September 15, 1995, the Company commenced a non-binding arbitration against Dr. Michelson and Karlin in Minneapolis before the American Arbitration Association asserting that the purported termination of the license agreement is meritless and ineffective. Dr. Michelson and Karlin have taken the position in the arbitration that they do not intend to seek to enforce the purported termination. They also contend, however, that they may in the future terminate the license agreement if the royalty reports are determined to have been inadequate. Although the Company believes that a valid termination of the agreement will not be a remedy available to Karlin and Dr. Michelson, a determination against the Company could have a material adverse effect on its business, financial condition and results of operations.* On August 13, 1996, Karlin and Dr. Michelson filed an arbitration before the American Arbitration Association in Los Angeles. Karlin and Dr. Michelson seek in this arbitration (i) an award of royalties which they claim the Company has not paid, and (ii) a declaration that Dr. Michelson is the inventor of certain surgical methods used by or claimed to be invented by the Company, damages for failure to give Dr. Michelson inventive credit for these methods, and an order that the Company place corrective advertising to ameliorate the purported failure. After the Company objected to Los Angeles as the forum for this arbitration, the AAA transferred the arbitration to Minnesota so that it could be coordinated with the prior pending arbitration filed by the Company. Both arbitrations are currently pending before the AAA in Minnesota. No discovery has yet taken place and no hearing dates have been set. The Company and Karlin and Dr. Michelson are also in litigation in the United States District Court for the District of Minnesota concerning inventorship of U.S. Patent No. 5,489,307. Prior to the issuance of the patent to the Company, Dr. Michelson in the above-referenced California action asserted that he was the true inventor of the then pending patent application for the patent. This claim was dismissed for lack of a justiciable controversy. In the Minnesota action brought by the Company, Dr. Michelson has filed a motion to dismiss for lack of personal jurisdiction, which was denied. Karlin and Dr. Michelson have since 17 filed a pending motion to dismiss, transfer or stay the action, asserting that the action should be heard only in the United States District Court for the Central District of California. On December 16, 1996, Karlin and Dr. Michelson filed an action against the Company in the United States District Court for the Central District of California. The complaint seeks (i) declaratory relief that Dr. Michelson is the true inventor and owner of the patent, or in the alternative, that the patent is invalid; (ii) unspecified damages and an injunction based upon the Company's acquisition and exploitation of the patent; (iii) unspecified damages and termination of the Karlin license agreement based upon numerous allegedly false representations made by the Company in connection with the entry into the License Agreement; (iv) unspecified damages for alleged disparagement of title in connection with the bilateral pre-distraction method and associated instruments specified in the patent; (v) unspecified damages for breach of fiduciary duty in connection with alleged failures by the Company to pay royalties due and the Company's conduct related to the patent; (vi) unspecified damages for misappropriation of trade secrets in connection with the application for and exploitation of the patent; and (vii) unspecified damages for statutory unfair competition in connection with the same alleged conduct. The complaint also seeks unspecified punitive damages. The parties have stipulated to extend the time for the Company to respond to this complaint while Karlin's and Dr. Michelson's motion to dismiss is pending in Minnesota. Although the Company believes that neither a termination of the agreement nor substantial damages will be remedies available to Karlin and Dr. Michelson in this action, a determination against the Company could have a material adverse effect on its business, financial condition and results of operation.* Surgical Dynamics, Inc., a competitor of the Company, has filed a complaint for declaratory judgment in the United States District Court for the Central District of California of patent invalidity, unenforceability and non-infringement against Karlin and Danek regarding U.S. Patent No. 5,015,247, which is part of the Karlin Technology. Karlin and Danek have counterclaimed against Surgical Dynamics claiming patent infringement. The outcome of the litigation is uncertain. There can be no assurances that the patent related to the Karlin Technology will be upheld or that the Company will continue to have such patent protection for its products. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 18 ITEM X. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers and directors of the Company are as follows: NAME AGE POSITION -------------------- --- ---------------------------------------- David W. Stassen 45 Chief Executive Officer, President and Director Keith M. Eastman 47 Chief Financial Officer and Secretary Ted K. Schwarzrock 47 Vice President, Sales and Marketing Douglas W. Kohrs 39 Vice President, Research and Product Development Richard C. Jansen 48 Vice President, Regulatory and Clinical Affairs David L. Shaw 51 Vice President, Manufacturing Operations DAVID W. STASSEN has served as President and Chief Executive Officer of the Company since June 1992 and as a director of the Company since June 1991. From 1990 to June 1992, Mr. Stassen served as Executive Vice President of St. Paul Venture Capital, Inc., a venture capital company. He is currently a director of Avecor Cardiovascular, Inc. and RSI Systems, Inc. KEITH M. EASTMAN has served as Chief Financial Officer of the Company since September 1992. Mr. Eastman was an independent consultant from January 1991 to September 1992 and served as Chief Financial Officer of CIMA Labs, Inc., a pharmaceutical manufacturer, from December 1991 to August 1992. TED K. SCHWARZROCK has served as Vice President, Sales and Marketing since November 1993. From June 1991 to October 1993, he served as Vice President of Ergodyne, Inc., a developer of ergonomic products for the workplace. He is currently a director of HPS Medical, Inc. and MedAmicus Inc. DOUGLAS W. KOHRS has served as Vice President, Research and Product Development since January 1993 and previously served as Director of Product Development and Marketing for the Company from August 1991 to January 1993. RICHARD C. JANSEN, PHARM.D., has served as Vice President, Regulatory and Clinical Affairs since August 1993 and previously served as Director of Regulatory Affairs and Operations of the Company from August 1991 to August 1993. DAVID L. SHAW has served as Vice President, Manufacturing Operations since June 1994 and previously served as Director of Manufacturing of the Company from June 1992 to June 1994. From December 1991 to June 1992, Mr. Shaw worked as a manufacturing consultant for the Company. Executive officers are elected annually by the Board of Directors and serve a one-year period or until their successors are elected. None of the above executive officers is related to each other or to any director of the Company. 19 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Incorporated herein by reference is the Company's Annual Report to Shareholders for the fiscal year ended December 31, 1996, page 24. ITEM 6. SELECTED FINANCIAL DATA Incorporated herein by reference is the Company's Annual Report to Shareholders for the fiscal year ended December 31, 1996, page 8. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Incorporated herein by reference is the Company's Annual Report to Shareholders for the fiscal year ended December 31, 1996, pages 8-11. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Incorporated herein by reference is the Company's Annual Report to Shareholders for the fiscal year ended December 31, 1996, pages 12-23. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Incorporated herein by reference is the information appearing under the headings "Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance," pages 3, 4 and 17, in the Company's Proxy Statement dated March 28, 1997. See also Part I hereof under the heading "Item X. Executive Officers of the Registrant." ITEM 11. EXECUTIVE COMPENSATION Incorporated herein by reference is the information appearing under the headings "Election of Directors," "Report of the Compensation Committee," "Executive Compensation" and "Performance Graph," pages 10 and 16, in the Company's Proxy Statement dated March 28, 1997. 20 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated herein by reference is the information appearing under the heading "Security Ownership of Principal Shareholders and Management," page 2, in the Company's Proxy Statement dated March 28, 1997. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated herein by reference is the information appearing under the heading "Certain Relationships and Transactions," page 17, in the Company's Proxy Statement dated March 28, 1997. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements: Report of Independent Auditors Statements of Operations for the years ended December 31, 1996, 1995 and 1994 Balance Sheets as of December 31, 1996 and 1995 Statements of Cash Flows for the years ended December 31, 1996, 1995 and 1994 Statements of Shareholders' Equity for the years ended December 31, 1996, 1995 and 1994 Notes to Financial Statements (Incorporated by reference to pages 12-23 of the Company's Annual Report to Shareholders for the fiscal year ended December 31, 1996.) 2. Financial Statement Schedules: Schedule II--Valuation and Qualifying Accounts All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted. 3. Exhibits: 3.1 Amended and Restated Articles of Incorporation of the Company. (1) (2) (3) 3.2 Restated By-Laws of the Company and Amendment to Restated By-Laws of the Company. (4) 4.1 Specimen of Common Stock certificate. (5) 21 4.2 Form of Rights Agreement dated as of August 21, 1996 between the Company and Norwest Bank Minnesota, N.A. (3) #10.1 1994 Spine-Tech, Inc. Stock Option Plan. (6) #10.2 Spine-Tech, Inc. 1993 Non-Employee Director Stock Option Plan. (7) #10.3 Spine-Tech, Inc. 1991 Stock Option Plan. (8) 10.4 Loan Agreement between the Company and Riverside Bank dated April 20, 1995. (9) #10.5 Spine-Tech, Inc. 1996 Employee Stock Purchase Plan. (10) #10.6 Spine-Tech, Inc. 1996 Omnibus Stock Plan. (11) 10.7 License Agreement dated as of May 10, 1992, among the Company, Karlin Technology, Inc. and Gary K. Michelson. (12) (13) 10.8 License Agreement dated as of January 1, 1995 between the Company and Dr. Ted Obenchain. (13) (14) #10.9 Employment Agreement between the Company and David W. Stassen dated June 15, 1992. (15) #10.10 Employment Letter from the Company to David W. Stassen dated June 2, 1992. (16) #10.11 Employment Agreement between the Company and Ted K. Schwarzrock dated November 1, 1993. (17) #10.12 Management Agreement dated as of February 1, 1996 between the Company and David W. Stassen. (18) #10.13 Management Agreement dated as of February 1, 1996 between the Company and Keith M. Eastman. (19) #10.14 Management Agreement dated as of February 1, 1996 between the Company and Ted K. Schwarzrock. (20) #10.15 Management Agreement dated as of February 1, 1996 between the Company and Douglas W. Kohrs. (21) #10.16 Management Agreement dated as of February 1, 1996 between the Company and Richard C. Jansen. (22) #10.17 Management Agreement dated as of February 1, 1996 between the Company and David L. Shaw. (23) 22 10.18 Collaberation Agreement between the Company and Ethicon Endo Surgery dated June 27, 1994 (24) 11 Statement of Computation of Net Income (Loss). 13 Annual report to Shareholders for the fiscal year ended December 31, 1996 (only those portions specifically incorporated by reference herein shall be deemed filed with the Securities and Exchange Commission). 23 Consent of Ernst & Young LLP. 27 Financial Data Schedule (EDGAR version only). - ------------------------------ # Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(c). (1) Incorporated by reference to Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1995 (File No. 0-26116). (2) Incorporated by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (3) Incorporated by reference to Exhibit 1 to the Company's Current Report on Form 8-K dated August 21, 1996. (4) Incorporated by reference to Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1996. (5) Incorporated by reference to Exhibit 4.1 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (6) Incorporated by reference to Exhibit 10.1 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (7) Incorporated by reference to Exhibit 10.2 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (8) Incorporated by reference to Exhibit 10.3 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (9) Incorporated by reference to Exhibit 10.11 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (10) Incorporated by reference to Exhibit 10.13 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. 23 (11) Incorporated by reference to Exhibit 10.14 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (12) Incorporated by reference to Exhibit 10.17 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (13) Exhibit contains portions for which confidential treatment has been granted to the Company. (14) Incorporated by reference to Exhibit 10.18 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (15) Incorporated by reference to Exhibit 10.19 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (16) Incorporated by reference to Exhibit 10.20 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (17) Incorporated by reference to Exhibit 10.21 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (18) Incorporated by reference to Exhibit 10.22 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (19) Incorporated by reference to Exhibit 10.23 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (20) Incorporated by reference to Exhibit 10.24 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (21) Incorporated by reference to Exhibit 10.25 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (22) Incorporated by reference to Exhibit 10.26 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (23) Incorporated by reference to Exhibit 10.27 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (24) Incorporated by reference to Exhibit 10.12 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). 24 (b) Reports on Form 8-K No reports were filed during the fourth quarter of the fiscal year ended December 31, 1996. 25 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 March 26, 1997. SPINE-TECH, INC. By /s/ David W. Stassen ------------------------------------------- David W. Stassen Chief Executive Officer and President 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 March 26, 1997. /s/ David W. Stassen --------------------------------------------- David W. Stassen, Chief Executive Officer and President (Principal Executive Officer) and Director /s/ Keith M. Eastman --------------------------------------------- Keith M. Eastman, Chief Financial Officer and Secretary (Principal Financial Officer and Principal Accounting Officer) /s/ Kenneth W. Anstey --------------------------------------------- Kenneth W. Anstey, Director /s/ Robert J. DePasqua --------------------------------------------- Robert J. DePasqua, Director /s/ Stephen D. Kuslich --------------------------------------------- Stephen D. Kuslich, Director /s/ James F. Lyons --------------------------------------------- James F. Lyons, Director 26 EXHIBIT INDEX
Exhibit Description Page - ------- ----------- ---- 3.1 Amended and Restated Articles of Incorporation of the Company. (1) (2) (3) . . . . . . . . . . . . . . . . . . . .Incorporated by Reference 3.2 Restated By-Laws of the Company and Amendment to Restated By-Laws of the Company. (4). . . . . . . . . . . . . . . . .Incorporated by Reference 4.1 Specimen of Common Stock certificate. (5). . . . . . . . . .Incorporated by Reference 4.2 Form of Rights Agreement dated as of August 21, 1996 between the Company and Norwest Bank Minnesota, N.A. (3) . .Incorporated by Reference #10.1 1994 Spine-Tech, Inc. Stock Option Plan. (6) . . . . . . . .Incorporated by Reference #10.2 Spine-Tech, Inc. 1993 Non-Employee Director Stock Option Plan. (7) . . . . . . . . . . . . . . . . . . . . . .Incorporated by Reference #10.3 Spine-Tech, Inc. 1991 Stock Option Plan. (8) . . . . . . . .Incorporated by Reference 10.4 Loan Agreement between the Company and Riverside Bank dated April 20, 1995. (9). . . . . . . . . . . . . . . . . .Incorporated by Reference #10.5 Spine-Tech, Inc. 1996 Employee Stock Purchase Plan. (10) . .Incorporated by Reference #10.6 Spine-Tech, Inc. 1996 Omnibus Stock Plan. (11) . . . . . . .Incorporated by Reference 10.7 License Agreement dated as of May 10, 1992, among the Company, Karlin Technology, Inc. and Gary K. Michelson. (12) (13). . . . . . . . . . . . . . . . . . . . . . . . . .Incorporated by Reference 10.8 License Agreement dated as of January 1, 1995 between the Company and Dr. Ted Obenchain. (13) (14) . . . . . . . .Incorporated by Reference #10.9 Employment Agreement between the Company and David W. Stassen dated June 15, 1992. (15) . . . . . . . . .Incorporated by Reference #10.10 Employment Letter from the Company to David W. Stassen dated June 2, 1992. (16) . . . . . . . . . . . . . . . . . .Incorporated by Reference #10.11 Employment Agreement between the Company and Ted K. Schwarzrock dated November 1, 1993. (17). . . . . . .Incorporated by Reference #10.12 Management Agreement dated as of February 1, 1996 between the Company and David W. Stassen. (18) . . . . . . .Incorporated by Reference
#10.13 Management Agreement dated as of February 1, 1996 between the Company and Keith M. Eastman. (19) . . . . . . .Incorporated by Reference #10.14 Management Agreement dated as of February 1, 1996 between the Company and Ted K. Schwarzrock. (20) . . . . . .Incorporated by Reference #10.15 Management Agreement dated as of February 1, 1996 between the Company and Douglas W. Kohrs. (21) . . . . . . .Incorporated by Reference #10.16 Management Agreement dated as of February 1, 1996 between the Company and Richard C. Jansen. (22). . . . . . .Incorporated by Reference #10.17 Management Agreement dated as of February 1, 1996 between the Company and David L. Shaw. (23). . . . . . . . .Incorporated by Reference 10.18 Collaberation Agreement between the Company and Ethicon Endo Surgery dated June 27, 1994 (24). . . . . . . .Incorporated by Reference 11 Statement of Computation of Net Income (Loss). . . . . . . .Filed Electronically 13 Annual report to Shareholders for the fiscal year ended December 31, 1996 (only those portions specifically incorporated by reference herein shall be deemed filed with the Securities and Exchange Commission). . . . . . . . . . . . . . . . . . . . . . . . .Incorporated by Reference 23 Consent of Ernst & Young LLP . . . . . . . . . . . . . . . .Filed Electronically 27 Financial Data Schedule (EDGAR version only).. . . . . . . .Filed Electronically
- ------------------------------ # Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(c). (1) Incorporated by reference to Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1995 (File No. 0-26116). (2) Incorporated by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (3) Incorporated by reference to Exhibit 1 to the Company's Current Report on Form 8-K dated August 21, 1996. (4) Incorporated by reference to Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1996. (5) Incorporated by reference to Exhibit 4.1 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (6) Incorporated by reference to Exhibit 10.1 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (7) Incorporated by reference to Exhibit 10.2 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (8) Incorporated by reference to Exhibit 10.3 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (9) Incorporated by reference to Exhibit 10.11 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (10) Incorporated by reference to Exhibit 10.13 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (11) Incorporated by reference to Exhibit 10.14 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (12) Incorporated by reference to Exhibit 10.17 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (13) Exhibit contains portions for which confidential treatment has been granted to the Company. (14) Incorporated by reference to Exhibit 10.18 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (15) Incorporated by reference to Exhibit 10.19 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (16) Incorporated by reference to Exhibit 10.20 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (17) Incorporated by reference to Exhibit 10.21 to the Company's Registration Statement on Form S-1 (Registration No. 33-91928). (18) Incorporated by reference to Exhibit 10.22 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (19) Incorporated by reference to Exhibit 10.23 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (20) Incorporated by reference to Exhibit 10.24 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (21) Incorporated by reference to Exhibit 10.25 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (22) Incorporated by reference to Exhibit 10.26 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. (23) Incorporated by reference to Exhibit 10.27 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. SPINE-TECH, INC. SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
Balance at Additions Beginning of Charged to Cost Less Balance at End Description Year and Expenses Deductions of Year - -------------------------------------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1996: Allowance for doubtful accounts $ 61,000 $ - $ - $ 61,000 Reserve for obsolete inventory 100,000 49,000 81,000 68,000 ---------------------------------------------------------------------- $ 161,000 $ 49,000 $ 81,000 $ 129,000 ---------------------------------------------------------------------- ---------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1995: Allowance for doubtful accounts $ - $ 61,000 $ - $ 61,000 Reserve for obsolete inventory 60,000 40,000 - 100,000 ---------------------------------------------------------------------- $ 60,000 $ 101,000 $ - $ 161,000 ---------------------------------------------------------------------- ---------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1994: Allowance for doubtful accounts $ - $ - $ - $ - Reserve for obsolete inventory 15,000 45,000 - 60,000 ---------------------------------------------------------------------- $ 15,000 $ 45,000 $ - $ 60,000 ---------------------------------------------------------------------- ----------------------------------------------------------------------
EX-11 2 EXHIBIT 11 SPINE-TECH, INC. EXHIBIT 11 - STATEMENT RE: COMPUTATION OF NET INCOME (LOSS) PER SHARE
Year ended December 31, 1996 1995 1994 ---------- ---------- ---------- PRIMARY LOSS PER SHARE: Average shares outstanding 9,831,733 5,633,473 2,090,000 Common share equivalents -- 1,534,143 -- SAB No. 83 shares -- for stock options granted at an exercise price less than the initial public offering price during the 12 months preceding the initial public offering using the treasury method -- 93,850 375,398 ---------- ---------- ---------- Total 9,831,733 7,261,466 2,465,398 ---------- ---------- ---------- ---------- ---------- ---------- Net income (loss) $ (247,000) $ 268,000 $ (379,000) ---------- ---------- ---------- ---------- ---------- ---------- Net income (loss) per share $ (0.02) $ 0.04 $ (0.18) ---------- ---------- ---------- ---------- ---------- ---------- FULLY DILUTED LOSS PER SHARE: Average shares outstanding 9,831,733 5,633,473 2,090,000 Common share equivalents -- 1,637,220 -- Preferred stock on an as if converted basis 2,277,208 4,135,232 SAB No. 83 shares -- for stock options granted at an exercise price less than the initial public offering price during the 12 months preceding the initial public offering using the treasury method -- 93,850 375,398 ---------- ---------- ---------- Total 9,831,733 9,641,751 6,600,630 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Net income (loss) $ (247,000) $ 268,000 $ (379,000) ---------- ---------- ---------- ---------- ---------- ---------- Net income (loss) per share $ (0.02) $ 0.03 $ (0.06) ---------- ---------- ---------- ---------- ---------- ----------
EX-13 3 ANNUAL REPORT ABOUT THE COMPANY Spine-Tech, Inc. designs, manufactures and markets an innovative series of spinal implants, instruments and procedures based on the company's BAK-TM- technology for the treatment of degenerative conditions of the human spine. The company's BAK systems are designed for the lumbar (BAK) and cervical (BAK/C-Registered Trademark-) regions of the spine. Spine-Tech intends to become an internationally recognized leader in this market by: - Expanding technological leadership; - Enhancing minimally invasive surgical treatments for degenerative spinal conditions; - Establishing the clinical utility and cost-effectiveness of its products; - Providing superior clinical, engineering and educational support to patients and customers; and - Developing focused worldwide marketing and sales capabilities. 1996 MILESTONES | | | U.S. PATENT OFFICE ISSUES TWO | PATENTS FOR BAK IMPLANTS, SURGICAL SURGICAL TRAINING CENTER | PROCEDURES AND INSTRUMENTS. OPENS AT HEADQUARTERS. | | | --------FEBRUARY-------------MAY----------------------AUGUST-------------- | U.S. FDA ORTHOPAEDIC AND REHABILITATION DEVICES PANEL RECOMMENDS APPROVAL OF SPINE-TECH'S BAK TECHNOLOGY. ISO 9001 QUALITY SYSTEMS AND CE MARK CERTIFICATIONS RECEIVED. LETTER TO SHAREHOLDERS ON SEPTEMBER 23, 1996, the U.S. Food and Drug Administration (FDA) approved the Spine-Tech BAK-TM- system, designed to treat chronic low back pain caused by degenerative disc disease in the lumbar spine, for marketing in the United States. This first FDA approval of a Spine-Tech product is a pivotal event for our company - establishing the opportunity to launch the BAK system in the United States and laying the foundation for future approvals of other BAK-based products. Now, we are transforming Spine-Tech from a development-stage entity to a company with full-fledged marketing and manufacturing operations. Our innovative series of proprietary implantable devices, instruments and surgical methods has been evaluated in clinical trials at more than 20 medical centers over five years. More than 1,900 patients have received BAK implants in clinical trials; an additional 900 patients have received BAK implants since commercial launch. The BAK system has produced outstanding results in comparison to traditional fusion techniques, and patient outcomes after commercial introduction have been consistent with data collected in clinical trials. The surgical procedure is less traumatic, operating times are short, pain relief is fast and patients recover quickly, reducing lost worker productivity. FINANCIAL RESULTS Revenues for the year ended December 31, 1996, reached $10.2 million, a 36 percent increase over revenues of $7.5 million in 1995. For the year ended December 31, 1996, we reported a loss of $247,000, or $.02 per share, compared to earnings of $268,000, or $.03 per share, in 1995. In the 1996 fourth quarter, which includes our first commercial sales of the BAK system in the United States, we recorded revenues of $5.7 million, a 159 percent increase over fourth quarter 1995 revenues, and earned $2.1 million, or $.19 per share. We believe this quarter begins to reflect Spine-Tech's potential. The commercial launch of the BAK system is well under way. We also continue to generate revenues from the sale of other BAK products in clinical trials, including trials using laparoscopic surgical procedures. SURGICAL TRAINING SEMINARS HELD AT NORTH AMERICAN SPINE SOCIETY MEETING. | | - -SEPTEMBER ------------------------ OCTOBER ---------------- DECEMBER | | FDA APPROVAL RECEIVED FOR THE BAK | SYSTEM FOR USE IN THE LUMBAR SPINE. | | AGREEMENT SIGNED WITH ORQUEST CORPORATION TO EVALUATE AND COMMERCIALIZE SYNTHETIC BONE GRAFT WITH BAK IMPLANTS. | | SUPPLEMENTAL PRE-MARKET APPROVAL (PMA) APPLICATION SUBMITTED TO FDA FOR A LAPAROSCOPIC PROCEDURE FOR THE BAK SYSTEM. 1 LETTER TO SHAREHOLDERS CONT'D Three significant factors affected 1996 results. First, we received FDA approval for the commercial launch of our principal product, which positively affected our revenue growth and established a foundation for future revenue growth in our major market. Second, we ended our distribution agreement outside the United States with Smith & Nephew, an orthopaedic products company based in the United Kingdom, and started to develop our own independent distributor network. This had a negative short-term effect on revenue. We believe that the overseas market offers strong potential and that we will be better served by developing our own network of independent distributors. Third, we decided to build a direct sales force in the United States to assure consistency in how the innovative BAK system is presented. Consequently, sales and marketing expenses were higher than originally projected. EXECUTING OUR PLAN In 1996, we established our surgeon education program and developed our marketing and sales organization - both essential to our commercial launch. As 1997 unfolds, we are focused on executing our plan for the commercial launch of the BAK system while continuing clinical trials for other BAK systems and conducting research and development to refine and develop complementary products. We have confidence in the design of the BAK system and recognize that surgeon training is critical to consistent, strong patient outcomes. In August, we opened our surgeon education center at our headquarters. By the end of 1996, more than 600 surgeons had attended our BAK surgical seminars. We plan to train more than 100 surgeons monthly during 1997 and expect to have trained most of the 1,800 spine surgeons who regularly perform lumbar fusion surgery in the United States by the end of 1997. Our seminar faculty includes 30 surgeons involved in our clinical trials, most of whom have three to five years of experience with the BAK system. In addition, we have developed a network of more than 100 sales and support specialists who are available to assist BAK-trained surgeons in operating rooms across the United States. Spine-Tech has become a familiar and exciting participant in major medical conferences. In 1996, we exhibited at the annual meetings of the North American Spine Society, American Association of Neurological Surgeons, Congress of Neurological Surgeons, American Academy of Orthopaedic Surgeons and the European Spine Society. At each of these meetings, several papers on the BAK system were presented, which consistently showed strong findings. To date, the feedback about the BAK system from surgeons, patients and payors has been consistently positive. Physicians appreciate the thoroughness of our clinical research, quality of our training and continuing technical support. Patients have been pleased with surgical outcomes. And payors note the low cost of the procedure itself and patients' faster return to work. 1996 REVENUES (IN MILLIONS) Q1 $1.4 Q2 $1.5 Q3 $1.5 Q4 $5.7 1996 NET INCOME (LOSS) Q1 $(355) Q2 $(585) Q3 $(1,449) Q4 $2,144 2 [PHOTO] (LEFT TO RIGHT) STEPHEN D. KUSLICH, M.D., ORTHOPAEDIC SURGEON AND MEDICAL DIRECTOR; DAVID W. STASSEN, CHIEF EXECUTIVE OFFICER AND PRESIDENT; DOUGLAS W. KOHRS, VICE PRESIDENT OF RESEARCH AND PRODUCT DEVELOPMENT. As in the United States, patients and surgeons in other nations have been awaiting the results of clinical trials and FDA approval before adopting BAK technology. We believe that the strength of our clinical trial results and FDA approval in the United States will support increasing international acceptance of the BAK system. BUILDING THE MOMENTUM The commercial launch of the BAK system will accelerate the growth of Spine-Tech's sales in 1997. Nearly half of our 96 employees are devoted to sales, education and clinical support. This reflects our commitment to the successful commercial launch of the BAK system. We now have 25 direct sales representatives, all with successful experience selling medical/surgical specialty devices, four regional sales managers and a network of seven agent groups. In December, we submitted a Pre-Market Approval (PMA) supplemental application to the FDA for a laparoscopic procedure to implant BAK devices. This is a less invasive procedure that significantly reduces surgical trauma and further shortens recovery times. We are optimistic that we will receive FDA clearance for this procedure during 1997. Clinical trials for the BAK/C-Registered Trademark- system, implants and procedures for the cervical spine (neck) are progressing. Patient enrollment continues in these clinical trials. Our commitment to research and development continues, with more than 17 percent of revenues devoted to this effort in 1996. Our focus is on refining our current implants, instruments and procedures, and developing new products related to treatment of spinal diseases. In December, we signed an agreement with Orquest Corporation, a medical manufacturer based in Mountain View, California, to evaluate and commercialize Healos-Registered Trademark-, a synthetic bone graft material. Healos has the potential to fill the BAK device and eliminate the need for a second surgery to harvest bone graft from the patient's hip. In closing, we are appreciative of our surgeon customers who have embraced the BAK technology and are adopting it in their practices. I am proud of the contributions of our employees. Through their hard work and commitment, we are moving forward with full-scale manufacturing and marketing of our BAK system. Sincerely, /s/ David W. Stassen DAVID W. STASSEN CHIEF EXECUTIVE OFFICER AND PRESIDENT 3 SPINE-TECH 1996 ANNUAL REPORT REVIEW OF OPERATIONS BACK PAIN CAUSED BY DEGENERATIVE DISC DISEASE disables millions annually and absorbs a large portion of health care resources in the United States and around the world. In the United States alone, back pain leads to an estimated $25 billion annually in medical treatment costs and $60 billion in lost worker productivity. The treatment of last resort for many back pain patients is spinal fusion surgery, in which adjacent vertebrae are joined to stabilize the joint and reduce pressure on nerves. Each year, more than 200,000 spinal fusion surgical procedures are performed in the United States and 400,000 such procedures are performed worldwide. The BAK system of implants, surgical procedures and instruments offers physicians and their patients an innovative approach to spinal fusion in the lumbar area of the spine, offering less invasive surgery, lower treatment costs and superior patient outcomes. Between 1992 and 1996, 1,900 patients were enrolled in BAK clinical trials conducted by 42 surgeons at 23 medical centers. On September 23, 1996, Spine-Tech received FDA approval to begin marketing the BAK system for spinal fusion in the lumbar area, the most common region for degenerative disc disease. Since then, Spine-Tech's sales and marketing efforts have focused on the U.S. introduction of the BAK system. By year- end 1996, more than 2,800 patients had received BAK implants. The adoption of a new technology is a process of creating awareness, building credibility and gaining acceptance. We offer comprehensive training programs to assist surgeons in understanding BAK procedures and to ensure their appropriate use. To assure physicians and patients of the efficacy of the BAK technology, Spine-Tech conducted extensive FDA-approved clinical trials. We continue to follow up with patients and collect long- term outcomes data. AVERAGE PATIENT PAIN SCORES AT FOLLOW-UP [CHART] [PHOTO] DIRECTOR OF PROFESSIONAL EDUCTION, DUANE LINENKUGEL, IN SPINE-TECH'S TRAINING LAB. SPINE-TECH 1996 ANNUAL REPORT 4 TRAINING FOR SUCCESSFUL OUTCOMES Spine-Tech is committed to preparing surgeons to use the BAK system by providing a comprehensive training program and follow-up technical support. As soon as we received FDA approval for the BAK system in late September, we launched the first seminars at our headquarters training facility. By year-end 1996, we had trained more than 600 surgeons. Currently, we provide training programs for four groups: ORTHOPAEDIC OR NEUROLOGICAL SURGEONS, whose practices are dedicated to spinal surgery. Surgeons invited to attend training seminars have the appropriate patient volume, referral patterns, surgical judgment and experience. Our goal is to only have surgeons who have completed training use the BAK system. CLINICAL PROFESSIONALS, such as physician's assistants and surgical technicians, who assist with BAK procedures and patients. CLINICAL SUPPORT NURSES, who are available for support in the operating room during BAK surgery. SPINE-TECH DIRECT AND INDIRECT SALES REPRESENTATIVES, who are technically oriented and have previous experience with medical and surgical products. The training seminar encompasses lectures on the bioscience and design of the BAK implant, patient indications and evaluation for BAK surgery. A review of clinical results helps surgeons determine which patients will benefit the most from BAK implants. TRAINING IS ESSENTIAL "BAK implants are re-engineering the management of degenerative disc disease. At Spine-Tech, we believe education is essential to the adoption of new technology and to preserving our consistently outstanding clinical results. We invite appropriate surgeons to attend our training seminars and require that surgeons complete training before performing BAK procedures." - Duane Linenkugel Director of Professional Education 5 REVIEW OF OPERATIONS CONT'D Anterior (from the front) and posterior (from the back) surgical procedures are reviewed in detail, as well as unusual situations. The anterior approach is new to many surgeons, but gaining acceptance as they see reduced operating times and less patient discomfort with this procedure. The traditional posterior approach involves dissecting back muscles to expose the spine; this additional surgical trauma can lengthen patient recovery time compared to our anterior approach. Our 30 faculty members performed BAK procedures under our U.S. clinical trials. Each has an average of three years of experience with the BAK system. Surgeons attending our seminars appreciate the opportunity to learn from their peers. In 1997, our training program will continue its focus on introducing BAK technology to U.S. spinal surgeons. In addition, we anticipate offering training in laparoscopic procedures, pending FDA approval for this less invasive surgical technique. As the BAK system gains acceptance overseas, we expect to train more surgeons in other nations. PREDICTABLE PATIENT OUTCOMES Traditional spinal fusion methods have met with mixed success, often leading to the need for second surgeries. In extensive clinical trials and early U.S. commercialization, the Spine-Tech BAK system has provided exceptional spinal stability and predictable patient outcomes. BAK instruments and procedures provide accuracy, precision and safety - for consistent results. BAK implants differ from previous spinal fusion devices by [GRAPHIC] A SUCCESS STORY "In 1992, I was in constant pain and needed to get back to living. My doctor said I needed spinal fusion surgery and recommended a traditional technique. He also said it would be six to 12 months before I could work, and I would have life-long limitations. The BAK implants made more sense to me. I was discharged three days after BAK surgery and, in five weeks, returned to work full-time in my position as a disability manager. Less than six months later, I could garden, go grocery shopping and do everything I couldn't do before surgery." - Vicki Carlson BAK patient SPINE-TECH 1996 ANNUAL REPORT 6 [PHOTO] VICKI CARLSON, BAK PATIENT, IS BACK TO ENJOYING THE THINGS SHE COULDN'T DO BEFORE SURGERY. directly addressing the pain source - the instability in the vertebral joint caused by a degenerative disc. The traditional instrumented spinal fusion involves attaching a device to the side of the spine. The BAK implants - two titanium alloy cylinders - are inserted between the vertebrae. The ribbed structure of the BAK implants enables them to withstand the enormous loading forces of the spine. In testing, BAK implants tolerated forces many times greater than those experienced in the lumbar spine. Further, the large hole design encourages bone growth through the implant for long-term stability. The BAK system offers improvements beginning with the surgical procedure and extending through recovery. The BAK fusion procedure is a less invasive surgical technique, reducing operating times and blood loss. The anterior approach, discussed above, results in even less surgical trauma. The average hospital stay experienced during clinical trials has been 4.1 days, compared to 6-7 days for traditional instrumented spinal fusion surgery. In clinical trials, BAK patients consistently reported improvements in pain relief. After one year, 83.3 percent of patients reported less pain, and after three years, 90.3 percent of patients reported less pain. Moreover, major complications have been minimal. Fast recovery and rehabilitation lead to exceptional return-to-work times. Of the patients who were not working prior to surgery due to disability, 38 percent were working within one year of surgery and 90 percent were working three years later. As we enter 1997, Spine-Tech is committed to providing physicians and their patients with innovative, effective solutions to degenerative disc disease, supported by thorough research, an exceptional training program and continuing technical support. BAK FUSION RESULTS (% OF PATIENTS WITH SUCCESSFUL FUSION) YEAR 1 86.2% 2 92.0% 3 98.3% 7 SPINAL FUSION AND THE BAK SYSTEM IN THE UNITED STATE back pain is the leading cause of workers' compensation expense, the second leading reason for physician office visits and a leading reason for surgical procedures. A commonly performed surgical treatment for back pain is spinal fusion, in which the disc between two adjacent vertebrae is removed and the two vertebrae are fused together using bone graft. Worldwide, an estimated 400,000 spinal fusion surgical procedures are performed each year, with approximately half of these occurring in the United States. [GRAPHIC] The Spine-Tech BAK system is a patented series of spinal implants, surgical instruments and procedures that aid the positioning of the implants between the vertebrae to stabilize the spine and facilitate the fusion of the vertebrae. The BAK implants are hollow, threaded titanium alloy cylinders that are implanted between two or more vertebrae. The implants are packed with bone graft and fusion is achieved when adjoining vertebrae grow together through the implant, resulting in stabilization and pain relief. In the United States, more than 2,800 patients have received BAK implants and have shown that the BAK system offers significant improvements over traditional fusion techniques, including: [GRAPHIC] - A high fusion success rate; - Quick functional recovery and rehabilitation, leading to exceptional return-to-work outcomes; - A low re-operation rate resulting from a predictable, definitive surgical procedure; and - Less invasive surgical techniques that can reduce operating times, hospitalization and blood loss, resulting in minimized patient stress and lower health care costs. Spine-Tech-Registered Trademark-, BAK/C-Registered Trademark- and Cervi-Lok- Registered Trademark- are registered trademarks of Spine-Tech, Inc. BAKTM is a trademark of Spine-Tech, Inc. Healos-Registered Trademark- is a registered trademark of Orquest Corporation. SPINE-TECH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS The following table sets forth selected financial data for the Company and should be read in conjunction with the financial statements and related notes included in this document and with the balance of the management's discussion and analysis. STATEMENT OF OPERATIONS DATA
YEAR ENDED DECEMBER 31, (IN THOUSANDS, EXCEPT PER SHARE DATA) 1996 1995 1994 1993 1992 - -------------------------------------------------------------------------------------------------------------------- Net sales $10,153 $7,517 $4,398 $2,001 $ 321 Cost of goods sold 2,849 2,488 1,330 391 38 --------------------------------------------------------------------- Gross profit 7,304 5,029 3,068 1,610 283 Operating expenses: Sales and marketing 5,387 1,563 962 -- -- General and administrative 3,294 2,487 1,491 1,638 879 Research and development 1,777 1,597 1,202 675 807 ---------------------------------------------------------------------- Total operating expenses 10,458 5,647 3,655 2,313 1,686 ---------------------------------------------------------------------- Operating loss (3,154) (618) (587) (703) (1,403) Exclusive distribution agreement -- 40 677 -- Interest income 1,223 896 168 38 25 ---------------------------------------------------------------------- Net pretax income (loss) (1,931) 278 (379) 12 (1,378) Provision (benefit) for income taxes (1,684) 10 -- -- -- Net income (loss) (247) 268 (379) 12 (1,378) Net income (loss) per weighted average common share $ (.02) $ .03 $ (.06) $ -- $ (.30) BALANCE SHEET DATA DECEMBER 31, (IN THOUSANDS, EXCEPT PER SHARE DATA) 1996 1995 1994 1993 1992 - --------------------------------------------------------------------------------------------------------------------- Current assets $24,053 $27,652 $ 4,337 $ 5,809 $ 1,345 Current liabilities 1,412 862 566 665 111 ---------------------------------------------------------------------- Working capital $22,641 $26,790 $ 3,771 $ 5,144 $ 1,234 Total assets $34,058 $32,667 $ 5,549 $ 5,955 $ 1,429 Accumulated deficit $ (2,562) $ (2,315) $(2,378) $(1,999) $(2,011) Shareholders' equity $32,646 $31,805 $ 4,983 $ 5,290 $ 1,317
All international sales are conducted in U.S. dollars. International revenues were $1.9 million, $5.2 million, $2.0 million and $607,000 for 1996, 1995, 1994 and 1993, respectively. No assets other than accounts receivable are specifically attributable to international sales. International accounts receivable at the end of the year were $800,000, $1.6 million, $467,000 and $173,000 for 1996, 1995, 1994 and 1993, respectively. 1996 COMPARED TO 1995 YEARS ENDED DECEMBER 31, 1996, AND DECEMBER 31, 1995 Net sales increased to $10.2 million for 1996 compared to $7.5 million for 1995 primarily as a result of increased sales of the BAK Interbody Fusion System in the United States. Domestic sales of the BAK Interbody Fusion System in the United States increased to $7.7 million for 1996 from $2.0 million for 1995. Sales of the BAK Interbody Fusion System to Smith & Nephew Richards, Inc. (Smith & Nephew) for international distribution decreased to $350,000 for 1996 compared to $4.7 million for 1995, decreasing to 3 percent of sales in 1996 from 61 percent for 1995. In February 1996, the Company ended its exclusive distribution agreement with Smith & Nephew and has been establishing a network of independent distributors for international SPINE-TECH 1996 ANNUAL REPORT 8 markets. As a result, international sales of the BAK/C-Registered Trademark- and Cervi-Lok-Registered Trademark- products exceeded $800,000 for 1996, compared to approximately $500,000 for 1995. Domestically, BAK/C and Cervi-Lok sales increased to $500,000 for 1996 from approximately $300,000 for 1995. Gross profit increased to $7.3 million for 1996 from $5.0 million for 1995. This increase is directly related to the increase in sales in 1996 versus 1995. As a percentage of net sales, gross profit increased to 71.9 percent in 1996 as compared to 66.9 percent in 1995, due primarily to the stabilization in prices paid to outside vendors for the manufacture of implants and instruments and increased utilization of the Company's manufacturing operations. Total operating expenses increased to $10.5 million for 1996 compared to $5.6 million for 1995. Sales and marketing expenses increased to $5.4 million for 1996 from $1.6 million for 1995, increasing as a percentage of net sales to 53.1 percent in 1996 compared to 20.8 percent in 1995. This increase occurred as the result of the Company's expansion of its capabilities to support both international and domestic sales activity. In June 1996, the Company began establishing a network of direct sales persons to complement the seven independent agency groups which service customers in certain geographic areas in the United States. This decision to establish a direct sales force across most of the United States resulted in higher than anticipated sales and marketing expenses for the last half of 1996. General and administrative expenses increased to $3.3 million for 1996 from $2.5 million for 1995, but decreased as a percentage of net sales to 32.4 percent in 1996 from 33.1 percent in 1995. The increase in these expenses was primarily the result of increased corporate activities required to support the expanded sales and marketing activities. Research and development expenses increased to $1.8 million for 1996 compared to $1.6 million for 1995, but decreased as a percentage of net sales to 17.5 percent in 1996 from 21.2 percent in 1995. The increase in these expenses reflects the hiring of additional development engineers and payments to outside contractors for prototype development projects. The Company's operating loss increased to $3.2 million in 1996 from $600,000 in 1995. The pre-tax loss for 1996 was $1.9 million, which included an increase in interest income to $1.2 million, compared to pre-tax income of $278,000 for 1995, which included interest income of $896,000. In 1996, a one- time income tax benefit of $1.7 million was recognized. Until the fourth quarter of 1996, there was substantial doubt whether the Company would be able to realize the benefits of its loss carry-forward. In recognition of this doubt, the Company had provided a full valuation allowance for the net deferred tax assets. With the Company receiving approval from the FDA in September 1996 to market the BAK Interbody Fusion System in the United States, the Company determined that the realization of the net deferred tax assets would be more likely than not. As a result, in the fourth quarter of 1996 the Company reversed the valuation allowance and recognized an income tax benefit of $1.7 million, or $.17 per share. This one-time event resulted in the Company recording a net loss of $247,000 for 1996 compared to net income of $268,000 in 1995. The 1996 loss before recognition of the $1.7 million income tax benefit was $1.9 million. 1995 COMPARED TO 1994 YEARS ENDED DECEMBER 31, 1995, AND DECEMBER 31, 1994 Net sales increased to $7.5 million for 1995 compared to $4.4 million for 1994 9 MANAGEMENT'S DISCUSSION AND ANALYSIS CONT'D reflecting primarily increased sales of the BAK Interbody Fusion System to Smith & Nephew for international distribution and sales of the BAK/C and Cervi-Lok implants (which were introduced in 1995). Sales of BAK devices to Smith & Nephew accounted for 61 percent of the Company's net sales in 1995. Domestic sales of BAK implants remained relatively constant between 1994 and 1995, reflecting the continuation of clinical trials. International sales of the BAK/C and Cervi-Lok products were approximately $500,000 for 1995. Domestically, BAK/C and Cervi-Lok sales increased to approximately $300,000. Gross profit increased to $5.0 million for 1995 from $3.1 million in 1994. This increase is directly related to the increase in net sales in 1995 versus 1994. As a percentage of net sales, gross profit decreased to 66.9 percent in 1995 from 69.8 percent in 1994, due primarily to variations in prices paid by the Company to outside vendors for the manufacture of implants and instruments and because of the costs associated with the introduction of new products. Total operating expenses increased to $5.6 million for 1995 compared to $3.7 million for 1994. Sales and marketing expenses increased to $1.6 million for 1995 from $1.0 million for 1994, but decreased as a percentage of net sales to 20.8 percent in 1995 compared to 21.9 percent in 1995. Increased expenses related primarily to the addition of personnel to support increased domestic and international sales activities. General and administrative expenses increased to $2.5 million for 1995 from $1.5 million for 1994, but decreased as a percentage of net sales to 33.1 percent in 1995 from 33.9 percent in 1994. Increased expenses resulted primarily from the Company's preparation for FDA approval of the BAK and the addition of personnel to support the increased levels of sales and corporate activities. Research and development expenses increased to $1.6 million in 1995 from $1.2 million in 1994. Research and development expenses declined as a percentage of net sales to 21.2 percent in 1995 from 27.3 percent in 1994. The increase in the amount of these expenses reflects the hiring of additional development engineers and payment to outside contractors for prototype development projects and the increase in clinical study activity. The Company's operating loss remained relatively constant at $600,000; however, the Company had net income of $268,000 in 1995 compared to a loss of $379,000 in 1994, due primarily to an increase in interest income to $896,000 in 1995 from $168,000 in 1994, due to a higher level of cash available for short- term investments resulting from the Company's initial public offering which was completed in June 1995. LIQUIDITY AND CAPITAL RESOURCES In June 1995, the Company successfully completed its initial public offering of 3,225,000 shares of newly issued Common Stock. After selling expenses, the Company received proceeds of just over $26 million from the offering. The Company expects to use these proceeds for working capital requirements, funding of clinical trials, expansion of research and development and sales and marketing activities, and other general corporate purposes. In November 1995, the Company used a portion of these proceeds to acquire and relocate to a new facility, and to renovate such new facility. During 1996, the Company used approximately $12.2 million for operating activities and for capital asset acquisitions. Of this amount, $5.2 million was used to increase inventory, $1.2 million was due to an increase in accounts receivable, and SPINE-TECH 1996 ANNUAL REPORT 10 $4.7 million was used to renovate the new facility and purchase equipment. Also during 1996 approximately $600,000 was provided by proceeds from the exercise of stock options and the purchase of Common Stock pursuant to the Employee Stock Purchase Plan. Cash and cash equivalents are invested in U.S. government obligations and corporate debt securities. Securities totaling $9.6 million and $3.5 million will mature during 1997 and 1998, respectively. During the first half of 1997, the Company expects to continue to use cash and cash equivalents to fund working capital needs associated with continued building of inventory and financing of accounts receivable associated with product sales. The Company may also use a portion of its available capital resources to acquire or license technology, products or businesses related to the Company's current business, although no such acquisitions or licenses are currently being negotiated or planned. During the second half of 1997, the Company expects, based upon existing operations, to begin generating cash resources from operations. The Company believes that its currently available cash and cash equivalents, combined with additional cash flow from operations, will be adequate to finance ongoing operations for the foreseeable future. The Company's future liquidity and capital requirements will depend on numerous factors, including FDA regulatory actions and continued domestic and international sales of its entire product line. FORWARD-LOOKING STATEMENTS Certain statements made above in Management's Discussion and Analysis and elsewhere in the Annual Report, which are summarized below, are forward-looking statements that inherently involve risks and uncertainties. Actual results may be materially different. Factors that could cause actual results to differ include the following: INCREASE IN REVENUES AND EARNINGS - General market conditions and competitive conditions within the market for the Company's products; acceptance by spine surgeons and other medical professionals; absence of adverse patient outcomes; continued intellectual property protection; development of direct internal sales force; development, acceptance and regulatory approval of the Company's new products and procedures; the entrance of additional competitors into the market. INCREASED TRAINING OF MEDICAL PROFESSIONALS - Continued acceptance of the BAK system by spine surgeons and other medical professionals; absence of adverse patient outcomes; continued acceptance by patients and payors; marketing efforts by competitors. INCREASED INTERNATIONAL SALES - Establishment of a network of independent distributors for the international market; obtaining necessary foreign regulatory approvals and acceptance by foreign spine surgeons and other medical professionals; absence of adverse patient outcomes; continued acceptance by patients and payors; continued intellectual property protection in foreign markets. FDA APPROVAL OF LAPAROSCOPIC PROCEDURES - Approval by the FDA of these procedures in line with the Company's projected timetable. ADEQUATE FUNDING - Unanticipated events or circumstances may alter the Company's capital requirements, including demand for the Company's products; general market and competitive conditions within the market for the Company's products; potential adverse patient outcomes; potential litigation relating to protection of the Company's intellectual property; development, acceptance and regulatory approval of the Company's new products and procedures. 11 SPINE-TECH, INC. BALANCE SHEETS
DECEMBER 31, (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1996 1995 - ------------------------------------------------------------------------------------------ ASSETS Current assets: Cash and cash equivalents $ 1,724 $ 1,171 Short-term investments 9,674 22,416 Accounts receivable, less allowances of $187--1996; $158--1995 3,151 1,957 Inventories 6,982 1,822 Deferred tax asset 2,155 -- Interest receivable 221 228 Prepaid expenses 146 58 ----------------------------- Total current assets 24,053 27,652 Property, plant and equipment: Land 438 438 Building, furniture and fixtures 5,317 1,429 Equipment 1,087 388 ----------------------------- 6,842 2,255 Accumulated depreciation (373) (196) ----------------------------- 6,469 2,059 Investments 3,536 2,956 ----------------------------- Total assets $34,058 $32,667 ----------------------------- ----------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 567 $ 233 Accrued clinical payments 42 330 Accrued royalties 365 199 Accrued commissions 337 16 Other accrued expenses 101 84 ----------------------------- Total current liabilities 1,412 862 Shareholders' equity: Preferred Stock, par value $.01 per share: Authorized shares--300,000 Issued and outstanding shares: 1996--none; 1995--none -- -- Common Stock, par value $.01 per share: Authorized shares--15,000,000 Issued and outstanding shares: 1996--9,939,055; 1995--9,653,252 99 96 Additional paid-in capital 35,109 34,024 Accumulated deficit (2,562) (2,315) ----------------------------- Total shareholders' equity 32,646 31,805 ----------------------------- Total liabilities and shareholders' equity $34,058 $32,667 ----------------------------- -----------------------------
See accompanying notes. SPINE-TECH 1996 ANNUAL REPORT 12 STATEMENTS OF OPERATIONS SPINE-TECH, INC
YEAR ENDED DECEMBER 31, (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1996 1995 1994 - ----------------------------------------------------------------------------------------------------------- Net sales $ 10,153 $ 7,517 $ 4,398 Cost of goods sold 2,849 2,488 1,330 ---------------------------------------------- Gross profit 7,304 5,029 3,068 Operating expenses: Sales and marketing 5,387 1,563 962 General and administrative 3,294 2,487 1,491 Research and development 1,777 1,597 1,202 ---------------------------------------------- Total operating expenses 10,458 5,647 3,655 Other operating income: Exclusive distribution agreement fee -- -- 40 ---------------------------------------------- Operating loss (3,154) (618) (547) Interest income 1,223 896 168 ---------------------------------------------- (Loss) income before income taxes (1,931) 278 (379) Income tax (benefit) expense 1,684) 10 -- ---------------------------------------------- Net (loss) income $ (247) $ 268 $ (379) ---------------------------------------------- ---------------------------------------------- Net (loss) income per share: Primary $ (.02) $ .04 $ (.18) Fully diluted $ (.02) $ .03 $ (.06) Weighted average number of shares outstanding: Primary 9,831,733 7,261,466 2,465,398 Fully diluted 9,831,733 9,641,751 6,600,630
SEE ACCOMPANYING NOTES. 13 SPINE-TECH, INC STATEMENT OF SHAREHOLDERS' EQUITY
CONVERTIBLE ADDITIONAL ACCUM- PREFERRED STOCK COMMON STOCK PAID-IN ULATED (IN THOUSANDS) SHARES AMOUNT SHARES AMOUNT CAPITAL DEFICIT TOTAL - ------------------------------------------------------------------------------------------------------------------------------------ Balance at December 31, 1993 2,757 $27 2,070 $21 $ 7,241 $(1,999) $ 5,290 Exercise of stock option in April 1994 -- -- 30 -- 30 -- 30 Value of stock options issued for research and development in process -- -- -- -- 42 -- 42 Net loss -- -- -- -- -- (379) (379) -------------------------------------------------------------------------------------- Balance at December 31, 1994 2,757 27 2,100 21 7,313 (2,378) 4,983 Issuance of Common Stock for consulting services in January 1995 -- -- 8 -- 27 -- 27 Value of stock options issued for consulting services in March 1995 -- -- -- -- 24 -- 24 Exercise of stock options -- -- 91 1 109 -- 110 Issuance of Common Stock, net of offering expense -- -- 3,225 32 26,361 -- 26,393 Conversion of Preferred Stock in July 1995 (2,757) (27) 4,135 41 (14) -- -- Exercise of warrants in October 1995 -- -- 94 1 204 (205) -- Net income -- -- -- -- -- 268 268 -------------------------------------------------------------------------------------- Balance at December 31, 1995 -- -- 9,653 96 34,024 (2,315) 31,805 Shares purchased for Employee Stock Purchase Plan -- -- 1 -- 22 -- 22 Tax benefit of stock options -- -- -- -- 471 -- 471 Exercise of stock options -- -- 285 3 592 -- 595 Net loss -- -- -- -- -- (247) (247) -------------------------------------------------------------------------------------- Balance at December 31, 1996 -- $-- 9,939 $99 $35,109 $(2,562) $32,646 -------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------
See accompanying notes. SPINE-TECH 1996 ANNUAL REPORT 14 STATEMENTS OF CASH FLOWS SPINE-TECH, INC
YEAR ENDED DECEMBER 31, (IN THOUSANDS) 1996 1995 1994 - ---------------------------------------------------------------------------------------------------------- Operating activities: Net income (loss) $ (247) $ 268 $ (379) Adjustments to reconcile net income (loss) to net cash used in operating activities: Depreciation 215 103 72 Common Stock and stock options issued for services provided -- 51 42 Deferred tax benefit (1,684) -- -- Loss on sale of equipment 31 -- -- Changes in operating assets and liabilities: Accounts receivable (1,194) (1,254) (292) Inventories (5,160) (906) (567) Interest receivable 7 (228) -- Prepaid expenses (88) (4) (51) Accounts payable and accrued expenses 550 296 (99) -------------------------------------------- Net cash used in operating activities (7,570) (1,674) (1,274) Investing activities: Purchases of property, plant and equipment (4,656) (1,866) (225) Purchase of investments (41,320) (22,211) (3,161) Proceeds from sales and maturities of investments 53,482 -- -- -------------------------------------------- Net cash provided by (used in) investing activities 7,506 (24,077) (3,386) Financing activities: Proceeds from sale of Common Stock 22 26,393 30 Proceeds from exercise of stock options 595 110 -- -------------------------------------------- Net cash provided by financing activities 617 26,503 30 -------------------------------------------- Increase (decrease) in cash and cash equivalents 553 752 (4,630) Cash and cash equivalents at beginning of year 1,171 419 5,049 -------------------------------------------- Cash and cash equivalents at end of year $ 1,724 $ 1,171 $ 419 -------------------------------------------- --------------------------------------------
See accompanying notes. 15 SPINE-TECH, INC. NOTES TO FINANCIAL STATEMENTS 1. DESCRIPTION OF BUSINESS The Company designs, develops, manufactures and sells spinal implant devices and instruments which facilitate the minimally invasive surgical treatment of degenerative diseases. The Company's primary products, the BAK- Lumbar, BAK-Cervical and BAK-Thoracic Interbody Fusion Systems and the Cervi-Lok System are designed to surgically treat spinal instability which can cause chronic, disabling back pain. The Company has, or has licensed, several patents and is currently developing additional instruments and techniques for use in spinal surgery. In the United States and internationally, customers consist of hospitals and medical centers. 2. SUMMARY OF ACCOUNTING POLICIES REVENUE RECOGNITION Revenue is recognized for domestic sales when implants or instruments are shipped to a hospital or medical center based upon a purchase order number generated by the hospital or medical center. 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 the estimates. CASH EQUIVALENTS The Company considers all highly liquid investments which are available immediately or upon a one-day notice to be cash equivalents. This includes all demand deposits, savings and money market accounts. MARKETABLE SECURITIES Short-term investments include all purchased U.S. government obligations and corporate debt securities with maturities of less than one year. Investments with a remaining maturity of more than one year are classified as long-term investments. Management determines the appropriate classification of debt and equity securities at the time of purchase and reevaluates such designation as of each balance sheet date. Debt securities are classified as held-to-maturity because the Company has the positive intent and ability to hold such securities to maturity. Investments are stated at amortized cost, which approximates market value. Interest on securities is included in interest income. INVENTORIES Inventories are valued at the lower of cost, first-in, first-out (FIFO) method, or market. As a medical device company, inventories are maintained and costed by lot. Inventory cost elements consist of: RAW MATERIALS - primarily packaging and labeling materials for implants WORK-IN-PROCESS - outside manufacturing costs for implants and instruments which have not been released into finished goods FINISHED GOODS-IMPLANTS - outside manufacturing costs, packaging materials and sterilization costs FINISHED GOODS-INSTRUMENTS - outside manufacturing costs PROPERTY AND EQUIPMENT Property and equipment is stated at cost. Depreciation and amortization expense is recognized on the straight-line basis over lives ranging from 5-20 years. SPINE-TECH 1996 ANNUAL REPORT 16 INCOME TAXES The Company accounts for income taxes using the liability method. Deferred income taxes are provided for temporary differences between the financial reporting and tax bases of assets and liabilities. NET INCOME (LOSS) PER COMMON SHARE Income (loss) per common share for the years ended December 31, 1996, 1995 and 1994 is computed using the weighted average number of shares of Common Stock and Common Stock equivalents, if dilutive, outstanding during the periods presented. Additionally, for 1994 and for the first quarter of 1995, pursuant to the rules of the Securities and Exchange Commission, Common Stock issued by the Company at prices less than the initial public offering price during the 12 months immediately preceding the initial public offering, plus stock options granted at exercise prices less than the initial public offering price during the same period, have been included in the calculation of shares used in the calculation of net income (loss) per share as if they were outstanding for all periods prior to the initial public offering. The fully diluted loss per share is presented using the "if converted" method and reflects the impact of the conversion of the Preferred Stock to Common Stock at the beginning of the earliest period presented or at the date of issuance, if later. STOCK-BASED COMPENSATION The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," but applies Accounting Principles Board Opinion No. 25 (APB 25) and related interpretations in accounting for its plans. Under APB 25, when the exercise price of employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. IMPAIRMENT OF LONG-LIVED ASSETS The Company will record 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. RECLASSIFICATION Certain prior year items have been reclassified to conform with the 1996 presentation. 3. INVESTMENTS The amortized cost and estimated market value of investments are as follows:
GROSS GROSS ESTIMATED AMORTIZED UNREALIZED UNREALIZED MARKET COST GAINS LOSSES VALUE - ---------------------------------------------------------------------------------------------------- As of December 31, 1996: U.S. government obligations $ 3,525,974 $ 7,691 $ -- $ 3,533,665 Corporate debt securities 6,022,928 -- 66,288 5,956,640 Commercial paper 3,660,794 15,059 -- 3,675,853 ---------------------------------------------------------------- $13,209,696 $ 22,750 $66,288 $13,166,158 ---------------------------------------------------------------- ---------------------------------------------------------------- As of December 31, 1995: U.S. government obligations $ 4,000,110 $ -- $ 149 $ 3,999,961 Corporate debt securities 6,102,249 -- 22,163 6,080,086 Commercial paper 15,269,432 142,661 -- 15,412,093 --------------------------------------------------------------- $25,371,791 $142,661 $22,312 $25,492,140 --------------------------------------------------------------- ---------------------------------------------------------------
17 NOTES TO FINANCIAL STATEMENTS CONT'D The amortized cost and estimated fair market value of investments at December 31st by contractual maturity are shown below.
1996 1995 ---------------------------------------------------------------------- ESTIMATED ESTIMATED AMORTIZED MARKET AMORTIZED MARKET COST VALUE COST VALUE - ---------------------------------------------------------------------------------------------------------- Due in one year or less $ 9,674,222 $ 9,645,727 $22,416,043 $22,545,909 Due after one year through two years 3,535,474 3,520,431 2,955,748 2,946,231 -------------------------------------------------------------------- $13,209,696 $13,166,158 $25,371,791 $25,492,140 -------------------------------------------------------------------- --------------------------------------------------------------------
4. INVENTORIES Inventories consist of the following: DECEMBER 31, 1996 1995 - --------------------------------------------------------------------------- Raw materials $ 38,653 $ 18,423 Work-in-process 1,285,133 213,202 Finished goods 5,657,986 1,589,934 --------------------------------- $6,981,772 $1,821,559 --------------------------------- At December 31, 1996, finished goods were comprised of $4,184,117 of final product implants and instruments, $1,233,117 of consigned implants and instruments, and $240,752 of instruments used in the training facility. 5. LINE OF CREDIT The Company has a line of credit arrangement that allows it to borrow up to $500,000. Any borrowings under this agreement bear interest at the prime rate plus 1 1/2 percent. Borrowings under the facility are limited to 75 percent of eligible domestic accounts receivable. The agreement contains certain financial and operational covenants. At December 31, 1996, the Company had no outstanding balance on the line of credit. 6. SHAREHOLDERS' EQUITY On April 7, 1995, the Board of Directors increased the authorized shares of Common Stock from 10,000,000 to 15,000,000 and approved a 3-for-2 stock split of the Common Stock to be effected in the form of a stock dividend, payable to shareholders of record as of April 21, 1995. Accordingly, all share, per share, weighted average share, and stock option information has been restated to reflect the split. The Company completed an initial public offering of Common Stock in 1995 in which it sold 3,225,000 shares of Common Stock, resulting in net proceeds to the Company of $26,391,000. At the time of the initial public offering, all outstanding Convertible Preferred Stock was converted into 4,135,232 shares of Common Stock on a one- for-one and one-half share basis. In connection with the sale of series of Convertible Preferred Stock in 1992, the Company issued warrants to purchase 71,067 shares of Series B Convertible Preferred Stock at $3.25 per share. The warrants were exercised in a cashless transaction in October 1995. SHAREHOLDER RIGHTS PLAN In 1996, the Company's Board of Directors adopted a Shareholder Rights Plan by declaring a dividend of one preferred share purchase right (the "Right") for each outstanding share of Common Stock. Under certain circumstances, a Right may be exercised to purchase one one-hundredth of a share of Series A Junior Preferred Stock for $150. The rights become exercisable if a person or group acquires 20 percent or more of the SPINE-TECH 1996 ANNUAL REPORT 18 Company's outstanding Common Stock, subject to certain exceptions, or announces an offer which would result in such person or group acquiring 20 percent or more of the Company's outstanding Common Stock. If a person or group acquires 20 percent or more of the Company's outstanding Common Stock, subject to certain exceptions, each right will entitle its holder to buy Common Stock of the Company having a market value of twice the exercise price of the Right. The Rights expire in 2006 and may be redeemed by the Company for $.01 per Right at any timebefore, or, in certain circumstances, within 20 days (subject to extension) following, the announcement that a person has acquired 20 percent or more of the Company's outstanding Common Stock. Until a Right is exercised, the holder of a Right, as such, has no rights as a shareholder of the Company. In connection with the adoption of the Shareholder Rights Plan, the Company authorized 300,000 shares of Series A Junior Participating Preferred Stock (the "Preferred Stock"). Holders of the Preferred Stock are entitled to quarterly dividends in the amount of $1.00 or one hundred times the aggregate per share amount of dividends paid to Common Stock shareholders, whichever is greater. Each Preferred Stock share is entitled to one hundred votes on all matters submitted to a vote of the shareholders of the Company. The Preferred Stock has liquidation preference over the Company's Common Stock. The liquidation rate on the Preferred Stock is the greater of $100 per share or an amount one hundred times greater than the amount distributed to the Common Stock shareholders. 7. STOCK PURCHASE AND OPTION PLANS STOCK PURCHASE PLAN The Company has an employee stock purchase plan under which the sale of 500,000 shares of its Common Stock has been authorized. The purchase price of the shares under the plan is the lesser of 85 percent of the fair market value on the first or last day of the offering period. Offering periods are three months each. Employees may designate up to 10 percent of their compensation for the purchase of stock. STOCK OPTION PLANS Under the Company's stock option plans, the Company may grant employees, Directors and consultants options to purchase Common Stock of the Company. Such options are generally granted at the fair market value on date of grant and vest over four years. The Company also has options outstanding to Smith & Nephew Richards Inc. ("Smith & Nephew"), pursuant to certain preemptive rights, to purchase an aggregate of 51,788 shares of Common Stock at exercise prices of $3.27 to $9.00 per share. These options were valued at the fair market value of the stock on the date of grant and generally vest over a four-year period. The following table summarizes the options to purchase shares of the Company's stock option plans: 19 NOTES TO FINANCIAL STATEMENTS CONT'D
WEIGHTED SHARES NON-PLAN AVERAGE AVAILABLE OPTIONS OPTIONS EXERCISE PRICE FOR GRANT OUTSTANDING OUTSTANDING PER SHARE - --------------------------------------------------------------------------------------------------------------- Balance at December 31, 1993 89,250 1,253,250 -- $ 1.20 Shares reserved 645,000 -- -- -- Granted (601,950) 601,950 38,981 3.28 Became exercisable -- -- -- -- Exercised -- (30,000) -- 1.00 Canceled 45,000 (45,000) -- 1.00 ---------------------------------------------------- Balance at December 31, 1994 177,300 1,780,200 38,981 1.90 Granted (173,950) 173,950 12,807 10.42 Became exercisable -- -- -- Exercised -- (91,000) -- 1.21 Canceled 55,750 (55,750) -- 5.00 --------------------------------------------------- Balance at December 31, 1995 59,100 1,807,400 51,7880 2.65 Shares reserved 500,000 -- -- -- Granted (558,200) 558,200 -- 24.08 Became exercisable -- -- -- -- Exercised -- (284,875) -- 2.09 Canceled 30,400 (30,400) -- 12.50 -------------------------------------------------- Balance at December 31, 1996 31,300 2,050,325 51,788 $ 8.41 -------------------------------------------------- --------------------------------------------------
The following table summarizes information about stock options outstanding at December 31, 1996:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE ---------------------------------------------------------------------------------------------------- RANGE OF NUMBER WEIGHTED AVERAGE WEIGHTED NUMBER WEIGHTED EXERCISE OUTSTANDING AT REMAINING AVERAGE EXERCISABLE AT AVERAGE PRICES DECEMBER 31, 1996 CONTRACTUAL LIFE PRICE DECEMBER 31, 1996 EXERCISE PRICE - ------------------------------------------------------------------------------------------------------------------------------- $ .34 to 1.67 738,250 5 years $ 0.96 738,250 $ .96 2.17 to 3.67 672,425 7 years 3.10 401,750 3.01 9.00 to 15.00 52,250 9 years 11.42 17,750 10.78 15.25 to 22.50 230,450 9.5 years 20.94 23,337 18.93 22.75 to 30.00 356,950 10 years 25.38 2,084 26.50 ----------- ----------------------------------------------------- 2,050,325 $ 8.41 1,183,171 $ 2.20 ----------- ------------------------------------------------------ ----------- ------------------------------------------------------
The weighted-average fair value of options granted during the years ended December 31, 1996 and 1995 were $13.33 and $5.20, respectively. PRO FORMA DISCLOSURES Pro forma information regarding net income and earnings per share is required by Statement 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of the Statement. The fair value for these options was estimated at the date of the grant using a Black-Scholes option pricing model with the following weighted average assumptions for 1996 and 1995, respectively: risk free interest rates of 5 1/2 percent; dividend yield of 0 percent; volatility factors of the expected market price of the Company's stock of .582 and .517; and a weighted-average expected life of the option of five 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 SPINE-TECH 1996 ANNUAL REPORT 20 require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different than 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 follows: DECEMBER 31, 1996 1995 - ------------------------------------------------------------------------ Pro forma net (loss) income (in thousands) $(866) $204 Pro forma (loss) income per share: Primary (.09) .03 Fully diluted (.09) .02 NOTE: THE PRO FORMA EFFECT ON NET INCOME FOR 1996 AND 1995 IS NOT REPRESENTATIVE OF THE PRO FORMA EFFECT ON NET INCOME IN FUTURE YEARS BECAUSE IT DOES NOT TAKE INTO CONSIDERATION PRO FORMA COMPENSATION EXPENSE RELATED TO GRANTS MADE PRIOR TO 1995. 8. LEASES The Company leased its administrative facilities under an operating lease through December 1995 and furniture and fixtures under operating leases through June 1996. Total rent expense was $46,143, $80,006 and $80,791 in 1996, 1995 and 1994, respectively. 9. INCOME TAXES The Company has operating loss carryforwards for income tax purposes expiring at various times through 2011 of approximately $2,872,000 at December 31, 1996, which can be used to offset future earnings. Until the fourth quarter of 1996, there was substantial doubt that the Company would be able to realize the benefits of its net deferred tax assets. In recognition of this doubt, the Company had provided a full valuation allowance for the net deferred tax assets. In September 1996, the Company obtained FDA approval of its BAK Interbody Fusion System, which caused the Company to consider the realization of the net deferred tax assets to be more likely than not. As a result, in the fourth quarter of 1996, the Company reversed the valuation allowance and recorded an income tax benefit of $1,684,000 or $.17 per share. Components of deferred tax assets and liabilities are as follows:
DECEMBER 31, 1996 1995 - -------------------------------------------------------------------------------------------- Deferred tax assets: Net operating loss carryforwards $1,106,000 $ 608,000 Tax benefit of stock options 471,000 -- Inventory capitalization and reserves 387,000 224,000 Research and development credits 194,000 159,000 Other 36,000 10,000 - -------------------------------------------------------------------------------------------- Total deferred tax assets 2,194,000 1,001,000 Deferred tax liabilities: Depreciation and amortization (39,000) (29,000) - ------------------------------------------------------------------------------------------- Net deferred tax assets 2,155,000 972,000 Valuation allowance -- (972,000) - ------------------------------------------------------------------------------------------- Total deferred tax assets $2,155,000 $ -- - ------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------
Income tax expense consists of:
1996 1995 1994 - ------------------------------------------------------------------------------------------------------------------ Current: Federal $ -- $ -- $ -- State -- -- -- Alternative minimum tax -- 10,000 -- Deferred: Federal (629,000) -- -- State (83,000) -- -- Change in valu- ation allowance (972,000) -- -- --------------------------------------------------------------- $(1,684,000) $10,000 $ -- --------------------------------------------------------------
21 NOTES TO FINANCIAL STATEMENTS CONT'D Reconciliation of the statutory federal income tax rate to the Company's effective tax rate follows: 1996 1995 1994 - ---------------------------------------------------------------------------- Tax at statutory rate 34.0% 34.0% 34.0% State income taxes 4.5 6.5 6.5 Alternative minimum tax -- 1.0 -- Impact of net operating loss carryforward (38.5) (39.5) (40.5) Change in valuation allowance (87.2) -- -- ------------------------------------------ (87.2)% 2.0% -- ------------------------------------------ ------------------------------------------ 10. DISTRIBUTION AGREEMENT In September 1993, the Company entered into an exclusive distribution agreement for the Spine-Tech BAK Lumbar Interbody Fusion System with Smith & Nephew for which the Company received a non-refundable fee of $1,000,000. The agreement grants Smith & Nephew sales exclusivity for the BAK-Lumbar product in all countries in the world other than the United States. Included in accounts receivable at December 31, 1996 and 1995 is $26,560 and $1,314,700, respectively, reflecting purchases of BAK Systems by Smith & Nephew. The agreement was terminated in February 1996 as certain minimum annual purchase requirements were not met. 11. LICENSE AGREEMENTS During 1992, the Company entered into a license agreement with Dr. Gary Michelson and an affiliated company, Karlin Technology, Inc. ("Karlin"), as the owners of certain patents and patent applications relating to threaded cylindrical spinal implants (the "Karlin Technology"), the technology which is the basis of the Company's BAK system. Pursuant to the license agreement, the Company has a co-exclusive worldwide license during the life of the patent to make, use or sell products covered by the Karlin Technology. During 1994, the Company entered into license agreements relating to the development of the BAK/C system, the Cervi-Lok System, and a set of minimally invasive hand-held dissectomy techniques and instruments. In connection with these license agreements, the Company granted options to purchase 90,000 shares of the Company's Common Stock at prices of $2.67 to $3.27 per share. In addition, the Company will pay royalties under some of these agreements based upon a percentage of net sales under these agreements. The Company determined the value of the technology associated with these license agreements to be $42,500 and expensed the entire amount as research and development in-process during 1994. 12. SIGNIFICANT CUSTOMERS Sales to Smith & Nephew, consisting entirely of export sales, accounted for $354,302, $4,670,595 and $1,813,000 or 3 percent, 61 percent and 41 percent of net sales for the years ended December 31, 1996, 1995 and 1994, respectively. In 1994, the Company had sales to a domestic customer which accounted for $474,000, or 11 percent of net sales. 13. LEGAL PROCEEDINGS In 1994, the Company was served with a lawsuit related to its license of the Karlin Technology. The suit alleged various causes of action concerning Dr. Michelson's and Karlin's (the plaintiffs) right to co-license the Karlin Technology to a third party, including tortious interference with prospective and contractual business relationships, unfair competition and breach of contract, and requested various types of relief, including money damages, injunctive relief and declaratory judgment. In February 1996, a final judgment was entered in favor of the Company regarding the lawsuit related to this license. The plaintiffs have appealed the decision. SPINE-TECH 1996 ANNUAL REPORT 22 In June 1995, the Company received a purported notice of termination of the license agreement with respect to the Karlin Technology. The Company has commenced non-binding arbitration against the plaintiffs concerning the termination of the license agreement. The plaintiffs have taken the position in the arbitration that they do not intend to seek to enforce the purported termination; however, they have also contended that they may in the future terminate the license agreement if the royalty reports are determined to have been inadequate. In February 1996, the Company filed a lawsuit which seeks a declaratory judgment concerning the respective rights of the Company and the plaintiffs on a patent issued to the Company in 1996. Procedural hearings and discovery continue in this case. In August 1996, the plaintiffs commenced non-binding arbitration to seek purported unpaid royalties and damages for failure to give Dr. Michelson credit as the inventor for certain surgical methods used or claimed to be invented by the Company. Arbitration is pending and no hearing date has been set. In December 1996, the plaintiffs served the Company with an additional lawsuit related to the 1996 patent and license agreement referred to above. The suit alleges that Dr. Michelson is the inventor of the Company patent and requests various types of relief including money damages, punitive damages and declaratory judgment. The Company has not yet responded to the Complaint and expects to vigorously contest the action both on procedural and substantive grounds. It is not possible at this time to estimate the loss, if any, the Company will incur with regards to the legal proceedings, and thus the Company has not established a reserve for the outcome of the proceedings. AUDITOR'S REPORT REPORT OF INDEPENDENT AUDITORS To the Shareholders Spine-Tech, Inc. We have audited the accompanying balance sheets of Spine-Tech, Inc. as of December 31, 1996 and 1995, and the related statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Spine-Tech, Inc. at December 31, 1996 and 1995, and the results of its operations and cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. /s/ Ernst & Young LLP Minneapolis, Minnesota February 7, 1997 23 CORPORATE INFORMATION EXECUTIVE OFFICERS DAVID W. STASSEN Chief Executive Officer and President KEITH M. EASTMAN Chief Financial Officer and Secretary RICHARD C. JANSEN Vice President, Regulatory and Clinical Affairs DOUGLAS W. KOHRS Vice President, Research and Product Development TED K. SCHWARZROCK Vice President, Sales and Marketing DAVID L. SHAW Vice President, Manufacturing Operations DIRECTORS KENNETH W. ANSTEY President and Chief Executive Officer Bio-field Corporation (medical technology company) ROBERT J. DEPASQUA(1, 2) Private Investor STEPHEN D. KUSLICH, M.D. Orthopaedic Surgeon Medical Director of the Company JAMES F. LYONS(1, 2) Chairman of the Board of Directors Biovascular, Inc. (medical technology company) DAVID W. Stassen Chief Executive Officer and President 1 Member of the Compensation Committee 2 Member of the Audit Committee SHAREHOLDER INFORMATION STOCK LISTING The Company's Common Stock trades on the Nasdaq National Market tier of the Nasdaq Stock Market under the symbol: SPYN. TRANSFER AGENT AND REGISTRAR Norwest Bank Minnesota, N.A. Stock Transfer Department 161 North Concord Exchange P.O. Box 738 South St. Paul, Minnesota 55075-0738 FORM 10-K A copy of the Company's annual report on Form 10-K as filed with the Securities and Exchange Commission is available free of charge by writing to Keith M. Eastman at the Company (see Investor Inquiries). ANNUAL MEETING The annual meeting of Spine-Tech shareholders will be held May 8, 1997, at 3:30 p.m. at Minneapolis Marriot Southwest, 5801 Opus Parkway, Minnetonka, Minnesota 55343. All shareholders and other interested parties are invited to attend. INVESTOR INQUIRIES Please direct all inquiries to: Keith M. Eastman, Chief Financial Officer, Spine-Tech, Inc., 7375 Bush Lake Road, Minneapolis, Minnesota 55439-2029. Phone: (612) 832-5600 STOCK INFORMATION High and low quarterly closing prices for Spine-Tech, Inc., Common Stock as quoted on the Nasdaq Stock Market were: 1996 1995 High Low High Low - ------------------------------------------------------------------------------ First Quarter $27 3/8 $21 1/4 $-- $ -- Second Quarter $34 $23 3/4 $11 $ 9 Third Quarter $28 3/8 $18 11/16 $16 7/8 $ 9 7/8 Fourth Quarter $28 3/4 $23 $23 1/4 $ 15 Public trading of the Company's Common Stock commenced June 23, 1995, the effective date of the initial public offering. There were 238 common shareholders of record as of December 31, 1996. The Company has not paid any stock dividends on its Common Stock since its inception, and management does not anticipate paying cash dividends in the foreseeable future. SPINE-TECH 1996 ANNUAL REPORT 24 EX-23 4 EXHIBIT 23 EXHIBIT 23 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in the Annual Report (Form 10-K) of Spine-Tech, Inc. of our report dated February 7, 1997, included in the 1996 Annual Report to Shareholders of Spine-Tech, Inc. Our audits also included the financial statement schedule of Spine-Tech, Inc. listed in Item 14(a). This schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. We also consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 33-99048) pertaining to the 1994 Spine-Tech, Inc. Stock Option Plan, the Spine-Tech, Inc. Non-Employee Director Stock Option Plan and the Spine-Tech, Inc. 1991 Stock Option Plan and Registration Statement on Form S-8 (No. 333-07349) pertaining to the 1996 Omnibus Stock Plan, of our report dated February 7, 1997, with respect to the financial statements incorporated herein by reference, and our report included in the preceding paragraph with respect to the financial statement schedule included in this Annual Report (Form 10-K) of Spine-Tech, Inc. /s/ Ernst & Young LLP ------------------------- Ernst & Young LLP Minneapolis, Minnesota March 26, 1997 EX-27 5 EXHIBIT 27 (FDS)
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE BALANCE SHEET AND STATEMENT OF OPERATIONS OF SPINE-TECH, INC. FOR THE TWELVE MONTHS ENDED DECEMBER 31, 1996, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATMENTS. 1,000 YEAR DEC-31-1996 JAN-01-1996 DEC-31-1996 1724 13210 3338 187 6982 24053 6842 373 34058 1412 0 0 0 99 32547 34058 10153 10153 2849 2849 10458 0 0 (1931) (1684) (247) 0 0 0 (247) (.02) (.02)
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