-----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, WdBlMZ4LHfom2dOdXC0lvrVOPCVnQonUa8bUI9VHV48KKMuZvJufSz/iAlMVeRt6 0Wj/9Ox0sXWc832p0Y/DAg== 0000950117-02-001984.txt : 20020819 0000950117-02-001984.hdr.sgml : 20020819 20020819172524 ACCESSION NUMBER: 0000950117-02-001984 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20020630 FILED AS OF DATE: 20020819 FILER: COMPANY DATA: COMPANY CONFORMED NAME: ORTEC INTERNATIONAL INC CENTRAL INDEX KEY: 0000889992 STANDARD INDUSTRIAL CLASSIFICATION: BIOLOGICAL PRODUCTS (NO DIAGNOSTIC SUBSTANCES) [2836] IRS NUMBER: 113068704 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-27368 FILM NUMBER: 02743129 BUSINESS ADDRESS: STREET 1: 3960 BROADWAY STREET 2: BLDG 28 CITY: NEW YORK STATE: NY ZIP: 10032 BUSINESS PHONE: 7183264698 10-Q 1 a33241.txt FORM 10-Q ================================================================================ SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ----------- FORM 10-Q ----------- (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTER ENDED JUNE 30, 2002 [ ] 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 0-27368 ORTEC INTERNATIONAL, INC. (Exact name of issuer as specified in its charter) Delaware 11-3068704 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 3960 Broadway 10032 New York, New York (Zip Code) (Address of principal executive offices)
(212) 740-6999 Issuer's telephone number, including area code ---------------- Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act during the past 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ---- ---- ---------------- The number of shares outstanding of the issuer's common stock is 9,691,608 (as of August 15, 2002) ================================================================================ ORTEC INTERNATIONAL, INC. INDEX TO QUARTERLY REPORT ON FORM 10-Q FILED WITH THE SECURITIES AND EXCHANGE COMMISSION QUARTER ENDED JUNE 30, 2002 ITEMS IN FORM 10-Q
Page ---- Facing Page Part I Item 1. Financial Statements (Unaudited). 1 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operation. 20 Item 3 Quantitative and Qualitative Disclosures About Market Risk. 28 Part II Item 1. Legal Proceedings and Claims. 29 Item 2. Changes in Securities and Use of Proceeds. 30 Item 3. Default Upon Senior Securities. None Item 4. Submission of Matters to a Vote of Security Holders. None Item 5. Other Information. 34 Item 6. Exhibits and Reports on Form 8-K. 36 Signatures
Item 1. FINANCIAL STATEMENTS ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) CONDENSED BALANCE SHEETS
JUNE 30, DECEMBER 31, 2002 2001 * ---- ---- (Unaudited) ASSETS Current assets: Cash and cash equivalents $784,262 $854,025 Accounts receivable 94,525 21,890 Other current assets 33,282 169,516 ---------- ---------- Total current assets 912,069 1,045,431 ---------- ---------- Property and equipment, at cost: Laboratory equipment 2,138,471 2,126,771 Office furniture and equipment 1,240,868 982,948 Leasehold improvements 1,567,513 1,367,784 ---------- ---------- 4,946,852 4,477,503 Accumulated depreciation and amortization 3,196,668 2,894,782 ---------- ---------- Property and equipment - net 1,750,184 1,582,721 ---------- ---------- Other assets: Patent application costs, net of accumulated amortization of $244,986 at June 30, 2002 and $213,105 at December 31, 2001 709,122 619,676 Deferred financing costs, net of accumulated amortization of $38,104 at June 30,2002 and $1,983 at December 31, 2001 209,106 57,517 Security deposit - New Jersey location 639,000 598,000 Deposits and other assets 26,349 135,256 ---------- ---------- Total other assets 1,583,577 1,410,449 ---------- ---------- Total Assets $4,245,830 $4,038,601 ========== ==========
* Derived from audited financial statements. See notes to condensed unaudited financial statements. 1 ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) CONDENSED BALANCE SHEETS
JUNE 30, DECEMBER 31, 2002 2001 * ---- ---- (Unaudited) LIABILITIES AND SHAREHOLDERS' DEFICIENCY Current liabilities: Accounts payable and accrued liabilities $ 3,929,482 $ 2,444,945 Accrued compensation 111,443 223,393 Accrued professional fees 146,474 301,783 Accrued interest 87,416 460,964 12% Convertible debentures due April 30, 2003--net 667,894 -- Other Loans payable - current 233,048 143,505 ------------ ------------ Total current liabilities 5,175,757 3,574,590 ------------ ------------ Loans payable and other long term obligations 12,693,584 6,768,983 ------------ ------------ Commitments and contingencies Redeemable Convertible Preferred Stock 1,870,120 -- ------------ ------------ Shareholders' equity/(deficit): Common stock, $.001 par value; authorized 35,000,000 shares; 9,711,608 shares issued, 9,691,608 shares outstanding at June 30, 2002 and December 31, 2001 9,712 9,712 Additional paid-in capital 56,245,642 53,017,615 Deficit accumulated during the development stage (71,571,340) (59,154,654) Treasury stock, at cost (20,000 shares at June 30, 2002 and December 31, 2001) (177,645) (177,645) ------------ ------------ Total shareholders' deficiency (15,493,631) (6,304,972) ------------ ------------ Total Liabilities and Shareholders' Deficiency $ 4,245,830 $ 4,038,601 ============ ============
* Derived from audited financial statements. See notes to condensed unaudited financial statements. 2 ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) CONDENSED STATEMENTS OF OPERATIONS (Unaudited)
Six months Cumulative from Quarter ended June 30, ended June 30, March 12, 1991 ---------------------- -------------- (inception) to 2002 2001 2002 2001 June 30, 2002 ---- ---- ---- ---- ------------- Product revenue $ 92,535 $ - $ 208,950 $ - $ 230,840 ----------- ------------ ------------ ----------- ------------ Expenses Research and development 1,060,793 1,073,288 2,214,630 2,328,635 20,263,022 Rent 210,038 147,334 385,269 291,208 2,564,804 Consulting 174,406 405,205 344,278 540,563 5,570,793 Personnel 2,097,025 1,504,077 4,170,468 3,000,229 27,119,828 General and administrative 941,356 652,579 1,851,439 1,209,006 13,854,124 Interest and other expense 2,882,691 20,156 3,666,872 40,971 4,686,378 Interest income (1,227) (49,509) (7,320) (163,009) (2,256,769) ----------- ------------ ------------ ----------- ------------ 7,365,082 3,753,130 12,625,636 7,247,603 71,802,180 ----------- ------------ ------------ ----------- ------------ Net loss (7,272,547) (3,753,130) (12,416,686) (7,247,603) (71,571,340) Preferred stock dividend -- -- -- ----------- ============ ------------ =========== ------------ Net loss applicable to common shareholders $(7,272,547) $ 3,753,130 $(12,416,686) $(7,247,603) $(71,571,340) =========== ============ ============ =========== ============ Net loss per share Basic and diluted $(.75) $(.39) $(1.28) $(.75) $(14.31) ===== ===== ====== ===== ======= Weighted average shares outstanding Basic and diluted 9,691,608 9,691,608 9,691,608 9,691,608 5,000,503 =========== ============ ============ =========== ============
See notes to condensed unaudited financial statements. ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) STATEMENT OF SHAREHOLDERS' EQUITY/(DEFICIT) (Unaudited)
Common Stock Additional Deficit accumulated Paid-in in the development Treasury Shares Amount Capital stage Stock Total ------ ------ ------- ----- ----- ----- Issuance of stock: Founders 1,553,820 $1,554 $ (684) $ 870 First private placement 217,440 217 64,783 65,000 The Director 149,020 149 249,851 250,000 Second private placement 53,020 53 499,947 500,000 Share issuance expenses (21,118) (21,118) Net loss for the period from March 12, 1991 (inception) to December 31, 1991 $ (281,644) (281,644) --------- ------ ---------- ----------- --------- Balance - December 31, 1991 1,973,300 1,973 792,779 (281,644) 513,108 Issuance of stock: Second private placement 49,320 49 465,424 465,473 Stock purchase agreement with The Director 31,820 32 299,966 299,998 Share issuance expenses (35,477) (35,477) Net loss for the year ended December 31, 1992 (785,941) (785,941) --------- ------ ---------- ----------- --------- Balance - December 31, 1992 2,054,440 $2,054 $1,522,692 $(1,067,585) $ 457,161 ========= ====== ========== =========== =========
See notes to condensed unaudited financial statements. ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) STATEMENT OF SHAREHOLDERS' EQUITY/(DEFICIT) (Unaudited)
Common Stock Additional Deficit accumulated Paid-in in the development Treasury Shares Amount Capital stage Stock Total ------ ------ ------- ----- ----- ----- (brought forward) 2,054,440 $2,054 $1,522,692 $(1,067,585) $ 457,161 Issuance of stock: Third private placement 132,150 132 1,321,368 1,321,500 Stock purchase agreement with Home Insurance Company 111,111 111 999,888 999,999 Stock purchase agreement with The Director 21,220 21 199,979 200,000 Shares issued in exchange for commissions earned 600 1 5,999 6,000 Share issuance expenses (230,207) (230,207) Net loss for the year ended December 31, 1993 (1,445,624) (1,445,624) --------- ------ ---------- ----------- ----------- Balance - December 31, 1993 2,319,521 2,319 3,819,719 (2,513,209) 1,308,829 Issuance of stock: Fourth private placement 39,451 40 397,672 397,712 Stock purchase agreement with Home Insurance Company 50,000 50 499,950 500,000 Share issuance expenses (8,697) (8,697) Net loss for the year ended December 31, 1994 (1,675,087) (1,675,087) --------- ------ ---------- ----------- ----------- Balance - December 31, 1994 2,408,972 $2,409 $4,708,644 $(4,188,296) $ 522,757 ========= ====== ========== =========== ===========
See notes to condensed unaudited financial statements. ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) STATEMENT OF SHAREHOLDERS' EQUITY/(DEFICIT) (Unaudited)
Common Stock Additional Deficit accumulated Paid-in in the development Treasury Shares Amount Capital stage Stock Total ------ ------ ------- ----- ----- ----- (brought forward) 2,408,972 $2,409 $4,708,644 $(4,188,296) $ 522,757 Rent forgiveness 40,740 40,740 Net loss for the year ended December 31, 1995 (1,022,723) (1,022,723) --------- ------ ----------- ----------- ----------- Balance - December 31, 1995 2,408,972 2,409 4,749,384 (5,211,019) (459,226) Issuance of stock: Initial public offering 1,200,000 1,200 5,998,800 6,000,000 Exercise of warrants 33,885 34 33,851 33,885 Fifth private placement 959,106 959 6,219,838 6,220,797 Share issuance expenses (1,580,690) (1,580,690) Non-cash stock compensation and interest 152,000 152,000 Net loss for the year ended December 31, 1996 (2,649,768) (2,649,768) --------- ------ ----------- ----------- ----------- Balance - December 31, 1996 4,601,963 $4,602 $15,573,183 $(7,860,787) $ 7,716,998 ========= ====== =========== =========== ===========
See notes to condensed unaudited financial statements. ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) STATEMENT OF SHAREHOLDERS' EQUITY/(DEFICIT) (Unaudited)
Common Stock Additional Deficit accumulated Paid-in in the development Treasury Shares Amount Capital stage Stock Total ------ ------ ------- ----- ----- ----- (brought forward) 4,601,963 $4,602 $15,573,183 $ (7,860,787) $ 7,716,998 Exercise of warrants 1,158,771 1,159 10,821,632 10,822,791 Share issuance costs (657,508) (657,508) Stock options and warrants issued for services 660,000 660,000 Net loss for the year ended December 31, 1997 (4,825,663) (4,825,663) --------- ------ ----------- ------------ -------- ----------- Balance - December 31, 1997 5,760,734 5,761 26,397,307 (12,686,450) 13,716,618 Exercise of warrants 221,486 221 1,281,736 1,281,957 Stock options and warrants issued for services 1,920,111 1,920,111 Sixth private placement 200,000 200 1,788,498 1,788,698 Warrants issued in Sixth private placement 211,302 211,302 Share issuance costs (48,000) (48,000) Purchase of treasury stock (at cost) $(67,272) (67,272) Net loss for the year ended December 31, 1998 (8,412,655) (8,412,655) --------- ------ ----------- ------------ -------- ----------- Balance - December 31, 1998 6,182,220 $6,182 $31,550,954 $(21,099,105) $(67,272) $10,390,759 ========= ====== =========== ============ ======== ===========
See notes to condensed unaudited financial statements. ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) STATEMENT OF SHAREHOLDERS' EQUITY/(DEFICIT) (Unaudited)
Common Stock Additional Deficit accumulated Paid-in in the development Treasury Shares Amount Capital stage Stock Total ------ ------ ------- ----- ----- ----- (brought forward) 6,182,220 $6,182 $31,550,954 $(21,099,105) $ (67,272) $ 10,390,759 Exercise of warrants 14,103 14 14,089 14,103 Stock options issued for services 64,715 64,715 Seventh private placement 389,156 389 3,168,396 3,168,785 Warrants issued in Seventh private placement 468,291 468,291 Eighth private placement 1,636,364 1,637 8,998,365 9,000,002 Share issuance costs (619,908) (619,908) Purchase of treasury stock (at cost) (75,518) (75,518) Net loss for the year ended December 31, 1999 (10,040,509) (10,040,509) --------- ------ ----------- ------------ --------- ------------ Balance - December 31, 1999 8,221,843 $8,222 $43,644,902 $(31,139,614) $(142,790) $ 12,370,720 ========= ====== =========== ============ ========= ============
See notes to condensed unaudited financial statements. ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) STATEMENT OF SHAREHOLDERS' EQUITY/(DEFICIT) (Unaudited)
Common Stock Additional Deficit accumulated Paid-in in the development Treasury Shares Amount Capital stage Stock Total ------ ------ ------- ----- ----- ----- (brought forward) 8,221,843 $8,222 $43,644,902 $(31,139,614) $(142,790) $ 12,370,720 Exercise of options and warrants 175,532 175 327,107 327,282 Stock options and warrants issued for services 56,265 56,265 Ninth private placement 66,667 67 999,938 1,000,005 Warrants issued in Ninth private placement 23,000 23,000 Tenth private placement 1,247,566 1,248 8,419,823 8,421,071 Share issuance costs (641,500) (641,500) Purchase of treasury stock (at cost) (34,855) (34,855) Net loss for the year ended December 31, 2000 (12,129,663) (12,129,663) --------- ------ ----------- ------------ --------- ------------ Balance - December 31, 2000 9,711,608 9,712 52,829,535 (43,269,277) (177,645) 9,392,325 Stock options issued for services 188,080 188,080 Net loss for the year ended December 31, 2001 (15,885,377) (15,885,377) --------- ------ ----------- ------------ --------- ------------ Balance - December 31, 2001 9,711,608 $9,712 $53,017,615 $(59,154,654) $(177,645) $ (6,304,972) ========= ====== =========== ============ ========= ============
See notes to condensed unaudited financial statements. ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) STATEMENT OF SHAREHOLDERS' EQUITY/(DEFICIT) (Unaudited)
Common Stock Additional Deficit accumulated Paid-in in the development Treasury Shares Amount Capital stage Stock Total ------ ------ ------- ----- ----- ----- (brought forward) 9,711,608 $9,712 $53,017,615 $(59,154,654) $(177,645) $ (6,304,972) Stock options and Warrants issued for services 106,260 106,260 Warrants issued with convertible debentures 421,929 421,929 Warrants issued with convertible redeemable preferred stock 559,289 559,289 Convertible Debenture conversion benefit 1,042,663 1,042,663 Redeemable convertible preferred stock conversion benefit 1,097,886 1,097,886 Net loss for the six months ended June 30, 2002 (12,416,686) (12,416,686) --------- ------ ----------- ------------ --------- ------------ Balance - June 30, 2002 9,711,608 $9,712 $56,245,642 $(71,571,340) $(177,645) $(15,493,631) ========= ====== =========== ============ ========= ============
See notes to condensed unaudited financial statements. 10 ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) CONDENSED STATEMENTS OF CASH FLOWS (Unaudited)
Six months ended June 30, Cumulative from ------------------------- March 12, 1991 (inception) to 2002 2001 June 30, 2002 ---- ---- --------------- Cash flows from operating activities: Net loss $(12,416,656) $(7,247,603) (71,571,340) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 333,767 352,679 3,452,095 Amortization of deferred financing costs 36,121 -- 36,121 Unrealized loss on marketable securities 11,404 Realized loss on marketable securities 5,250 Non-cash stock compensation 106,260 168,390 3,147,454 Non-cash interest 3,531,016 3,985,768 Purchases of marketable securities (19,075,122) Sales of marketable securities 19,130,920 Changes in operating assets and liabilities Accounts receivable (72,635) (94,525) Other current assets and other assets 246,234 18,191 76,720 Accounts payable and accrued liabilities 1,268,482 339,670 4,273,119 ------------ ----------- ------------ Net cash used in operating activities (6,967,441) (6,368,673) (56,622,136) ------------ ----------- ------------ Cash flows from investing activities: Purchases of property and equipment, excluding capital leases (200,705) (318,683) (4,591,142) Payments for patent application (121,327) (25,147) (952,329) Organization costs (10,238) Deposits (42,093) 2,821 (773,366) Purchases of marketable securities (594,986) Sale of marketable securities 522,532 ------------ ----------- ------------ Net cash provided by (used in) investing activities (364,125) (341,009) (6,399,529) ------------ ----------- ------------
See notes to condensed unaudited financial statements. 11 ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) CONDENSED STATEMENTS OF CASH FLOWS (Unaudited)
Six months ended June 30, Cumulative from ------------------------ March 12, 1991 (inception) to 2002 2001 June 30, 2002 ---- ---- ------------- Cash flows from financing activities: Proceeds from issuance of notes payable -- $515,500 Proceeds from issuance of convertible debentures 2,583,000 -- 2,583,000 Proceeds from issuance of redeemable preferred stock 1,200,000 1,200,000 Proceeds from issuance of common stock 53,550,522 Financing costs for convertible debentures and preferred stock (400,655) (400,655) Share issuance expenses (3,605,105) Purchase of treasury stock (177,645) Proceeds from issuance of loans payable 1,446,229 Proceeds from other long-term Obligations 4,000,000 10,000,000 Repayment of capital lease obligations (42,806) (150,010) Repayment of loans payable (70,304) $ (64,849) (632,977) Repayment of long term obligation (7,432) (7,432) Repayment of notes payable (515,500) ---------- ----------- ----------- Net cash provided by (used in) financing activities 7,261,803 (64,849) 63,805,927 ---------- ----------- ----------- Net increase (decrease) in cash and cash equivalents (69,763) (6,774,531) 784,262 Cash and cash equivalents at beginning of period 854,025 9,292,478 ---------- ----------- ----------- Cash and cash equivalents at end of period $ 784,262 $ 2,517,947 $ 784,262 ========== =========== ===========
See notes to condensed unaudited financial statements. 12 ORTEC INTERNATIONAL, INC. (A DEVELOPMENT STAGE ENTERPRISE) STATEMENTS OF CASH FLOWS (Unaudited)
Six months ended June 30, Cumulative from ------------------------- March 12, 1991 (inception) to 2002 2001 June 30, 2002 ---- ---- ------------- Supplemental disclosure of cash flow information: Non-cash financing activities Capital lease obligations $268,644 $ - $387,547 Deferred offering costs included in accounts payable and accrued liabilities - - - Financing costs - other long-term obligations included in accounts payable and accrued liabilities - - Forgiveness of rent payable - - 40,740 Share issuance expenses - warrants - - 255,000 Warrants issued with debentures 421,929 - 421,929 Warrants issued with preferred stock 559,289 - 559,289 Debenture conversion feature 1,042,663 - 1,042,663 Preferred stock conversion feature 1,097,886 - 1,097,886 Cash paid for interest 26,876 41,410 514,417 Cash paid for income taxes - 23,508 199,576
See notes to condensed unaudited financial statements. 13 ORTEC INTERNATIONAL, INC. (a development stage enterprise) NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1 - FINANCIAL STATEMENTS The condensed balance sheet as of June 30, 2002, and the condensed statements of operations for the three and six month periods ended June 30, 2002 and 2001 and the statements of shareholders' equity (deficiency) and cash flows for the six month periods ended June 30, 2002 and 2001, and for the period from March 12, 1991 (inception) to June 30, 2002, have been prepared by the Company and are unaudited. In the opinion of management, all adjustments (which include normal recurring adjustments) necessary to present fairly the financial position as of June 30, 2002, results of operations for the three and six month periods ended June 30, 2002 and 2001, and stockholders equity and cash flows for the six month periods ended June 30, 2002 and 2001 and for the period from March 12, 1991 (inception) to June 30, 2002, have been made. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. It is suggested that these condensed financial statements be read in conjunction with the financial statements and notes thereto in the Company's December 31, 2001 annual report on Form 10-K filed with the Securities and Exchange Commission. The results of operations for the three and six month periods ended June 30, 2002, are not necessarily indicative of the operating results for the full year or for any other interim period. NOTE 2 - FORMATION OF THE COMPANY AND BASIS OF PRESENTATION Formation of the Company Ortec International, Inc. ("Ortec" or the "Company") was incorporated in March 1991 as a Delaware corporation to secure and provide funds for the further development of the technology developed by Dr. Mark Eisenberg of Sydney, Australia, to replicate in the laboratory, a tissue engineered skin substitute for use in skin regeneration procedures (the "Technology"). Pursuant to a license agreement dated September 7, 1991, Dr. Eisenberg had granted Ortec a license for a term of ten years, with automatic renewals by Ortec for two additional ten-year periods, to commercially use and exploit the Technology for the development of products. In April 1998, Dr. Eisenberg assigned his patent for the Technology to Ortec. 14 Basis of Presentation and liquidity Ortec is a development stage enterprise, which had no operating revenue prior to December 2001. During 2001, the Company received Food and Drug Administration ("FDA") approval for the use of OrCel for treatment of Epidermolysis Bullosa and donor sites in burn patients. The Company then began marketing and selling its product for use on patients with these indications. Revenues to date have not been significant. On March 27, 2002, the Company engaged H.C. Wainwright & Co., Inc. an investment banking firm, to act as its financial advisor in connection with raising capital for the Company through debt and/or equity financing. Wainwright is assisting the Company in raising financing of approximately $8.5 million. On May 13, 2002, the Company secured the first $2.3 million of this financing, in the form of 12% convertible debentures, which are convertible into common shares at the lesser of $3.36 or the price per share of the equity securities to be issued in an anticipated forthcoming financing. It is expected that these debentures will be converted into equity securities upon the final closing of this financing. As June 30, 2002, $0.6 million has been converted into redeemable convertible preferred stock. The Company also issued 291,625 stock purchase warrants as part of this May 13, 2002 financing, which are exercisable at $4.50 per share for up to 5 years from the date of grant subject to adjustment under certain conditions. On June 28, 2002, an additional $1.5 million of financing was secured, which consists of $1.2 million in redeemable convertible preferred stock and $.3 million in 12% convertible debentures, which the Company also expects will be converted into equity securities. The Company also issued 31,250 stock purchase warrants at an exercise price of $4.50 per share and 623,374 stock purchase warrants, at an exercise price of $1.875 per common share for a five-year period, as part of the June 28, 2002 financing. Subsequent to June 30, 2002, the Company has issued an additional $0.2 million in convertible debentures, similar to those raised in the May 7, 2002 and June 28, 2002 financings. The Company anticipates continuing its financing efforts with the issuance of its Series B Convertible Preferred Stock. The preferred stock is convertible into common shares at any time at the option of the investor, based on a fixed conversion rate of $1.67 or commencing after January 1, 2003, based on a alternative conversion rate equal to 90% of the average of the five lowest volume weighted average prices for the common stock for the twenty trading days immediately prior to conversion, subject to a floor price. The alternative conversion price is cancelable under certain circumstances, as described below. Conversion is mandatory, upon the occurrence of certain financial events, such as, beginning six months from the date of issue, if the closing bid price of common shares exceeds $3.35 for a period of 20 consecutive trading days, or if within nine months from the date of issue, the Company completes a public offering, raising a minimum of $8 million. In the event that the Company receives a licensing fee or a strategic investment of at least $8.0 million, within six months of closing, the alternative conversion rate is adjusted to the closing rate of the investment or the fixed rate of $1.67, if lower. Similarly, if the Company completes a subsequent public or private financing of a least $5.0 million, within six months of closing, the alternative conversion rate is adjusted to the closing price or the fixed rate of $l.67 if lower. Dividends will be paid in common shares at the rate of 12% in the first year after issue and in either cash or common shares in subsequent years at the election of the Company, until at such time as the preferred stock is converted to common shares. Along with the convertible preferred stock, the Company is also issuing warrants to purchase common shares. The Series A warrants, exercisable at $.001 per share, must be exercised immediately upon closing of the purchase of 15 preferred stock. The Series B-1 warrants are exercisable nine months after closing at $2.00 per share and the Series B-2 warrants are exercisable at $3.00 per share, twelve months after closing. The Company anticipates completing the balance of this financing with H.C. Wainwright in August 2002. We require substantial funding to continue our research and development activities, clinical trials, manufacturing, sales, distribution and administrative activities. We believe that our cash and cash equivalents on hand at June 30, 2002, (approximately $.8 million) and the anticipated additional new financing expected in August 2002 of approximately $5.0 million will enable us to continue our operations until December 2002. In addition, on August 5, 2002, we executed a letter of intent with a securities brokerage firm, whereby they agreed to act as the underwriter for the Company on a firm commitment basis and to complete a $12.0 million follow on public offering. We continue to explore and, as appropriate, enter into discussions with other companies regarding the potential for equity investment, collaborative arrangements, license agreements or other funding programs with us, in exchange for manufacturing, marketing, distribution or other rights to our products. However, we can give no assurances that discussions with other companies will result in any additional investments, collaborative arrangements, agreements or other funding, or that the necessary additional financing through debt or equity will be available to us on acceptable terms, if at all. Further, we can give no assurance that any arrangements resulting from these discussions will successfully reduce our funding requirements. If additional funding is not available to us when needed, we may not be able to continue operations. These financial statements have been prepared assuming that Ortec will continue as a going concern. Successful future operations depend upon the successful development and marketing of Ortec's product to be used for the repair, replacement and regeneration of human skin. Historically Ortec has funded its operating losses by periodically raising additional sources of capital. If additional funding is not available to Ortec when needed, Ortec may not be able to continue operations. No adjustments have been made to the accompanying financials as a result of this uncertainty. NOTE 3 - NET LOSS PER SHARE As of June 30, 2002, an aggregate of 3,740,119 outstanding warrants and options were excluded from the weighted average share calculations, as the effect was antidilutive. As of June 30, 2001, an aggregate of 2,764,579 outstanding warrants and options were excluded from the weighted average share calculations for the same reason. Additionally, the effects of the conversion of the debentures and preferred stock were excluded from the weighted average share calculation as the effect would be antidilutive. An aggregate of 1,322,000 and 1,246,747 shares of common stock would be issuable upon conversion of the debentures and preferred stock at June 30, 2002, respectively. NOTE 4 - LONG TERM OBLIGATIONS On August 29, 2001, the Company entered into a Royalty Revenue Interest Assignment agreement with Paul Capital Royalty Acquisition Fund L.P. and as part of this agreement has 16 received $10.0 million. $6.0 million was received in 2001 with the remaining $4.0 million in January 2002. Such amounts are reflected as long term debt as of June 30, 2002 and December 31, 2001. On August 6, 2002, the Company reached an agreement in principle to a non-binding term sheet with Paul Capital. The term sheet provides that Paul Capital would relinquish 70% of its revenue interest in exchange for $7.0 million in Series C Secured Participating Preferred Stock and 500,000 warrants exercisable at a nominal exercise price. This agreement is contingent upon completion of the current financing with H.C. Wainwright (Note 2). Beginning in 2003, these securities will accrue fixed dividends at 12% per annum, payable in preferred stock and will also earn an additional dividend of .875%, which may be adjusted upward, if certain level of sales are not achieved by the Company. If the Company does not redeem the preferred stock and accrued dividends prior to December 31, 2011, the accrued dividends will be converted into common shares and the face value of the preferred stock will remain outstanding at an increased dividend rate. The Company may redeem these securities at any time by payment of the preferred stock and accrued dividends to date. The remaining $3.0 million of the original $10.0 million received from Paul Capital will continue to be treated as Long Term Debt, under the Royalty Interest Assignment Agreement. The Company may incrementally receive up to an additional $15.0 million, but only upon the mutual agreement of both the Company and Paul Capital. Under the August 29, 2001 agreement, in consideration for the original $10.0 million, Paul Capital received a minimum of 3-1/3% of end user revenues from the sale of the Company's products in the United States, Canada and Mexico. These percentage payments may be further adjusted upward or downward, based on the volume of net sales to end users of the Company's products in those three countries. As of June 30, 2002, the Company estimated that its effective cost of the amounts it received from Paul Capital was 28% per annum, and has accrued interest accordingly which is reflected as long-term at June 30, 2002. The non-binding terms of the agreement reached in principle provides that Paul Capital will receive a minimum of 1.125% on end user revenues up to $100 million and 0.6% on revenues in excess of $100 million. Under the August 29, 2001 agreement, beginning on January 1, 2003, Paul Capital will be entitled to receive each year the first proceeds to the Company from end user sales of its products. Such annual amounts Paul Capital will be able to draw in advance will range from $1.5 million in 2003 to $7.5 million in 2005 and thereafter. Based upon the proposed revision to the original contract, prorated amounts of the advance payments will be due in each year of the agreement. The agreement provides for quarterly and annual accountings between Paul Capital and the Company for those advance payments, compared to amounts owed based on actual sales. In the event of a change in control of the Company or upon the occurrence of certain other events as defined in the agreement, Paul Capital has the option to put its revenue interest back to the Company for an amount as provided in the agreement. The Company also has the option to repurchase Paul Capital's interest upon the occurrence of a change in control of the Company or a complete divestiture by the Company of its interests in its products, for an amount as provided in the agreement. The Company granted Paul Capital a security interest in its United States and Canadian patents and trademarks relating to its technology for its product, to secure payments required to be 17 made by the Company to Paul Capital based on sales generated under the Royalty Revenue Interest Assignment and the Secured Participating Redeemable Preferred Stock agreements, as described above. The original agreement and the modification to the agreement reached in principle terminate on December 31, 2011, unless terminated earlier by either party, as permitted by the terms of the agreement. NOTE 5 - ISSUANCE OF DEBENTURES- On May 13, 2002, the Company issued an aggregate of $2,333,000 in convertible debentures. An additional $250,000 of convertible debentures were issued on June 28, 2002. These debentures are payable April 10, 2003, bear interest at the rate of 12% per annum, increasing to 18% per annum on October 10, 2002, which is payable at the end of each quarter. The Company has deferred payment of interest due June 30, 2002, until it completes additional financing. The debentures and accrued interest were to be converted into Ortec's equity securities if the Company completed a sale of the Company's equity securities for a minimum of an additional $5,000,000 by July 12, 2002. Although the Company only sold $1,200,000 of convertible redeemable preferred stock prior to July 13, 2002, the Company remains in negotiation with some of the note holders and other potential investors to secure additional equity financing. The Company believes that that the note holders will convert their debentures into the equity securities that the Company intends to issue in such additional financing on the terms set forth in the debentures as if the Company had completed such additional financing by July 12, 2002. The debentures provide for conversion of the debentures into equity securities (if the Company had secured not less than an additional $5,000,00 in equity financing by July 12, 2002) issued in such equity financing, by taking 110% of the principal amount of the debentures and 110% of the unpaid accrued interest, and purchasing so many of such equity securities determined by dividing such 110% principal and accrued interest of the note by the purchase price of one equity security in such equity financing. The debentures may be converted at the option of the holder of the debenture, to shares of the Company's common stock at a conversion rate which is the lower of $3.36 or the price per share of the equity securities in the proposed equity financing described above. However, the debentures provide for "price protection" so that the conversion rates at which the debentures are convertible to the Company's common stock is reduced if the Company sells its common stock in the future, or the exercise price or conversion rate of any warrants or options to purchase, or other securities which may be converted into, the Company's common stock, which the Company may issue in the future, are sold at a price, or are exercisable or convertible at a price, lower than the conversion rate of these debentures. The purchasers of the debentures were also granted five-year warrants to purchase an aggregate of 322,875 shares of the Company's common stock at an exercise price of $4.50 per share. Like the debentures, these warrants also provide "price protection" so that the exercise price is reduced if the Company sell common stock in the future, or the exercise price or conversion rate of any warrants or options to purchase, or other securities which may be converted into, the Company's common stock, which the Company may issue in the future, is lower than the exercise price of these warrants. The relative estimated fair value of the warrants of $421,929 was recorded as additional debt discount and is being amortized over the life of the convertible debentures. In addition, the estimated fair value of the beneficial conversion feature of $1,042,663 has been recorded as additional debt discount and is being amortized over the remaining life of the convertible debentures. NOTE 6 - AMENDMENT OF CERTIFICATE OF INCORPORATION AND ISSUANCE OF SERIES A REDEEMABLE CONVERTIBLE PREFERRED STOCK On June 28, 2002, the Company's board of directors unanimously adopted an amendment to the Company's certificate of incorporation designating 2,000 shares out of the 1,000,000 shares of preferred stock that the Company is authorized to issue, as Series A Convertible Preferred Stock, and designating the relative rights and preferences of the Series A Convertible Preferred Stock. The stated value, which is also the Liquidation Preference of the Series A Convertible Preferred Stock, is $10,000 per share. The Company is required to pay dividends on the Series A Preferred shares, at the rate of 6% per annum of the $10,000 Liquidation Preference per share, through June 30, 2003; at the rate of 9% per annum thereafter until June 30, 2004; and thereafter at the rate of 12% per annum. At the Company's option such dividends may be paid in the Company's common stock at the "conversion price" for the conversion of such preferred shares if such shares of common stock have been registered under the Securities Act of 1933 for sale in the public securities markets. The conversion price is fixed initially at $1.50 per share of the Company's common stock. Commencing nine months after the date of issuance of any shares of Series A Convertible Preferred Stock, the holder may elect to convert its Series A shares plus interest accrued thereon at an "Alternative Conversion Price" which shall be the average of the five lowest volume the weighted average prices for the Company's common stock during the 15 days immediately prior to conversion. However, at no time is the Alternative Conversion Price to be less than 50% of the fixed conversion price. The Alternative Conversion Price will be cancelled if within six months of issuance (i) the Company sell shares of the Company's common stock in a financing in which aggregate cash proceeds are not less than $5,000,000 and the price at which each share is sold is not less than $2.00, or (ii) the Company receive at least $8,000,000 as an up-front payment for a licensing fee from a third party. There is price protection for the alternative conversion price only so that the alternative conversion price is reduced if the Company sells shares of the Company's common stock in the future at, or the exercise price of any warrants or options to purchase the Company's common stock which the Company may grant in the future, or the conversion price for the conversion of other securities (the Company may issue in the future) to the Company's common stock, is lower than the alternative conversion price for the Series A Preferred shares. The Company has the right to redeem all or a portion of the outstanding Series A Convertible Preferred Stock by payment of $15,000 per share plus any accrued and unpaid dividends. The holders of the Series A Convertible Preferred Stock may compel the Company to redeem their shares upon the occurrence of certain events, at $12,000 or $15,000 per Series A Preferred share, plus accrued dividends, depending on the event which triggers the holders' rights to compel redemption. 18 On June 28, 2002 the Company sold to one institutional investor 187.012 shares of the Company's Series A Convertible Preferred Stock for a cash investment of $1,200,000 and conversion of $600,000 of the debentures the Company issued to such investor in May 2002. The Company also granted five year warrants to such purchaser to purchase an aggregate of 623,374 shares of the Company's common stock at an exercise price of $1.875 per share. Such warrants contain the same type of "price protection" provisions as were contained in the warrants the Company issued with its debentures. Under EITF 00-19, "Accounting for Derivative Instruments Indexed to and Potentially Settled in the Company's Own Stock", the beneficial conversion feature related to the redeemable convertible preferred stock and the warrants issued in connection with such preferred stock, do not qualify for presentation as permanent equity or temporary equity because the common shares that must be delivered upon conversion of the redeemable preferred stock or exercise of the warrants must be registered shares of the Company's common stock. The Company does not have sufficient registered shares of common stock as of June 30, 2002, and has not yet filed a registration statement for such shares. As the preferred stock has no stated redemption date, the entire amount of the discount has been reflected as interest expense during the three and six month periods ended June 30, 2002. The relative estimated fair value of the warrants of $559,289 was recorded as a discount to the preferred stock and was reflected as interest expense during the period ended June 30, 2002. In addition, the estimated fair value of the beneficial conversion feature of $1,097,886 has been recorded as an additional discount and has been reflected as interest expense during the period ended June 30, 2002. The debentures, the Series A Preferred shares and all of the warrants issued in connection with the debentures and Series A Preferred financings have "blocking" provisions which prevent the issuance of most of the shares of the Company's common stock issuable upon conversion of such debentures or Series A Preferred shares, or upon exercise of such warrants, until the Company secures shareholder approval for the sale of the debentures, the Series A Preferred shares and the grant of the warrants. The Company intends to secure such shareholder approval at the next annual meeting of the Company's shareholders which the Company intends to schedule for October 2002. If the Company does not secure such shareholder approval, the Company will suffer monetary penalties. The Company also are required to qualify all of the shares of the Company's common stock issuable upon conversion of the debentures and the Series A Preferred shares, and/or the exercise of the warrants, for sale in the public securities markets by registering them under the Securities Act of 1933, as amended, and keeping such registration statement in effect for close to two years. Although the Company has not filed the Company's proxy statement for the Company's annual meeting or the registration statement to qualify such shares of the Company's common stock for sale in the public securities markets within the time required by the Company's agreements and other documents, the Company believes that the holders of the debentures, the Series A Preferred shares and such warrants will participate in the Company's next equity financing and that therefore they will waive the monetary penalties that may be invoked against the Company for such delays in filing. NOTE 7 - LEGAL PROCEEDINGS, CLAIMS AND OTHER CONTINGENCIES On August 15, 2001, a complaint was filed against the Company and its directors in the United States District Court for the Southern District of New York. The complaint claims that the plaintiff purchased the Company's class B warrants which expired December 31, 2000, claiming that he received assurances from the Company's chief executive officer that the board would reduce the strike price of such warrants and/or extend the due date of such warrants, and that the plaintiff relied on actions taken in the past by the Company to extend these warrants. The Company's chief executive officer denies giving such assurances. The Company denies that the plaintiff could rely upon actions taken in the past as representation that future actions would be taken. On April 25, 2002, the claim was settled by the issuance 36,000 three-year warrants to the claimant to purchase the Company common stock at $4.50 per share and reflected $61,560 of expense related to such warrants during such quarter. The Company has been notified by Columbia University, the landlord of premises at 3960 Broadway in New York City, where we maintain our principal offices, laboratory and production facilities, that the Company has been delinquent in payment of rent. The Company has recently surrendered approximately 11% of the space occupied by us in that building and will surrender an additional 11% within the next sixty days, as part of its program to reduce spending. The Company is now negotiating a pay out of the remainder of its unpaid obligations to Columbia. The Company's ability to make such payment is dependent on its ability to secure the additional equity financing, noted above. ClinTrials Networks, LLC has claimed that the Company has breached its agreement with them, which provided for ClinTrials to arrange and manage the FDA mandated clinical trials for use of our OrCel product for the treatment of venous stasis ulcers, and for other services. ClinTrials claims that as a result of such a breach the Company owes an unspecified amount, in excess of $100,000. The Company has advised ClinTrials that it is not in breach of its contract and that in any event, under the terms of the contract, ClinTrials is not entitled to recovery of any damages from the Company. The Company has reached an agreement with the New Jersey Economic Development Administration to terminate the current lease of approximately 58,000 square feet and to enter into a new lease for approximately 26,000 square feet of production and office space in North Brunswick, New Jersey. By letter dated June 27, 2002, the staff of the Nasdaq Stock Market, Inc., advised the Company that it had not met Nasdaq's requirements for continued listing of its common stock on the Nasdaq SmallCap market. On July 1, 2002 the Company appealed that determination and requested an oral hearing before a Nasdaq Listing Qualification Panel. At that hearing, which was held on August 8, 2002, the Company asked the panel to defer delisting the Company's common stock for up to six months in order to give the Company time to complete a plan, which it presented to the panel, to raise sufficient capital to provide for the Company's cash needs for the next twelve months and to enable the Company to meet Nasdaq's requirements for continued listing of its common stock on the Nasdaq SmallCap market. The Company's common stock will continue to be listed pending the panel's determination of our request. The debentures, the Series A Preferred Shares and the warrants issued in connection with such financings provide for monetary penalties against the Company if its common stock is deleted from Nasdaq and is not listed for trading on the Bulletin Board. NOTE 8- EQUIPMENT FINANCING- In January 2002, the Company secured a $1,300,000 lease line of credit to be used for the acquisition of additional manufacturing, laboratory and other equipment required to expand its manufacturing capacity. During the six months ended June 30, 2002, the Company purchased $268,644 of equipment under this financing which was accounted for as a sales-leaseback. 19 NOTE 9 - STOCK OPTIONS AND WARRANTS The following represents stock option and warrant activity during the six months ended June 30, 2002:
Stock Options Warrants Total ------------- -------- ----- Balance at December 31, 2002 2,033,306 395,412 2,428,718 Granted 194,150 1,336,331 1,510,481 Exercised - - - Expired or cancelled (121,250) (77,830) (199,080) -------------------------------------------- Balance at June 30, 2002 2,106,206 1,633,913 3,740,119 ============================================
During the three and six months ended June 30, 2002, there were 35,000 options and 36,000 issued to non-employees for services, which resulted in an aggregate expense of $106,260. The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force ("EITF") Issue No. 96-18, "Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction With Selling, Goods or Services." All transactions in which goods or services are the consideration received for the issuance of equity instruments are accounted for based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably measurable. The Company is required to grant to the placement agent who arranged for the sale of the debentures and the Series A Preferred shares, 5 year warrants to purchase a percentage of the shares of the Company's common stock issuable upon conversion of the debentures and the Series A Preferred shares. The terms of the warrants the Company are to grant to the placement agent, including the exact number of shares of the Company's common stock the placement agent may purchase, and other warrants the Company will grant to the placement on the completion of the proposed additional financing discussed above, are being negotiated by the Company and the placement agent. As the Company is unable to estimate the amount of warrants or the price of such warrants, no compensation expense has been recognized for such warrants during the three and six months ended June 30, 2002. The Company is also required to grant 3 year warrants to purchase 300,000 shares of the Company's common stock at exercise prices of $3.50 per share for 100,000 shares, at $5.50 per share for the second 100,000 shares and at $7.50 per share for the third 100,000 shares, to one entity in exchange for financial consulting services rendered by that entity. The warrants vest as to each 100,000 share tranche on June 1, 2002, on December 1, 2002 and on June 1, 2003. The Company has the right to cancel such financial consulting services agreement on 30 days' notice. If the Company cancel the agreement, all warrants which did not vest prior to the date of termination of the agreement are cancelled. The Company has not yet issued such warrants, but has accrued an aggregate of $143,083 of expense (which is reflected in accrued expenses) related to such warrants as of June 30, 2002. NOTE 10 - ADOPTION OF RECENTLY ISSUED ACCOUNTING STANDARD AND IMPACT OF RECENTLY ISSUED PRONOUNCEMENTS Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 142 Goodwill and Other Intangible Assets. Under SFAS No. 142, goodwill and indefinite lived intangible assets are no longer amortized but will be reviewed at least annually for impairment. Separable intangible assets that are not deemed to have an indefinite life will continue to be amortized over their useful lives. The Company's intangible assets subject to amortization primarily consists of patent application costs totaling $832,781 as of January 1, 2002. As of January 1, 2002, there were no intangible assets with indefinite useful lives. The Company continues to amortize these costs over their estimated useful lives. Adoption of this accounting standard did not have a material effect on financial position or results of operations. The Company adopted the provisions of SFAS No. 144 effective January 1, 2002. The adoption of SFAS No. 144 had no effect on the financial position or results of operations of the Company. On April 30, 2002 the FASB issued Statement of Financial Accounting Standard No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of SFAS No. 13, and Technical Corrections" ("SFAS No. 145"). SFAS No. 145 rescinds Statement No. 4, which required all gains and losses from extinguishments of debt to be aggregated and, if material, classified as an extraordinary item, net the related income tax effect. Upon adoption of SFAS No. 145, companies will be required to apply the criteria in APB Opinion No. 30, "Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" in determining the classification of gains and losses resulting from the extinguishment of debt. SFAS No. 145 is effective for fiscal years beginning after May 15, 2002. The Company is currently evaluating the requirements and impact of this statement on its consolidated results of operations and financial position. On July 30, 2002, the FASB issued Statement of Financial Accounting Standard No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" ("SFAS No. 146"). The standard requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. Examples of costs covered by the standard include lease termination costs and certain employee severance costs that are associated with a restructuring, discontinued operation, plant closing, or other exit or disposal activity. SFAS No. 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The Company iscurrently evaluating the requirements and impact of this statement on its consolidated results of operations and financial position. NOTE 11 - SUBSEQUENT EVENTS- Issuance of debentures- In August 2002, the Company issued an aggregate of $175,000 in convertible debentures with comparable terms as those that were issued on May 13, 2002. An aggregate of 21,875 warrants were issued in connection with such financing with the same terms as those that were issued on May 13, 2002. Letter of Intent- As more fully discussed in Note 2, the Company signed a non-binding letter of intent with Paul Capital on August 6, 2002 in order to convert a portion of the outstanding obligations to Paul Capital to Series C Preferred Stock. Item 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward Looking Information May Prove Inaccurate 20 This Quarterly Report on Form 10-Q contains certain forward looking statements and information relating to Ortec, that are based on the beliefs of management, as well as assumptions made by and information currently available to us. When used in this document, the words "anticipate," "believe," "estimate," and "expect" and similar expressions, as they relate to Ortec, are intended to identify forward looking statements. Such statements reflect our current views with respect to future events and are subject to certain risks, uncertainties and assumptions, including those described in this discussion and elsewhere in this Quarterly Report on Form 10-Q. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated or expected. We do not intend to update these forward-looking statements. The following discussion should be read in conjunction with our financial statements and notes thereto. This discussion may be deemed to include forward-looking statements. General Since Ortec's inception we have been principally engaged in the research and development of our tissue engineered skin regeneration product, for use in the treatment of chronic and acute wounds, such as venous and diabetic skin ulcers, and autograft donor site wounds for burn victims. We call our product OrCel'TM' and in June 2001 we filed a trademark application for such name with the United States Patent and Trademark Office. In February 2001 Ortec received FDA approval to make commercial sales of OrCel for use on patients with recessive dystrophic epidermolysis bullosa, followed by FDA approval in September 2001 for use of the product in the treatment of donor site wounds in burn patients. With these approvals, though we are still a development stage enterprise, in December 2001 we began commercial sales of our product. From inception to date, we have incurred cumulative net losses of approximately $71.6 million. We expect to continue to incur substantial losses until at least 2003, due to continued spending on research and development programs, the funding of clinical trials and regulatory activities and the increased personnel costs of manufacturing, marketing and sales, distribution and administrative activities. We are currently conducting pivotal clinical trials of OrCel in the treatment of venous stasis ulcers. Venous stasis ulcers are open lesions on the legs, which result from the poor circulation of blood returning from the legs to the heart. We expect to complete the venous stasis pivotal clinical trials by the end of 2002, with submission of the FDA filing by the first quarter of 2003. We anticipate obtaining FDA approval in 2003 for the use of our OrCel product in the treatment of venous stasis ulcers. Diabetic ulcers are open sores that remain after the destruction of surface tissue. We have deferred the implementation of the diabetic ulcers pivotal clinical trials and expect to resume these trials in 2003 dependent on obtaining additional financing. We anticipate that future revenues and results of operations may continue to fluctuate significantly depending on, among other factors, the timing and outcome of applications for 21 additional regulatory approvals, our ability to successfully manufacture, market and distribute OrCel and/or the establishment of collaborative arrangements for the manufacturing, marketing and distribution of our product. We anticipate that our operating activities will result in substantial net losses until at least 2003. Critical Accounting Policies Revenue Recognition. Revenues from sales are recognized upon shipment of product to customers. Research and Development Costs. We are a development stage enterprise and as such, all research and development costs, including consulting and personnel costs, relating to products under development, are expensed as incurred. Research and Development Costs. As we are still engaged in clinical trials of our product and remain a development stage enterprise, the cost of producing product for clinical trials and for sale, is included in Research and Development costs. Long Term Obligations. We account for our Revenue Interest Assignment Agreement in a manner similar to that of debt and provide for interest to reflect the estimated cost of the funds received. Interest is imputed at approximately 28% per annum, which is the estimated return under the agreement. Interest may range from 20-30% per annum depending on our sales and the ultimate terms of the agreement. Adoption of Recently Issued Accounting Standard. Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 142 Goodwill and Other Intangible Assets. Under SFAS No. 142, goodwill and indefinite lived intangible assets are no longer amortized but will be reviewed at least annually for impairment. Separable intangible assets that are not deemed to have an indefinite life will continue to be amortized over their useful lives. The Company's intangible assts subject to amortization consists primarily of patent application costs. There are no intangible assets with indefinite useful lives. The Company adopted the provisions of SFAS No. 144 effective January 1, 2002. The adoption of SFAS No. 144 had no effect on the financial position or results of operations of the Company. Impact of recently issued accounting pronouncements: On April 30, 2002 the Financial Accounting Standards Board (the FASB) issued Statement of Financial Accounting Standard No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of SFAS No. 13, and Technical Corrections" ("SFAS No. 145"). SFAS No. 145 rescinds Statement No. 4, which required all gains and losses from extinguishments of debt to be aggregated and, if material, classified as an extraordinary item, net the related income tax effect. Upon adoption of SFAS No. 145, companies will be required to apply the criteria in APB Opinion No. 30, "Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" in determining the classification of gains and losses resulting from the extinguishment of debt. SFAS No. 145 is effective for fiscal years beginning after May 15, 2002. The Company is currently evaluating the requirements and impact of this statement on its consolidated results of operations and financial position. On July 30, 2002, the FASB issued Statement of Financial Accounting Standard No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" ("SFAS No. 146"). The standard requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. Examples of costs covered by the standard include lease termination costs and certain employee severance costs that are associated with a restructuring, discontinued operation, plant closing, or other exit or disposal activity. SFAS No. 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The Company is currently evaluating the requirements and impact of this statement on its consolidated results of operations and financial position. Results of Operations Three and Six Months Ended June 30, 2002, and June 30, 2001. Revenues We earned revenues of approximately $93,000 in the 2002 quarter, and $209,000 for the six months ended June 30, 2002 from commercial shipments of products to customers. Since sales to commercial customers only began in December 2001, there was no comparable revenue generated in the quarter and six months ended June 30, 2001. Expenses 22 Expenses increased by approximately $1.7 million in the quarter from approximately $3.8 million in 2001 to approximately $5.5 million in 2002 and by $3.6 million in the six month period from approximately $7.2 million in 2001 to approximately $10.8 million in 2002. Personnel. Personnel costs increased by approximately $1.2 million in the quarter from $3.0 million in 2001 to $4.2 million in 2002, and $0.6 million in the six month period from $1.5 million in 2001 to $2.1 million in 2002. This increased expense resulted from the additional personnel required to conduct and manage larger clinical trial programs, to manufacture the increased quantity of product required by our clinical trial programs to initiate our sales and marketing program for our FDA approved products and for additional administrative personnel required as a result of such increased staffing levels. This personnel increase resulted in increased rent expense as additional space was needed to accommodate the increased staffing levels. Consulting. These fees decreased by $231,000 in the quarter and $196,000 in the six months ended June 30, 2002 compared with the six months ended June 30, 2001. This was due to the increased costs in 2001 related to the specific requirements for concluding the clinical trials for donor site wounds and FDA submissions, noted above, as well as the costs of conducting the pilot clinical trials for venous leg stasis and diabetic foot ulcers. In 2002, only the costs of beginning the pivotal clinical trials for venous leg stasis ulcers were incurred. Research and Development. These expenses decreased by approximately $12,000 in the quarter and $114,000 in the six months ended June 30, 2002 compared with the quarter and six months ended June 30, 2001. The decrease in research and development expenses was due to the fact that higher costs were incurred in 2001 for conducting the donor site pivotal clinical trials, as well as the venous and diabetic ulcers pilot trials, which were concluded in 2001, compared with the costs incurred in 2002 relevant to only the venous stasis pivotal trials. This decrease was partially offset by the higher costs incurred in 2002 relevant to producing cryo OrCel for the larger venous stasis clinical trial, as well as fresh OrCel for sales to customers. General and Administrative. These expenses increased by $289,000 in the quarter and $642,000 in the six months ended June 30, 2002, compared with the similar period in 2001, due to increased marketing, recruitment, insurance and other expenses incurred, as Ortec prepares for commercial sales of its product and continues its financing activities. Interest Expense. Interest expense increased by $2.8 million in the quarter and by $3.6 million in the six months ended June 30, 2002, compared with the expense incurred in the quarter and six months ended June 30, 2001, due to the imputed interest accrued on the Paul Capital agreement, and interest accrued on convertible debentures issued on May 13, 2002. Based on the original $10 million received from Paul Capital and the anticipated revenue stream over the term of this agreement, management anticipates that the effective cost of these funds will range between 20% to 35% per annum and, as such, approximately $1.4 million in interest expense has been accrued in the six months ended June 30, 2002. Interest expense of $0.3 million was accrued as a result of the issuance of convertible debentures on May 13, 2002. Additionally, interest of $1.9 million was recorded due to the beneficial conversion feature and warrants on the convertible preferred stock. 23 Interest Income. Interest income declined by approximately $48,000 in the quarter and $156,000 in the six months ended June 30, 2002 compared with the similar periods in 2001, primarily due to the smaller average cash balances outstanding during 2002 compared with 2001. Liquidity and Capital Resources Since inception (March 12, 1991) through June 30, 2002, we have accumulated a deficit of approximately $71.6 million and we expect to continue to incur substantial operating losses until at least 2003. We have financed our operations primarily through private placements of our common stock, preferred stock and convertible debentures, our initial public offering and the exercise of our publicly traded Class A warrants. From inception to June 30, 2002, we received cash proceeds from the sale of equity securities, net of share issuance expenses, of approximately $51.5 million, we received proceeds from the issuance of convertible debentures of $2.6 million proceeds from issuance of convertible redeemable preferred stock of $1.2 million, and received a total of $10 million from the sale of a percentage interest in our future revenues from the sale of our product in North America. On August 6, 2002, the Company reached an agreement in principle to a non-binding term sheet with Paul Capital. The term sheet provides that Paul Capital would relinquish 70% of its revenue interest in exchange for $7.0 million in Series C Secured Participating Preferred Stock and 500,000 warrants exercisable at a nominal exercise price. This agreement is contingent upon completion of the current financing with H.C. Wainwright. The remaining $3.0 million of the original $10.0 million received from Paul Capital will continue to be treated as Long Term Debt, under the Royalty Interest Assignment Agreement. The Company may 24 incrementally receive up to an additional $15.0 million, but only upon the mutual agreement of both the Company and Paul Capital. For the six months ended June 30, 2002, we used net cash for operating activities of approximately $7.0 million. Cash used in operating activities resulted primarily from our net loss of $12.4 million, offset by depreciation and amortization of approximately $334,000, approximately $3.5 million of non-cash interest expense and an increase in accounts payable and accrued expenses of approximately $1.3 million. In the six months ended June 30, 2002 we invested approximately $322,000 in property, plant, equipment and patent application costs. In January 2002, we received a $1,300,000 line of credit from GE Capital for equipment lease financing on which we financed $268,000 of additional purchases of fixed assets. These proceeds are available to be utilized in financing manufacturing equipment purchases in 2002. In January 2002, we secured a $1,300,000 lease line of credit to be used for the acquisition of additional manufacturing, laboratory and other equipment required to expand our manufacturing capacity. During the six months ended June 30, 2002, we purchased $268,644 of equipment under this financing. We repaid $119,000 on our loans payable and long-term debt during the six months ended June 30, 2002. We did not sell our common stock, but we did receive $4.0 million under our agreement with Paul Capital Royalty Acquisition Fund, L.P. and $3.8 million in our Convertible Debentures and Preferred Stock financing through H.C. Wainwright, as noted above. In December 2001, we entered into a ten-year lease with New Jersey Economic Development Authority ("NJEDA") to lease approximately 58,000 square feet of manufacturing and office space located in North Brunswick, New Jersey. We have reached an agreement with NJEDA to terminate the current lease and enter into a new lease for approximately 26,000 square feet of manufacturing and office space. The new lease will begin on August 1, 2002 and terminate on December 31, 2005, with a 7-year renewal option beyond the initial term. Rent will begin at $14 per square foot on January 1, 2003, the expected occupancy date of these premises, and will incrementally increase to $16 per square foot in 2005. A security deposit of $639,000, which was paid by us on the original lease, will be applied as a security deposit on the new lease. All construction costs advanced to NJEDA for the renovation of the premises, approximately $420,000, will be included as a construction allowance in the new lease and is reflected in the rent base, noted above. Under the August 29, 2001 agreement with Paul Capital, in consideration for the original $10.0 million, Paul Capital received a minimum of 3-1/3% of end user revenues from the sale of the Company's products in the United States, Canada and Mexico. These percentage payments may be further adjusted upward or downward, based on the volume of net sales to end users of the Company's products in those three countries. As of June 30, 2002, the Company estimated that its effective cost of the amounts it received from Paul Capital was 28% per annum, and has accrued interest accordingly. On August 6, 2002, the Company reached an agreement in principle to a non-binding term sheet with Paul Capital. The term sheet provides that Paul Capital would relinquish 70% of its revenue interest in exchange for $7.0 million in Series C Secured Participating Preferred Stock and 500,000 warrants exercisable at a nominal exercise price. This agreement is contingent upon 25 completion of the current financing with H.C. Wainwright. The non-binding terms of the agreement in principle provides that Paul Capital will receive a minimum of 1.125% on end user revenues up to $100 million and 0.6% on revenues in excess of $100 million. Under the August 29, 2001 agreement, beginning on January 1, 2003, Paul Capital will be entitled to receive each year the first proceeds to the Company from end user sales of its products. Such annual amounts Paul Capital will be able to draw in advance will range from $1.5 million in 2003 to $7.5 million in 2005 and thereafter. Based upon the proposed revision to the original contract, prorated amounts of the advance payments will be due in each year of the agreement. The agreement provides for quarterly and annual accountings between Paul Capital and the Company for those advance payments, compared to amounts owed based on actual sales. The remaining $3.0 million of the original $10.0 million received will continue to be treated as Long Term Debt, under the revised Royalty Interest Assignment Agreement. We may incrementally receive another $15 million, but only upon mutual agreement by both Ortec and Paul Capital. In the event of a change in control of Ortec or upon the occurrence of certain other events as defined in the agreement, Paul Capital has the option to put its revenue interest back to us for an amount as provided in the agreement. Ortec also has the option to repurchase Paul Capital's interest upon the occurrence of a change in control of Ortec or a complete divestiture by us of our products, for an amount provided in the agreement. We have granted Paul Capital a security interest in our United States and Canadian patents and trademarks relating to our technology for our product, to secure payments we are required to make to Paul Capital, based on sales generated under the Royalty Revenue Interest Assignment agreement, as described above. The original agreement and the modification to the agreement reached in principle terminate on December 31, 2011, unless terminated earlier by either party, as permitted by the terms of the agreement. 26 On March 27, 2002, we engaged H.C, Wainwright & Co. Inc., an investment banking firm, to act as our financial advisor in connection with raising capital for the Company through debt and/or equity financing. While we can give no assurance of the total amount of financing that will be secured, Wainwright is assisting us in raising financing of approximately $8.5 million. On May 13, 2002, the Company secured the first $2.3 million of this financing, in the form of 12% convertible debentures, which are convertible into common shares at the lesser of $3.36 or the price per share of the equity securities to be issued in an anticipated forthcoming financing. The debentures are due on April 30, 2003. It is expected that these debentures will be converted into equity securities upon the final closing of this financing. As of June 28, 2002, $0.6 million has been converted into redeemable convertible preferred stock. The Company also issued 291,000 stock purchase warrants as part of this May 7, 2002 financing, which are exercisable at $4.50 per share for up to 5 years from the date of grant. On June 28, 2002, an additional $1.5 million of financing was secured, which consists of $1.2 million in convertible preferred stock and $.3 million in 12% convertible debentures, which the Company also expects will be converted into equity securities. The Company also issued 655,000 stock purchase warrants, at an exercise price of $1.875 per common share for a five-year period, as part of the June 28, 2002 financing. Subsequent to June 30, 2002, the Company has raised an additional $0.2 million in convertible debentures, similar to those raised in the May 7, 2002 and June 28, 2002 financings. The Company anticipates continuing its financing efforts with the issuance of its Series B Convertible Preferred Stock. The preferred stock is convertible into common shares at any time at the option of the investor, based on a fixed conversion rate of $1.67 or commencing after January 1, 2003, based on a alternative conversion rate equal to 90% of the average of the five lowest volume weighted average prices for the common stock for the twenty trading days immediately prior to conversion, subject to a floor price. The alternative conversion price is cancelable under certain circumstances, as described below. Conversion is mandatory, upon the occurrence of certain financial events, such as, beginning six months from the date of issue, if the closing bid price of common shares exceeds $3.35 for a period of 20 consecutive trading days, or if within nine months from the date of issue, the Company completes a public offering, raising a minimum of $8 million. In the event that the Company receives a licensing fee or a strategic investment of at least $8.0 million, within six months of closing, the alternative conversion rate is adjusted to the closing rate of the investment or the fixed rate of $1.67, if lower. Similarly, if the Company completes a subsequent public or private financing of a least $5.0 million, within six months of closing, the alternative conversion rate is adjusted to the closing price or the fixed rate of $l.67 if lower. Dividends will be paid in common shares at the rate of 12% in the first year after issue and in either cash or common shares in subsequent years at the election of the Company, until at such time as the preferred stock is converted to common shares. Along with the convertible preferred stock, the Company is also issuing warrants to purchase common shares. The Series A warrants, exercisable at $.001 per share, must be exercised immediately upon closing of the purchase of preferred stock. The Series B-1 warrants are exercisable nine months after closing at $2.00 per share and the Series B-2 warrants are exercisable at $3.00 per share, twelve months after closing. The Company anticipates completing the balance of this financing with H.C. Wainwright in August 2002. Our capital funding requirements will depend on numerous factors, including the progress and magnitude of our research and development programs, preclinical testing and clinical trials, the time involved in obtaining regulatory approvals for commercial sale of our product to treat venous stasis and diabetic foot ulcers, the cost involved in filing and maintaining patent claims, technological advances, competitive and market conditions, our ability to establish and maintain collaborative arrangements, our cost of manufacturing scale up and the cost and effectiveness of commercialization activities and arrangements. We have raised funds in the past through the public or private sale of equity securities, debentures and preferred stocks and through the agreement with Paul Capital. We will need to raise additional funds in the future through public or private financings, collaborative arrangements or from other sources. The success of such efforts will depend in large part upon continuing developments in our clinical trials and upon market conditions. 27 We require substantial funding to continue our research and development activities, clinical trials, manufacturing, sales, distribution and administrative activities. We believe that our cash and cash equivalents on hand at June 30, 2002, (approximately $.8 million) and the anticipated additional financing expected in August 2002 of approximately $5.0 million will enable us to continue our operations until December 2002. On August 5, 2002, we signed a letter of intent with a securities brokerage firm, and expect to complete a $12.0 million follow on public offering before December 31, 2002. We believe that this additional anticipated financing will enable us to continue our operations through the end of 2003. We continue to explore and, as appropriate, enter into discussions with other companies regarding the potential for equity investment, collaborative arrangements, license agreements or other funding programs with us, in exchange for manufacturing, marketing, distribution or other rights to our product. However, we can give no assurance that discussions with other companies will result in any additional investments, collaborative arrangements, agreements or other funding, or that the necessary additional financing through debt or equity financing will be available to us on acceptable terms, if at all. Further, we can give no assurance that any arrangements resulting from these discussions will successfully reduce our funding requirements. If additional funding is not available to us when needed, we may not be able to continue operations. Item 3- Quantitative and Qualitative Disclosures about Market Risk See Note 6 to the financial statements for information regarding the conversion of the Company's convertible notes and redeemable convertible preferred stock. 28 PART II Item 1. Legal Proceedings and Claims 1. The litigation instituted against Ortec, five of its directors, one former director and one officer who is not a director, by Dov Shellef in the United States District Court for the Southern District of New York, was settled in April 2002. In full satisfaction of Mr. Shellef's claims, we issued a three year warrant to Mr. Shellef entitling him to purchase 36,000 shares of Ortec's common stock at an exercise price of $4.50 per share. 2. We have been notified by Columbia University, the landlord of premises 3960 Broadway in New York City, where we maintain our principal offices, laboratory and production facilities, that we have been delinquent in payment of rent. We have recently surrendered approximately 11% of the space occupied by us in that building, and we intend to surrender an additional 11% by the middle of October 2002, as part of our program to reduce spending. We are negotiating a pay out of the remainder of our unpaid obligations to Columbia. Our ability to make such payments is dependent on our ability to secure additional equity financing. 3. ClinTrials Networks, LLC has claimed that we have breached our agreement with ClinTrials which provided for ClinTrials to arrange and manage the FDA mandated clinical trials for use of our OrCel product for the treatment of venous stassis ulcers, and for other services. ClinTrials claims that as a result of such a breach we owe it an unspecified amount, but in excess of $100,000. We have advised ClinTrials that we are not in breach of our contract with it and that in any event ClinTrials is not, under the terms of its contract with us, entitled to recover any damages from us. 4. We have reached an agreement with the New Jersey Economic Development Administration to terminate our lease for approximately 58,000 sq. ft. of production and office space in North Brunswick, New Jersey. We have entered into a new lease with the New Jersey Economic Development Administration for approximately 26,000 sq. ft. of office and laboratory 29 space and future production facilities in one of those same buildings in North Brunswick, New Jersey. Item 2. Changes in Securities (c) Recent Sales of Unregistered Securities 1. In May, June and August 2002, we borrowed from 20 accredited investors an aggregate of $2,758,000. More than 80% of such loans were made to us by institutional investors. We issued notes to those investors for such loans. The notes are payable April 10, 2003, bear interest at the rate of 12% per annum, increasing to 18% per annum on October 10, 2002, payable at the end of each quarter. Payment of interest due June 30, 2002 has been deferred pending completion of an additional $5,000,000 in equity financing which we are now trying to secure. The notes and accrued interest were to be converted into Ortec's equity securities if we completed a sale of our equity securities for a minimum of an additional $5,000,000 by July 12, 2002. Although we only sold $1,200,000 of our equity securities prior to July 13, 2002, we are still in negotiation with some of the note holders and other potential investors to secure additional equity financing. We believe that the note holders will convert their notes into the equity securities we issue in such additional financing on the terms set forth in the notes as if we had completed such additional equity financing by July 12, 2002. The notes provide for conversion of the notes into our equity securities (if we had secured not less than an additional $5,000,00 in equity financing by July 12, 2002) issued in such equity financing, by taking 110% of the principal amount of the notes and 110% of the unpaid accrued interest, and purchasing so many of such equity securities determined by dividing such 110% principal and accrued interest of the note by the purchase price of one equity security in such equity financing. The notes may be converted at the holders' options to shares of our common stock at a conversion rate which is the lower of $3.36 or the price per share of the equity securities in the proposed equity financing described above. However, the notes provide for "price protection" so 30 that the conversion rates at which the notes are convertible to our common stock is reduced if we sell our common stock in the future, or the exercise price or conversion rate of any warrants or options to purchase, or other securities which may be converted into, our common stock, which we may issue in the future, are sold at a price, or are exercisable or convertible at a price, lower than the conversion rate of these notes. The 20 purchasers of the notes were also granted five-year warrants to purchase an aggregate of 344,750 shares of our common stock at an exercise price of $4.50 per share. Like the notes, these warrants also provide "price protection" so that the exercise price is reduced if we sell common stock in the future, or the exercise price or conversion rate of any warrants or options to purchase, or other securities which may be converted into, our common stock, which we may issue in the future, is lower than the exercise price of these warrants. 2. On June 28, 2002, pursuant to the authority granted our directors by our certificate of incorporation, our board of directors unanimously adopted an amendment to our certificate of incorporation designating 2,000 shares out of the 1,000,000 shares of preferred stock we are authorized to issue, as Series A Convertible Preferred Stock, and designating the relative rights and preferences of the Series A Convertible Preferred Stock. The stated value, which is also the Liquidation Preference of the Series A Convertible Preferred Stock, is $10,000 per share. We are required to pay dividends on the Series A Preferred shares, out of our assets legally available therefore, at the rate of 6% per annum of the $10,000 Liquidation Preference per share, through June 30, 2003; at the rate of 9% per annum thereafter until June 30, 2004; and thereafter at the rate of 12% per annum. At our option such dividends may be paid in our common stock at the "conversion price" for the conversion of such preferred shares if such shares of common stock have been registered under the Securities Act of 1933 for sale in the public securities markets. The conversion price is fixed initially at $1.50 per share of our common stock. Commencing nine months after the date of issuance of any shares of Series A Convertible Preferred Stock, the holder may elect to convert its Series A shares plus interest accrued thereon at an "Alternative Conversion Price" which shall be the average of the five lowest volume weighted average prices for our common stock during the 15 days immediately prior to conversion. However, at no time is the 31 Alternative Conversion Price to be less than 50% of the fixed conversion price. The Alternative Conversion Price will be cancelled if within six months of issuance (i) we sell shares of our common stock in a financing in which aggregate cash proceeds are not less than $5,000,000 and the price at which each share is sold is not less than $2.00, or (ii) we receive at least $8,000,000 as an up-front payment for a licensing fee from a third party. There is price protection for the alternative conversion price only so that the alternative conversion price is reduced if we sell shares of our common stock in the future at, or the exercise price of any warrants or options to purchase our common stock which we may grant in the future, or the conversion price for the conversion of other securities (we may issue in the future) to our common stock, is lower than the alternative conversion price for the Series A Preferred shares. We have the right to redeem all or a portion of the outstanding Series A Convertible Preferred Stock by payment of $15,000 per share plus any accrued and unpaid dividends. The holders of the Series A Convertible Preferred Stock may compel us to redeem their shares upon the occurrence of certain events, at $12,000 or $15,000 per Series A Preferred share, plus accrued dividends, depending on the event which triggers the holders' rights to compel redemption. On June 28, 2000 we sold to one institutional investor 187.012 shares of our New Series A Convertible Preferred Stock for a cash investment of $1,200,000 and cancellation of $600,000 of the notes we issued to such investor in May 2002. We also granted five year warrants to such purchaser to purchase an aggregate of 623,374 shares of our common stock at an exercise price of $1.875 per share. Such warrants contain the same type of "price protection" provisions as were contained in the warrants we issued to the 20 accredited investors who acquired our notes described in paragraph 1 above. 3. The notes, the Series A Preferred shares and all of the warrants described in paragraphs numbered 1 and 2 of this Item 2 of Part II, have "blocking" provisions which prevent the issuance of most of the shares of our common stock issuable upon conversion of such notes or Series A Preferred shares, or upon exercise of such warrants, until we secure shareholder approval for the sale of the notes, the Series A Preferred shares and the grant of the warrants. We intend to secure such shareholder approval at the next annual meeting of our shareholders which we intend to schedule for October 2002. If we do not secure such shareholder approval, we will suffer 32 monetary penalties. We also are required to qualify all of the shares of our common stock issuable upon conversion of the notes and the Series A Preferred shares, and/or the exercise of the warrants, for sale in the public securities markets by registering them under the Securities Act of 1933, as amended, and keeping such registration statement in effect for close to two years. Although we have not filed our proxy statement for our annual meeting or the registration statement to qualify such shares of our common stock for sale in the public securities markets within the time required by our agreements and other documents, we believe that the holders of the notes, the Series A Preferred shares and such warrants will participate in our next equity financing and that therefore they will waive the monetary penalties that may be invoked against us for such delays in filing. 4. We are required to grant to the placement agent who arranged for the sale of the notes and the Series A Preferred shares, 5 year warrants to purchase a percentage of the shares of our common stock issuable upon conversion of the notes and the Series A Preferred shares. The terms of the warrants we are to grant to the placement agent, including the exact number of shares of our common stock the placement agent may purchase, and other warrants we will grant to the placement on the completion of the proposed additional financing discussed above, are being negotiated by us and the placement agent. 5. We are also required to grant 3 year warrants to one entity for financial consulting services rendered by that entity to us, to purchase 300,000 shares of our common stock at exercise prices of $3.50 per share for 100,000 shares, at $5.50 per share for the second 100,000 shares and at $7.50 per share for the third 100,000 shares. The warrants vest as to each 100,000 share tranche on June 1, 2002, on December 1, 2002 and on June 1, 2003. We have the right to cancel such financial consulting services agreement on 30 days' notice. If we cancel the agreement, all warrants which did not vest prior to the date of termination of the agreement are cancelled. We have not yet issued such warrants. 6. As noted in paragraph numbered 1 of Item 1 of this Part II, we have granted to Mr. Dov Shellef a three year warrant to purchase 36,000 shares of our common stock at an exercise 33 price of $4.50 per share, in full satisfaction of all claims he has against us or our directors, a former director and a non-director officer, whom he named as defendants in the litigation he instituted against us. 7. The sale of all such notes and Series A Preferred shares, and the grant of all such warrants, as described in paragraphs numbered 1 through 6, both inclusive, of this Item 2 of Part II, were exempt from the registration requirements of the Securities Act of 1933, as amended, pursuant to the provisions of Section 4(2) of the Act, as not involving any public offering, and with respect to the sale of the notes and the Series A Preferred shares, and the warrants granted as part of such sales, pursuant to Regulation D promulgated by the Securities and Exchange Commission under the Act, since all the purchasers represented that they were "accredited investors", as such term is defined in Regulation D. 8. During the second quarter of 2002 we granted to 15 full-time employees and to one consultant options under our Employee Stock Option Plan, expiring in the case of our employees 7 years after the date of grant, and in the case of the consultant 3 years after the date of grant, to purchase an aggregate of 60,500 shares of our common stock, at exercise prices ranging from $1.90 to $5.00 per share. Such grants were in consideration for services rendered to Ortec. The grant of such options was exempt from the registration requirements of the Securities Act of 1933, as amended, pursuant to the provisions of Section 4(2) of the Act, as not involving any public offering. Item 5. Other Information By letter dated June 27, 2002, the staff of the Nasdaq Stock Market, Inc., advised us that we had not met Nasdaq's requirements for continued listing of our common stock on the Nasdaq SmallCap market. On July 1, 2002 we appealed that determination and requested an oral hearing before a Nasdaq Listing Qualification Panel. At that hearing, which was held on August 8, 2002, we asked the panel to defer delisting our common stock for up to six months in order to give 34 us time to complete a plan, which we presented to the panel, to raise sufficient capital to provide for our cash needs for the next twelve months and to enable us to meet Nasdaq's requirements for continued listing of our common stock on the Nasdaq SmallCap market. Our common stock will continue to be listed pending the panel's determination of our request. The notes, the Series A Preferred Shares and the warrants described in paragraphs numbered 1 and 2 of Item 2 of Part II, provide for monetary penalties against us if our common stock is deleted from Nasdaq and is not listed for trading on the Bulletin Board. 35 Item 6. Exhibits and Reports on Form 8-K
(a) Exhibit No. Description ----------- ----------- 3.2 Restated Certificate of Incorporation (2) 3.3 By-Laws (1) 3.4 Amendment to Certificate of Incorporation adopted June 28, 2002, being a Certificate of Designation of the Relative Rights and Preferences of the Series A Convertible Preferred Stock (3) 99.1 Certification of Principal Executive Officer (3) 99.2 Certification of Principal Financial Officer (3)
- --------------------- (1) Filed as an Exhibit to our Registration Statement on Form SB-2 (file No. 33-96090), or Amendment 1 thereto, and incorporated herein by reference. (2) Filed as an Exhibit to our Form 10-Q filed for the quarter ended September 30, 2001, and incorporated herein by reference. (3) Filed herewith. (b) Reports on Form 8-K We did not file any reports on Form 8-K in the second quarter of 2002. 36 SIGNATURES In accordance with Section 13 or 15(d) of the Exchange Act, the registrant has caused this report to be signed on its behalf by the undersigned, thereto duly authorized. Registrant: ORTEC INTERNATIONAL, INC. Date: August 19, 2002 By: /s/ Steven Katz ------------------------------------ Steven Katz, PhD Chairman and Chief Executive Officer (Principal Executive Officer) Date: August 19, 2002 By: /s/ Ron Lipstein ------------------------------------ Ron Lipstein Chief Financial Officer (Principal Financial Officer) 37 STATEMENT OF DIFFERENCES ------------------------ The trademark symbol shall be expressed as............................. 'TM' EX-3 3 ex3-4.txt EXHIBIT 3.4 Exhibit 3.4 CERTIFICATE OF DESIGNATION OF THE RELATIVE RIGHTS AND PREFERENCES OF THE SERIES A CONVERTIBLE PREFERRED STOCK OF ORTEC INTERNATIONAL, INC. The undersigned, the Chief Executive Officer of Ortec International, Inc., a Delaware corporation (the "Company"), in accordance with the provisions of the Delaware General Corporation Law, does hereby certify that, pursuant to the authority conferred upon the Board of Directors by the Certificate of Incorporation of the Company, the following resolution creating a series of Series A Convertible Preferred Stock, was duly adopted on June 28, 2002: RESOLVED, that pursuant to the authority expressly granted to and vested in the Board of Directors of the Company by provisions of the Certificate of Incorporation of the Company (the "Certificate of Incorporation"), there hereby is created out of the shares of Preferred Stock, par value $.001 per share, of the Company authorized in Article IV of the Certificate of Incorporation (the "Preferred Stock,"), a series of Preferred Stock of the Company, to be named "Series A Convertible Preferred Stock," consisting of Two Thousand (2,000) shares, which series shall have the following designations, powers, preferences and relative and other special rights and the following qualifications, limitations and restrictions: 1. Designation and Rank. The designation of such series of the Preferred Stock shall be the Series A Convertible Preferred Stock, par value $.001 per share (the "Series A Preferred Stock"). The maximum number of shares of Series A Preferred Stock shall be Two Thousand (2,000) Shares. The Series A Preferred Stock shall rank prior to the common stock, par value $.001 per share (the "Common Stock"), and to all other classes and series of equity securities of the Company which by its terms does not rank senior to the Series A Preferred Stock ("Junior Stock"). The Series A Preferred Stock shall be subordinate to and rank junior to all indebtedness of the Company now or hereafter outstanding. 2. Dividends. (a) Payment of Dividends. The holders of record of shares of Series A Preferred Stock shall be entitled to receive, out of any assets at the time legally available therefor and when and as declared by the Board of Directors, dividends at the rate of six percent (6%) of the stated Liquidation Preference Amount (as defined below) per share per annum commencing on the Issuance Date through June 30, 2003; at the rate of nine percent (9%) of the stated Liquidation Preference Amount per share per annum from July 1, 2003 through June 30, 2004; and at the rate of twelve percent (12%) of the stated Liquidation Preference Amount per share per annum thereafter (the "Dividend Payment"), and no more, payable at the option of the Company in cash or in shares of Common Stock registered pursuant to an effective registration statement under the Securities Act of 1933, as amended, in an amount equal to the quotient of (i) the Dividend Payment divided by (ii) the Conversion Price (as defined in Section 5(d) below). In the case of shares of Series A Preferred Stock outstanding for less than a full year, dividends shall be pro rated based on the portion of each year during which such shares are outstanding. Dividends on the Series A Preferred Stock shall be cumulative, shall accrue and be payable semi-annually or at conversion of the Series A Preferred Stock, at the option of the Company in cash or into shares of Common Stock. Dividends on the Series A Preferred Stock are prior and in preference to any declaration or payment of any distribution (as defined below) on any outstanding shares of Common Stock or any other equity securities of the Company ranking junior to the Series A Preferred Stock as to the payment of dividends. Such dividends shall accrue on each share of Series A Preferred Stock from day to day whether or not earned or declared so that if such dividends with respect to any previous dividend period at the rate provided for herein have not been paid on, or declared and set apart for, all shares of Series A Preferred Stock at the time outstanding, the deficiency shall be fully paid on, or declared and set apart for, such shares on a pro rata basis with all other equity securities of the Company ranking on a parity with the Series A Preferred Stock as to the payment of dividends before any distribution shall be paid on, or declared and set apart for Common Stock or any other equity securities of the Company ranking junior to the Series A Preferred Stock as to the payment of dividends. (b) So long as any shares of Series A Preferred Stock are outstanding, the Company shall not declare, pay or set apart for payment any dividend or make any distribution on any Junior Stock (other than dividends or distributions payable in additional shares of Junior Stock), unless at the time of such dividend or distribution the Company shall have paid all accrued and unpaid dividends on the outstanding shares of Series A Preferred Stock. (c) In the event of a dissolution, liquidation or winding up of the Company pursuant to Section 4, all accrued and unpaid dividends on the Series A Preferred Stock shall be payable on the day immediately preceding the date of payment of the preferential amount to the holders of Series A Preferred Stock. In the event of (i) a mandatory redemption pursuant to Section 9 or (ii) a redemption upon the occurrence of a Major Transaction (as defined in Section 8(c)) or a Triggering Event (as defined in Section 8(d)), all accrued and unpaid dividends on the Series A Preferred Stock shall be payable on the day immediately preceding the date of such redemption. In the event of a voluntary conversion pursuant to Section 5(a), all accrued and unpaid dividends on the Series A Preferred Stock being converted shall be payable on the day immediately preceding the Voluntary Conversion Date (as defined in Section 5(b)(i)). (d) For purposes hereof, unless the context otherwise requires, "distribution" shall mean the transfer of cash or property without consideration, whether by way of dividend or otherwise, payable other than in shares of Common Stock or other equity securities of the Company, or the purchase or redemption of shares of the Company (other than redemptions set forth in Section 8 below or repurchases of Common Stock held by employees or consultants of the Corporation upon termination of their employment or services pursuant to agreements -2- providing for such repurchase or upon the cashless exercise of options held by employees or consultants) for cash or property. 3. Voting Rights. (a) Class Voting Rights. The Series A Preferred Stock shall have the following class voting rights (in addition to the voting rights set forth in Section 3(b) hereof). So long as any shares of the Series A Preferred Stock remain outstanding, the Company shall not, without the affirmative vote or consent of the holders of at least three-fourths (3/4) of the shares of the Series A Preferred Stock outstanding at the time, given in person or by proxy, either in writing or at a meeting, in which the holders of the Series A Preferred Stock vote separately as a class: (i) authorize, create, issue or increase the authorized or issued amount of any class or series of stock, including but not limited to the issuance of any more shares of previously authorized Common Stock or Preferred Stock, ranking prior to the Series A Preferred Stock, with respect to the distribution of assets on liquidation, dissolution or winding up; (ii) amend, alter or repeal the provisions of the Series A Preferred Stock, whether by merger, consolidation or otherwise, so as to adversely affect any right, preference, privilege or voting power of the Series A Preferred Stock; provided, however, that any creation and issuance of another series of Junior Stock shall not be deemed to adversely affect such rights, preferences, privileges or voting powers; (iii) repurchase, redeem or pay dividends on, shares of the Company's Junior Stock; (iv) amend the Certificate of Incorporation or By-Laws of the Company so as to affect materially and adversely any right, preference, privilege or voting power of the Series A Preferred Stock; provided, however, that any creation and issuance of another series of Junior Stock or any other class or series of equity securities which by its terms shall rank on parity with the Series A Preferred Stock shall not be deemed to materially and adversely affect such rights, preferences, privileges or voting powers; (v) effect any distribution with respect to Junior Stock; or (vi) reclassify the Company's outstanding securities. (b) General Voting Rights. Except with respect to transactions upon which the Series A Preferred Stock shall be entitled to vote separately as a class pursuant to Section 3(a) above and except as otherwise required by Delaware law, the Series A Preferred Stock shall have no voting rights. The Common Stock into which the Series A Preferred Stock is convertible shall, upon issuance, have all of the same voting rights as other issued and outstanding Common Stock of the Company. -3- 4. Liquidation Preference. (a) In the event of the liquidation, dissolution or winding up of the affairs of the Company, whether voluntary or involuntary, after payment or provision for payment of the debts and other liabilities of the Company, the holders of shares of the Series A Preferred Stock then outstanding shall be entitled to receive, out of the assets of the Company whether such assets are capital or surplus of any nature, an amount equal to $10,000 per share (the "Liquidation Preference Amount") of the Series A Preferred Stock plus any accrued and unpaid dividends before any payment shall be made or any assets distributed to the holders of the Common Stock or any other Junior Stock. If the assets of the Company are not sufficient to pay in full the Liquidation Preference Amount plus any accrued and unpaid dividends payable to the holders of outstanding shares of the Series A Preferred Stock and any series of preferred stock or any other class of stock on a parity, as to rights on liquidation, dissolution or winding up, with the Series A Preferred Stock, then all of said assets will be distributed among the holders of the Series A Preferred Stock and the other classes of stock on a parity with the Series A Preferred Stock, if any, ratably in accordance with the respective amounts that would be payable on such shares if all amounts payable thereon were paid in full. The liquidation payment with respect to each outstanding fractional share of Series A Preferred Stock shall be equal to a ratably proportionate amount of the liquidation payment with respect to each outstanding share of Series A Preferred Stock. All payments for which this Section 4(a) provides shall be in cash, property (valued at its fair market value as determined by the Company's independent, outside accountant) or a combination thereof; provided, however, that no cash shall be paid to holders of Junior Stock unless each holder of the outstanding shares of Series A Preferred Stock has been paid in cash the full Liquidation Preference Amount plus any accrued and unpaid dividends to which such holder is entitled as provided herein. After payment of the full Liquidation Preference Amount plus any accrued and unpaid dividends to which each holder is entitled, such holders of shares of Series A Preferred Stock will not be entitled to any further participation as such in any distribution of the assets of the Company. (b) A consolidation or merger of the Company with or into any other corporation or corporations, or a sale of all or substantially all of the assets of the Company, or the effectuation by the Company of a transaction or series of transactions in which more than 50% of the voting shares of the Company is disposed of or conveyed, shall not be deemed to be a liquidation, dissolution, or winding up within the meaning of this Section 4. In the event of the merger or consolidation of the Company with or into another corporation, the Series A Preferred Stock shall maintain its relative powers, designations and preferences provided for herein and no merger shall result inconsistent therewith. (c) Written notice of any voluntary or involuntary liquidation, dissolution or winding up of the affairs of the Company, stating a payment date and the place where the distributable amounts shall be payable, shall be given by mail, postage prepaid, no less than forty-five (45) days prior to the payment date stated therein, to the holders of record of the Series -4- A Preferred Stock at their respective addresses as the same shall appear on the books of the Company. 5. Conversion. The holder of Series A Preferred Stock shall have the following conversion rights (the "Conversion Rights"): (a) Right to Convert. At any time on or after the Issuance Date, the holder of any such shares of Series A Preferred Stock may, at such holder's option, subject to the limitations set forth in Section 7 herein, elect to convert (a "Voluntary Conversion") all or any portion of the shares of Series A Preferred Stock held by such person into a number of fully paid and nonassessable shares of Common Stock (the "Conversion Rate") equal to the quotient of (i) the Liquidation Preference Amount of the shares of Series A Preferred Stock being converted divided by (ii) the Conversion Price (as defined in Section 5(d) below) then in effect as of the date of the delivery by such holder of its notice of election to convert. (b) Mechanics of Voluntary Conversion. The Voluntary Conversion of Series A Preferred Stock shall be conducted in the following manner: (i) Holder's Delivery Requirements. To convert Series A Preferred Stock into full shares of Common Stock on any date (the "Voluntary Conversion Date"), the holder thereof shall (A) transmit by facsimile (or otherwise deliver), for receipt on or prior to 5:00 p.m., New York time on such date, a copy of a fully executed notice of conversion in the form attached hereto as Exhibit I (the "Conversion Notice"), to the Company, and (B) surrender to a common carrier for delivery to the Company as soon as practicable following such Voluntary Conversion Date but in no event later than six (6) business days after such date the original certificates representing the shares of Series A Preferred Stock being converted (or an indemnification undertaking with respect to such shares in the case of their loss, theft or destruction) (the "Preferred Stock Certificates") and the originally executed Conversion Notice. (ii) Company's Response. Upon receipt by the Company of a facsimile copy of a Conversion Notice, the Company shall immediately send, via facsimile, a confirmation of receipt of such Conversion Notice to such holder. Upon receipt by the Company of the Preferred Stock Certificates to be converted pursuant to a Conversion Notice, together with the originally executed Conversion Notice, the Company or its designated transfer agent (the "Transfer Agent"), as applicable, shall, within three (3) business days following the date of receipt by the Company of both, issue and deliver to the Depository Trust Company ("DTC") account on the Holder's behalf via the Deposit Withdrawal Agent Commission System ("DWAC") as specified in the Conversion Notice, registered in the name of the holder or its designee, for the number of shares of Common Stock to which the holder shall be entitled. If the number of shares of Preferred Stock represented by the Preferred Stock Certificate(s) submitted for conversion is greater than the number of shares of Series A Preferred Stock being converted, then the Company shall, as soon as practicable and in no event later than three (3) business days after receipt of the Preferred Stock Certificate(s) and at the Company's expense, issue and deliver -5- to the holder a new Preferred Stock Certificate representing the number of shares of Series A Preferred Stock not converted. (iii) Dispute Resolution. In the case of a dispute as to the arithmetic calculation of the number of shares of Common Stock to be issued upon conversion, the Company shall promptly issue to the holder the number of shares of Common Stock that is not disputed and shall submit the arithmetic calculations to the holder via facsimile as soon as possible, but in no event later than two (2) business days after receipt of such holder's Conversion Notice. If such holder and the Company are unable to agree upon the arithmetic calculation of the number of shares of Common Stock to be issued upon such conversion within one (1) business day of such disputed arithmetic calculation being submitted to the holder, then the Company shall within one (1) business day submit via facsimile the disputed arithmetic calculation of the number of shares of Common Stock to be issued upon such conversion to the Company's independent, outside accountant. The Company shall cause the accountant to perform the calculations and notify the Company and the holder of the results no later than seventy-two (72) hours from the time it receives the disputed calculations. Such accountant's calculation shall be binding upon all parties absent manifest error. The reasonable expenses of such accountant in making such determination shall be paid by the Company, in the event the holder's calculation was correct, or by the holder, in the event the Company's calculation was correct, or equally by the Company and the holder in the event that neither the Company's or the holder's calculation was correct. The period of time in which the Company is required to effect conversions or redemptions under this Certificate of Designation shall be tolled with respect to the subject conversion or redemption pending resolution of any dispute by the Company made in good faith and in accordance with this Section 5(b)(iii). (iv) Record Holder. The person or persons entitled to receive the shares of Common Stock issuable upon a conversion of the Series A Preferred Stock shall be treated for all purposes as the record holder or holders of such shares of Common Stock on the Conversion Date. (v) Company's Failure to Timely Convert. If within three (3) business days of the Company's receipt of the Conversion Notice and the Preferred Stock Certificates to be converted (the "Share Delivery Period") the Company shall fail to issue and deliver to a holder the number of shares of Common Stock to which such holder is entitled upon such holder's conversion of the Series A Preferred Stock or to issue a new Preferred Stock Certificate representing the number of shares of Series A Preferred Stock to which such holder is entitled pursuant to Section 5(b)(ii) (a "Conversion Failure"), in addition to all other available remedies which such holder may pursue hereunder and under the Series A Convertible Preferred Stock Purchase Agreement dated as of June 28, 2002 (the "Purchase Agreement") between the Company and the initial holders of the Series A Preferred Stock (including indemnification pursuant to Section 6 thereof), the Company shall pay additional damages to such holder on each business day after such third (3rd) business day that such conversion is not timely effected in an amount equal 0.5% of the product of (A) the sum of the number of shares of Common Stock not -6- issued to the holder on a timely basis pursuant to Section 5(b)(ii) and to which such holder is entitled and, in the event the Company has failed to deliver a Preferred Stock Certificate to the holder on a timely basis pursuant to Section 5(b)(ii), the number of shares of Common Stock issuable upon conversion of the shares of Series A Preferred Stock represented by such Preferred Stock Certificate, as of the last possible date which the Company could have issued such Preferred Stock Certificate to such holder without violating Section 5(b)(ii) and (B) the Closing Bid Price (as defined in Section 5(d)(vi) below) of the Common Stock on the last possible date which the Company could have issued such Common Stock and such Preferred Stock Certificate, as the case may be, to such holder without violating Section 5(b)(ii). If the Company fails to pay the additional damages set forth in this Section 5(b)(v) within five (5) business days of the date incurred, then such payment shall bear interest at the rate of 2% per month (pro rated for partial months) until such payments are made. (c) Mandatory Conversion. (i) Subject to the Exchange Cap (as defined in Section 7 hereof), each share of Series A Preferred Stock outstanding on the Mandatory Conversion Date shall, automatically and without any action on the part of the holder thereof, convert into a number of fully paid and nonassessable shares of Common Stock equal to the quotient of (i) the Liquidation Preference Amount of the shares of Series A Preferred Stock outstanding on the Mandatory Conversion Date divided by (ii) the Conversion Price in effect on the Mandatory Conversion Date. (ii) As used herein, a "Mandatory Conversion Date" shall be (i) the date which is at least six (6) months after the date of issuance of the Series A Preferred Stock (the "Issuance Date"), provided, that the Closing Bid Price (as defined in Section 5(d)(vi) hereof) of the Common Stock exceeds 200% of the Fixed Conversion Price for a period of twenty (20) consecutive trading days; or (ii) the date which is at least ninety (90) days after the effective date of the registration statement under the Securities Act of 1933, as amended, registering the shares of Common Stock issuable upon conversion of the Series A Preferred Stock (the "Registration Statement"), provided, that the Company completes an underwritten public offering whereby the Company receives gross proceeds of at least $10,000,000 at a price per share of Common Stock no less than an amount equal to 150% of the Fixed Conversion Price (as defined in Section 5(d)(i)); and provided further that in either case of (i) or (ii) above of this Section 5(c)(ii), the Registration Statement is effective or the shares of Common Stock into which the Series A Preferred Stock can be converted may be offered for sale to the public pursuant to Rule 144(k) ("Rule 144(k)") under the Securities Act of 1933, as amended. Notwithstanding the foregoing, the Mandatory Conversion Date shall be extended for as long as (A) the conversion of such share of Preferred Stock would violate Section 7, (B) a Triggering Event (as defined in Section 8(d) hereof) shall have occurred and be continuing or (C) any event shall have occurred and be continuing which with the passage of time and the failure to cure would result in a Triggering Event. The Mandatory Conversion Date and the Voluntary Conversion Date collectively are referred to in this Certificate of Designation as the "Conversion Date." -7- (iii) On the Mandatory Conversion Date, the outstanding shares of Series A Preferred Stock shall be converted automatically without any further action by the holders of such shares and whether or not the certificates representing such shares are surrendered to the Company or its transfer agent; provided, however, that the Company shall not be obligated to issue the shares of Common Stock issuable upon conversion of any shares of Series A Preferred Stock unless certificates evidencing such shares of Series A Preferred Stock are either delivered to the Company or the holder notifies the Company that such certificates have been lost, stolen, or destroyed, and executes an agreement satisfactory to the Company to indemnify the Company from any loss incurred by it in connection therewith. Upon the occurrence of the automatic conversion of the Series A Preferred Stock pursuant to this Section 5, the holders of the Series A Preferred Stock shall surrender the Preferred Stock Certificates representing the Series A Preferred Stock for which the Mandatory Conversion Date has occurred to the Company and the Company shall deliver the shares of Common Stock issuable upon such conversion (in the same manner set forth in Section 5(b)(ii)) to the holder within three (3) business days of the holder's delivery of the applicable Preferred Stock Certificates. (d) Conversion Price. (i) The term "Fixed Conversion Price" shall mean $1.50 per share, which is an amount equal to the average of the Volume Weighted Average Prices (as defined below) for the Company's Common Stock during the three (3) trading days immediately prior to the Issuance Date, subject to adjustment under Section 5(e) hereof. Notwithstanding any adjustment hereunder, at no time shall the Fixed Conversion Price be greater than $1.75 per share. (ii) Commencing nine months after the Issuance Date, the holders of the Series A Preferred Stock may elect to apply an "Alternative Conversion Price", which shall mean the average of the five (5) lowest Volume Weighted Average Prices for the Company's Common Stock during the fifteen (15) trading days immediately prior to conversion, subject to adjustment under Section 5(e) hereof. Notwithstanding any adjustment hereunder, at no time shall the Alternative Conversion Price be less than fifty percent (50%) of the Fixed Conversion Price (the "Alternative Conversion Price Floor"). Additionally, in no event shall the Alternative Conversion Price exceed the Fixed Conversion Price. The Fixed Conversion Price and the Alternative Conversion Price collectively are referred to in this Certificate of Designation as the "Conversion Price." (iii) In the event that the Company (A) consummates a financing within six (6) months of the Issuance Date at a price per share of Common Stock of at least $2.00 and the Company receives aggregate cash proceeds in connection with such financing of at least $5,000,000 or (B) receives a licensing fee from a third party whereby it receives an up-front payment of at least $8,000,000 within six (6) months of the Issuance Date, then in either such case, the Alternative Conversion Price shall be cancelled and shall no longer apply. -8- (iv) In the event that the Company receives a strategic investment, which when combined with a licensing fee received by the Company referred to in Section 5(d)(iii) above, generates at least $8,000,000 in proceeds (a "Strategic Investment"), the Alternative Conversion Price Floor shall be adjusted to equal the purchase price per share of Common Stock issued in the Strategic Investment. (v) The term "Volume Weighted Average Price" shall mean the daily volume weighted average price (based on a trading day from 9:30 a.m. to 4:00 p.m., eastern time) of the Common Stock of the Company on the Nasdaq SmallCap Market (or any successor thereto) as reported by Bloomberg Financial LP using the AQR function. (vi) The term "Closing Bid Price" shall mean, for any security as of any date, the last closing bid price of such security in the Nasdaq SmallCap Market for such security as reported by Bloomberg, or, if no closing bid price is reported for such security by Bloomberg, the last closing trade price of such security as reported by Bloomberg, or, if no last closing trade price is reported for such security by Bloomberg, the average of the bid prices of any market makers for such security as reported in the "pink sheets" by the National Quotation Bureau, Inc. If the Closing Bid Price cannot be calculated for such security on such date on any of the foregoing bases, the Closing Bid Price of such security on such date shall be the fair market value as mutually determined by the Company and the holders of a majority of the outstanding shares of Series A Preferred Stock. (e) Adjustments of Conversion Price. (i) Adjustments for Stock Splits and Combinations. If the Company shall at any time or from time to time after the Issuance Date, effect a stock split of the outstanding Common Stock, the Conversion Price shall be proportionately decreased. If the Company shall at any time or from time to time after the Issuance Date, combine the outstanding shares of Common Stock, the Conversion Price shall be proportionately increased. Any adjustments under this Section 5(e)(i) shall be effective at the close of business on the date the stock split or combination occurs. (ii) Adjustments for Certain Dividends and Distributions. If the Company shall at any time or from time to time after the Issuance Date, make or issue or set a record date for the determination of holders of Common Stock entitled to receive a dividend or other distribution payable in shares of Common Stock, then, and in each event, the Conversion Price shall be decreased as of the time of such issuance or, in the event such record date shall have been fixed, as of the close of business on such record date, by multiplying, as applicable, the Conversion Price then in effect by a fraction: (1) the numerator of which shall be the total number of shares of Common Stock issued and outstanding immediately prior to the time of such issuance or the close of business on such record date; and -9- (2) the denominator of which shall be the total number of shares of Common Stock issued and outstanding immediately prior to the time of such issuance or the close of business on such record date plus the number of shares of Common Stock issuable in payment of such dividend or distribution. (iii) Adjustment for Other Dividends and Distributions. If the Company shall at any time or from time to time after the Issuance Date, make or issue or set a record date for the determination of holders of Common Stock entitled to receive a dividend or other distribution payable in securities of the Company other than shares of Common Stock, then, and in each event, an appropriate revision to the applicable Conversion Price shall be made and provision shall be made (by adjustments of the Conversion Price or otherwise) so that the holders of Series A Preferred Stock shall receive upon conversions thereof, in addition to the number of shares of Common Stock receivable thereon, the number of securities of the Company which they would have received had their Series A Preferred Stock been converted into Common Stock on the date of such event and had thereafter, during the period from the date of such event to and including the Conversion Date, retained such securities (together with any distributions payable thereon during such period), giving application to all adjustments called for during such period under this Section 5(e)(iii) with respect to the rights of the holders of the Series A Preferred Stock. (iv) Adjustments for Reclassification, Exchange or Substitution. If the Common Stock issuable upon conversion of the Series A Preferred Stock at any time or from time to time after the Issuance Date shall be changed to the same or different number of shares of any class or classes of stock, whether by reclassification, exchange, substitution or otherwise (other than by way of a stock split or combination of shares or stock dividends provided for in Sections 5(e)(i), (ii) and (iii), or a reorganization, merger, consolidation, or sale of assets provided for in Section 5(e)(v)), then, and in each event, an appropriate revision to the Conversion Price shall be made and provisions shall be made (by adjustments of the Conversion Price or otherwise) so that the holder of each share of Series A Preferred Stock shall have the right thereafter to convert such share of Series A Preferred Stock into the kind and amount of shares of stock and other securities receivable upon reclassification, exchange, substitution or other change, by holders of the number of shares of Common Stock into which such share of Series A Preferred Stock might have been converted immediately prior to such reclassification, exchange, substitution or other change, all subject to further adjustment as provided herein. (v) Adjustments for Reorganization, Merger, Consolidation or Sales of Assets. If at any time or from time to time after the Issuance Date there shall be a capital reorganization of the Company (other than by way of a stock split or combination of shares or stock dividends or distributions provided for in Section 5(e)(i), (ii) and (iii), or a reclassification, exchange or substitution of shares provided for in Section 5(e)(iv)), or a merger or consolidation of the Company with or into another corporation, or the sale of all or substantially all of the Company's properties or assets to any other person (an "Organic Change"), then as a part of such -10- Organic Change an appropriate revision to the Conversion Price shall be made and provision shall be made (by adjustments of the Conversion Price or otherwise) so that the holder of each share of Series A Preferred Stock shall have the right thereafter to convert such share of Series A Preferred Stock into the kind and amount of shares of stock and other securities or property of the Company or any successor corporation resulting from Organic Change. In any such case, appropriate adjustment shall be made in the application of the provisions of this Section 5(e)(v) with respect to the rights of the holders of the Series A Preferred Stock after the Organic Change to the end that the provisions of this Section 5(e)(v) (including any adjustment in the Conversion Price then in effect and the number of shares of stock or other securities deliverable upon conversion of the Series A Preferred Stock) shall be applied after that event in as nearly an equivalent manner as may be practicable. (vi) Adjustments for Issuance of Additional Shares of Common Stock. (A) In the event the Company, shall, at any time, from time to time, issue or sell any additional shares of Common Stock (otherwise than as provided in the foregoing subsections (i) through (v) of this Section 5(e) or pursuant to Common Stock Equivalents (hereafter defined) granted or issued prior to the Issuance Date) (the "Additional Shares of Common Stock"), at a price per share less than the Alternative Conversion Price Floor, or without consideration, the Alternative Conversion Price Floor then in effect shall be reduced to a price equal to the consideration per share paid for such Additional Shares of Common Stock. (B) The provisions of paragraph (A) of Section 5(e)(vi) shall not apply to any issuance of Additional Shares of Common Stock for which an adjustment is provided under Section 5(e)(i), 5(e)(ii), 5(e)(iii) or 5(e)(iv). No adjustment of the number of shares of Common Stock shall be made under paragraph (A) of Section 5(e)(vi) upon the issuance of any Additional Shares of Common Stock which are issued pursuant to the exercise of any warrants or other subscription or purchase rights or pursuant to the exercise of any conversion or exchange rights in any Common Stock Equivalents (as defined below), if any such adjustment shall previously have been made upon the issuance of such warrants or other rights or upon the issuance of such Common Stock Equivalents (or upon the issuance of any warrant or other rights therefor) pursuant to Section 5(e)(vii). (vii) Issuance of Common Stock Equivalents. If the Company, at any time after the Issuance Date, shall issue any securities convertible into or exchangeable for, directly or indirectly, Common Stock ("Convertible Securities"), other than the Series A Preferred Stock, or any rights or warrants or options to purchase any such Common Stock or Convertible Securities, shall be issued or sold (collectively, the "Common Stock Equivalents") and the aggregate of the price per share for which Additional Shares of Common Stock may be issuable thereafter pursuant to such Common Stock Equivalent, plus the consideration received by the Company for issuance of such Common Stock Equivalent divided by the number of shares of Common Stock issuable pursuant to such Common Stock Equivalent (the "Aggregate Per Common Share Price") shall be less than the Alternative Conversion Price Floor, or if, after -11- any such issuance of Common Stock Equivalents, the price per share for which Additional Shares of Common Stock may be issuable thereafter is amended or adjusted, and such price as so amended shall make the Aggregate Per Common Share Price be less than Alternative Conversion Price Floor in effect at the time of such amendment, then the Alternative Conversion Price then in effect shall be reduced to a price equal to the Aggregate Per Common Share Price. No adjustment of the Alternate Conversion Price shall be made under this subsection (vii) upon the issuance of any Convertible Security which is issued pursuant to the exercise of any warrants or other subscription or purchase rights therefor, if any adjustment shall previously have been made to the exercise price of such warrants then in effect upon the issuance of such warrants or other rights pursuant to this subsection (vii). If no adjustment is required under this subsection (vii) upon issuance of any Common Stock Equivalent or once an adjustment is made under this subsection (vii) based upon the Per Share Market Value in effect on the date of such adjustment, no further adjustment shall be made under this subsection (vii) based solely upon a change in the Per Share Market Value after such date. (viii) Consideration for Stock. In case any shares of Common Stock or Convertible Securities other than the Series A Preferred Stock, or any rights or warrants or options to purchase any such Common Stock or Convertible Securities, shall be issued or sold: (1) in connection with any merger or consolidation in which the Company is the surviving corporation (other than any consolidation or merger in which the previously outstanding shares of Common Stock of the Company shall be changed to or exchanged for the stock or other securities of another corporation), the amount of consideration therefore shall be, deemed to be the fair value, as determined reasonably and in good faith by the Board of Directors of the Company, of such portion of the assets and business of the nonsurviving corporation as such Board may determine to be attributable to such shares of Common Stock, Convertible Securities, rights or warrants or options, as the case may be; or (2) in the event of any consolidation or merger of the Company in which the Company is not the surviving corporation or in which the previously outstanding shares of Common Stock of the Company shall be changed into or exchanged for the stock or other securities of another corporation, or in the event of any sale of all or substantially all of the assets of the Company for stock or other securities of any corporation, the Company shall be deemed to have issued a number of shares of its Common Stock for stock or securities or other property of the other corporation computed on the basis of the actual exchange ratio on which the transaction was predicated, and for a consideration equal to the fair market value on the date of such transaction of all such stock or securities or other property of the other corporation. If any such calculation results in adjustment of the applicable Conversion Price, or the number of shares of Common Stock issuable upon conversion of the Series A Preferred Stock, the determination of the applicable Conversion Price or the number of shares of Common Stock issuable upon conversion of the Series A Preferred Stock immediately prior to such merger, consolidation or sale, shall be made after giving effect to such adjustment of the number of shares of Common Stock issuable upon conversion of the Series A Preferred Stock. -12- (ix) Record Date. In case the Company shall take record of the holders of its Common Stock or any other Preferred Stock for the purpose of entitling them to subscribe for or purchase Common Stock or Convertible Securities, then the date of the issue or sale of the shares of Common Stock shall be deemed to be such record date. (x) Certain Issues Excepted. Anything herein to the contrary notwithstanding, the Company shall not be required to make any adjustment of the Conversion Price of shares of Common Stock issuable upon conversion of the Series A Preferred Stock upon (i) the Company's issuance of any Additional Shares of Common Stock in connection with a merger and/or acquisition, consolidation, sale or disposition of all or substantially all of the Company's assets, (ii) the Company's issuance of Additional Shares of Common Stock in connection with strategic license agreements so long as such issuances are not for the purpose of raising capital, (iii) the Company's issuance of Additional Shares of Common Stock in connection with a public offering of its Securities, (iv) the Company's issuance of Common Stock or the issuance or grants of options to purchase Common Stock pursuant to the Company's stock option plans and employee stock purchase plans as they now exist, or (v) any transaction where the first use of proceeds from such transaction would be used to redeem all of the Preferred Shares in accordance with Section 8(h) of this Certificate of Designation. (f) No Impairment. The Company shall not, by amendment of its Certificate of Incorporation or through any reorganization, transfer of assets, consolidation, merger, dissolution, issue or sale of securities or any other voluntary action, avoid or seek to avoid the observance or performance of any of the terms to be observed or performed hereunder by the Company, but will at all times in good faith, assist in the carrying out of all the provisions of this Section 5 and in the taking of all such action as may be necessary or appropriate in order to protect the Conversion Rights of the holders of the Series A Preferred Stock against impairment. In the event a holder shall elect to convert any shares of Series A Preferred Stock as provided herein, the Company cannot refuse conversion based on any claim that such holder or any one associated or affiliated with such holder has been engaged in any violation of law, unless, an injunction from a court, on notice, restraining and/or adjoining conversion of all or of said shares of Series A Preferred Stock shall have been issued and the Company posts a surety bond for the benefit of such holder in the amount of the difference between the Conversion Price and the Closing Bid Price on the trading day preceding the date of the attempted conversion multiplied by the number of shares of Series A Preferred Stock sought to be converted, which bond shall remain in effect until the completion of arbitration/litigation of the dispute and the proceeds of which shall be payable to such holder in the event it obtains judgment. (g) Certificates as to Adjustments. Upon occurrence of each adjustment or readjustment of the Conversion Price or number of shares of Common Stock issuable upon conversion of the Series A Preferred Stock pursuant to this Section 5, the Company at its expense shall promptly compute such adjustment or readjustment in accordance with the terms hereof and furnish to each holder of such Series A Preferred Stock a certificate setting forth such -13- adjustment and readjustment, showing in detail the facts upon which such adjustment or readjustment is based. The Company shall, upon written request of the holder of such affected Series A Preferred Stock, at any time, furnish or cause to be furnished to such holder a like certificate setting forth such adjustments and readjustments, the Conversion Price in effect at the time, and the number of shares of Common Stock and the amount, if any, of other securities or property which at the time would be received upon the conversion of a share of such Series A Preferred Stock. Notwithstanding the foregoing, the Company shall not be obligated to deliver a certificate unless such certificate would reflect an increase or decrease of at least one percent of such adjusted amount. (h) Issue Taxes. The Company shall pay any and all issue and other taxes, excluding federal, state or local income taxes, that may be payable in respect of any issue or delivery of shares of Common Stock on conversion of shares of Series A Preferred Stock pursuant thereto; provided, however, that the Company shall not be obligated to pay any transfer taxes resulting from any transfer requested by any holder in connection with any such conversion. (i) Notices. All notices and other communications hereunder shall be in writing and shall be deemed given if delivered personally or by facsimile or three (3) business days following being mailed by certified or registered mail, postage prepaid, return-receipt requested, addressed to the holder of record at its address appearing on the books of the Company. The Company will give written notice to each holder of Series A Preferred Stock at least twenty (20) days prior to the date on which the Company closes its books or takes a record (I) with respect to any dividend or distribution upon the Common Stock, (II) with respect to any pro rata subscription offer to holders of Common Stock or (III) for determining rights to vote with respect to any Organic Change, dissolution, liquidation or winding-up and in no event shall such notice be provided to such holder prior to such information being made known to the public. The Company will also give written notice to each holder of Series A Preferred Stock at least twenty (20) days prior to the date on which any Organic Change, dissolution, liquidation or winding-up will take place and in no event shall such notice be provided to such holder prior to such information being made known to the public. (j) Fractional Shares. No fractional shares of Common Stock shall be issued upon conversion of the Series A Preferred Stock. In lieu of any fractional shares to which the holder would otherwise be entitled, the Company shall pay cash equal to the product of such fraction multiplied by the average of the Closing Bid Prices of the Common Stock for the five (5) consecutive trading immediately preceding the Voluntary Conversion Date or Mandatory Conversion Date, as applicable. (k) Reservation of Common Stock. The Company shall, so long as any shares of Series A Preferred Stock are outstanding, reserve and keep available out of its authorized and unissued Common Stock, solely for the purpose of effecting the conversion of the Series A Preferred Stock, such number of shares of Common Stock as shall from time to time be -14- sufficient to effect the conversion of all of the Series A Preferred Stock then outstanding; provided that the number of shares of Common Stock so reserved shall at no time be less than 200% of the number of shares of Common Stock for which the shares of Series A Preferred Stock are at any time convertible. The initial number of shares of Common Stock reserved for conversions of the Series A Preferred Stock and each increase in the number of shares so reserved shall be allocated pro rata among the holders of the Series A Preferred Stock based on the number of shares of Series A Preferred Stock held by each holder at the time of issuance of the Series A Preferred Stock or increase in the number of reserved shares, as the case may be. In the event a holder shall sell or otherwise transfer any of such holder's shares of Series A Preferred Stock, each transferee shall be allocated a pro rata portion of the number of reserved shares of Common Stock reserved for such transferor. Any shares of Common Stock reserved and which remain allocated to any person or entity which does not hold any shares of Series A Preferred Stock shall be allocated to the remaining holders of Series A Preferred Stock, pro rata based on the number of shares of Series A Preferred Stock then held by such holder. The Company shall, from time to time in accordance with the Delaware General Corporation Law, as amended, increase the authorized number of shares of Common Stock if at any time the unissued number of authorized shares shall not be sufficient to satisfy the Company's obligations under this Section 5(k). (l) Retirement of Series A Preferred Stock. Conversion of Series A Preferred Stock shall be deemed to have been effected on the applicable Voluntary Conversion Date or Mandatory Conversion Date, and such date is referred to herein as the "Conversion Date". Upon conversion of only a portion of the number of shares of Series A Preferred Stock represented by a certificate surrendered for conversion, the Company shall issue and deliver to such holder at the expense of the Company, a new certificate covering the number of shares of Series A Preferred Stock representing the unconverted portion of the certificate so surrendered as required by Section 5(b)(ii). (m) Regulatory Compliance. If any shares of Common Stock to be reserved for the purpose of conversion of Series A Preferred Stock require registration or listing with or approval of any governmental authority, stock exchange or other regulatory body under any federal or state law or regulation or otherwise before such shares may be validly issued or delivered upon conversion, the Company shall, at its sole cost and expense, in good faith and as expeditiously as possible, endeavor to secure such registration, listing or approval, as the case may be. 6. No Preemptive Rights. Except as provided in Section 5 hereof and in the Purchase Agreement, no holder of the Series A Preferred Stock shall be entitled to rights to subscribe for, purchase or receive any part of any new or additional shares of any class, whether now or hereinafter authorized, or of bonds or debentures, or other evidences of indebtedness convertible into or exchangeable for shares of any class, but all such new or additional shares of any class, or any bond, debentures or other evidences of indebtedness convertible into or exchangeable for shares, may be issued and disposed of by the Board of Directors on such terms -15- and for such consideration (to the extent permitted by law), and to such person or persons as the Board of Directors in their absolute discretion may deem advisable. 7. Conversion Restrictions. (a) Notwithstanding any other provision herein, the Company shall not be obligated to issue any shares of Common Stock upon conversion of the Series A Preferred Stock if the issuance of such shares of Common Stock would exceed that number of shares of Common Stock which the Company may issue upon conversion of the Series A Preferred Stock (the "Exchange Cap") without breaching the Company's obligations under the rules or regulations of The Nasdaq Stock Market, Inc. or any Alternative Exchange, except that such limitation shall not apply in the event that the Company (a) obtains the approval of its stockholders as required by applicable rules of The Nasdaq Stock Market, Inc. or any Alternative Exchange, for issuances of Common Stock in excess of such amount (the "Shareholder Approval") or (b) obtains a written opinion from outside counsel to the Company that such approval is not required, which opinion shall be reasonably satisfactory to the holders of a majority of the shares of Series A Preferred Stock then outstanding; provided, however, that notwithstanding anything herein to the contrary, the Company, will issue such number of shares of Common Stock issuable upon conversion of the Series A Preferred Stock at the then current Conversion Price up to the Exchange Cap. If the conversion of any shares of Series A Preferred Stock would result in the issuance of Common Stock which in the aggregate would equal or exceed the Exchange Cap, the Company shall within forty-five (45) days of such conversion request, (i) call a meeting of its stockholders in order to seek the Shareholder Approval as required by the applicable rules or regulations of Nasdaq or the Alternative Exchange, as applicable (the "Stockholders Meeting"), which Stockholders Meeting shall take place within one hundred ninety (90) days of the conversion request and (ii) file a proxy statement with the Securities and Exchange Commission. Until such approval or written opinion is obtained, no holder of Series A Convertible Preferred Stock pursuant to the Purchase Agreement shall be issued, upon conversion of shares of Series A Preferred Stock, shares of Common Stock in an amount greater than the product of (i) the Exchange Cap amount multiplied by (ii) a fraction, the numerator of which is the number of shares of Series A Preferred Stock issued to such holder pursuant to the Purchase Agreement and the denominator of which is the aggregate amount of all the shares of Series A Preferred Stock issued to the holders pursuant to the Purchase Agreement (the "Cap Allocation Amount"). In the event that any holder of Series A Preferred Stock shall convert all of such holder's shares of Series A Preferred Stock into a number of shares of Common Stock which, in the aggregate, is less than such holder's Cap Allocation Amount, then the difference between such holder's Cap Allocation Amount and the number of shares of Common Stock actually issued to such holder shall be allocated to the respective Cap Allocation Amounts of the remaining holders of Series A Preferred Stock on a pro rata basis in proportion to the number of shares of Series A Preferred Stock then held by each such holder. If the Company obtains the Shareholder Approval, the Company shall be obligated to issue upon conversion of the Series A Preferred Stock, in the aggregate, shares of Common Stock in excess of the Exchange Cap. If the Company fails to obtain the Shareholder Approval or call the Stockholder Meeting within the time period set forth -16- herein, any holder of Series A Preferred Stock may exercise its rights pursuant to Section 9(a) hereof. Nothing in this Section 7(a) shall limit a holder's right to request conversion of its shares of Series A Preferred Stock or such holder's rights under Section 9 hereof. (b) Notwithstanding anything to the contrary set forth in Section 5 of this Certificate of Designation, at no time may a holder of shares of Series A Preferred Stock convert shares of the Series A Preferred Stock if the number of shares of Common Stock to be issued pursuant to such conversion would exceed, when aggregated with all other shares of Common Stock owned by such holder at such time, the number of shares of Common Stock which would result in such holder owning more than 4.99% of all of the Common Stock outstanding at such time; provided, however, that upon a holder of Series A Preferred Stock providing the Company with sixty-one (61) days notice (pursuant to Section 5(i) hereof) (the "Waiver Notice") that such holder would like to waive Section 7(b) of this Certificate of Designation with regard to any or all shares of Common Stock issuable upon conversion of Series A Preferred Stock, this Section 7(b) shall be of no force or effect with regard to those shares of Series A Preferred Stock referenced in the Waiver Notice; provided, further, that this provision shall be of no further force or effect during the sixty-one (61) days immediately preceding the Mandatory Conversion Date. (c) Notwithstanding anything to the contrary set forth in Section 5 of this Certificate of Designation, at no time may a holder of shares of Series A Preferred Stock convert shares of the Series A Preferred Stock if the number of shares of Common Stock to be issued pursuant to such conversion would exceed, when aggregated with all other shares of Common Stock owned by such holder at such time, would result in such holder beneficially owning (as determined in accordance with Section 13(d) of the Securities Exchange Act of 1934, as amended, and the rules thereunder) in excess of 9.999% of the then issued and outstanding shares of Common Stock outstanding at such time; provided, however, that upon a holder of Series A Preferred Stock providing the Company with a Waiver Notice that such holder would like to waive Section 7(c) of this Certificate of Designation with regard to any or all shares of Common Stock issuable upon conversion of Series A Preferred Stock, this Section 7(c) shall be of no force or effect with regard to those shares of Series A Preferred Stock referenced in the Waiver Notice; provided, further, that this provision shall be of no further force or effect during the sixty-one (61) days immediately preceding the Mandatory Conversion Date. 8. Redemption. (a) Redemption Option Upon Major Transaction. In addition to all other rights of the holders of Series A Preferred Stock contained herein, simultaneous with the occurrence of a Major Transaction (as defined below), each holder of Series A Preferred Stock shall have the right, at such holder's option, to require the Company to redeem all or a portion of such holder's shares of Series A Preferred Stock at a price per share of Series A Preferred Stock equal to the greater of (i) 120% of the Liquidation Preference Amount plus any accrued but unpaid dividends and liquidated damages and (ii) the product of (A) the Conversion Rate and (B) -17- the Closing Bid Price of the Common Stock on the trading date immediately preceding such Major Transaction (the "Major Transaction Redemption Price"). (b) Redemption Option Upon Triggering Event. In addition to all other rights of the holders of Series A Preferred Stock contained herein, after a Triggering Event (as defined below), each holder of Series A Preferred Stock shall have the right, at such holder's option, to require the Company to redeem all or a portion of such holder's shares of Series A Preferred Stock at a price per share of Series A Preferred Stock equal to the greater of (i) 150% of the Liquidation Preference Amount plus any accrued but unpaid dividends and liquidated damages for a period of eighteen (18) months following the date hereof and 200% of the Liquidation Preference Amount plus any accrued but unpaid dividends and liquidated damages after such eighteen (18) month period and (ii) the product of (A) the Conversion Rate (as defined in Section 5(a)) at such time and (B) the Closing Bid Price of the Common Stock calculated as of the date immediately preceding such Triggering Event on which the exchange or market on which the Common Stock is traded is open (the "Triggering Event Redemption Price" and, collectively with the "Major Transaction Redemption Price," the "Redemption Price"). (c) "Major Transaction". A "Major Transaction" shall be deemed to have occurred at such time as any of the following events: (i) the consolidation, merger or other business combination of the Company with or into another Person (other than (A) pursuant to a migratory merger effected solely for the purpose of changing the jurisdiction of incorporation of the Company or (B) a consolidation, merger or other business combination in which holders of the Company's voting power immediately prior to the transaction continue after the transaction to hold, directly or indirectly, the voting power of the surviving entity or entities necessary to elect a majority of the members of the board of directors (or their equivalent if other than a corporation) of such entity or entities). (ii) the sale or transfer of all or substantially all of the Company's assets; or (iii) consummation of a purchase, tender or exchange offer made to the holders of more than 30% of the outstanding shares of Common Stock. (d) "Triggering Event". A "Triggering Event" shall be deemed to have occurred at such time as any of the following events: (i) so long as any shares of Series A Preferred Stock are outstanding, the effectiveness of the Registration Statement lapses for any reason (including, without limitation, the issuance of a stop order) or is unavailable to the holder of the Series A Preferred Stock for sale of the shares of Common Stock, and such lapse or unavailability continues for a period of ten consecutive trading days, and the shares of Common Stock into which such holder's -18- Series A Preferred Stock can be converted cannot be sold in the public securities market pursuant to Rule 144(k), provided that the cause of such lapse or unavailability is not due to factors solely within the control of such holder of Series A Preferred Stock; (ii) the suspension from listing or the failure of the Common Stock to be listed on the Nasdaq SmallCap Market, the OTC Bulletin Board, The New York Stock Exchange, Inc. or The American Stock Exchange, Inc., for a period of five (5) consecutive days; (iii) the Company's notice to any holder of Series A Preferred Stock, including by way of public announcement, at any time, of its inability to comply (including for any of the reasons described in Section 9) or its intention not to comply with proper requests for conversion of any Series A Preferred Stock into shares of Common Stock; (iv) the Company's failure to comply with a Conversion Notice tendered in accordance with the provisions of this Certificate of Designation within ten (10) business days after the receipt by the Company of the Conversion Notice and the Preferred Stock Certificates; or (v) the Company breaches any representation, warranty, covenant or other term or condition of the Purchase Agreement, this Certificate of Designation or any other agreement, document, certificate or other instrument delivered in connection with the transactions contemplated thereby or hereby, except to the extent that such breach would not have a Material Adverse Effect (as defined in the Purchase Agreement) and except, in the case of a breach of a covenant which is curable, only if such breach continues for a period of a least ten (10) days. (e) Mechanics of Redemption at Option of Buyer Upon Major Transaction. No sooner than fifteen (15) days nor later than ten (10) days prior to the consummation of a Major Transaction, but not prior to the public announcement of such Major Transaction, the Company shall deliver written notice thereof via facsimile and overnight courier ("Notice of Major Transaction") to each holder of Series A Preferred Stock. At any time after receipt of a Notice of Major Transaction (or, in the event a Notice of Major Transaction is not delivered at least ten (10) days prior to a Major Transaction, at any time within ten (10) days prior to a Major Transaction), any holder of Series A Preferred Stock then outstanding may require the Company to redeem, effective immediately prior to the consummation of such Major Transaction, all of the holder's Series A Preferred Stock then outstanding by delivering written notice thereof via facsimile and overnight courier ("Notice of Redemption at Option of Buyer Upon Major Transaction") to the Company, which Notice of Redemption at Option of Buyer Upon Major Transaction shall indicate (i) the number of shares of Series A Preferred Stock that such holder is electing to redeem and (ii) the applicable Major Transaction Redemption Price, as calculated pursuant to Section 8(a) above. (f) Mechanics of Redemption at Option of Buyer Upon Triggering Event. Within one (1) day after the occurrence of a Triggering Event, the Company shall deliver written -19- notice thereof via facsimile and overnight courier ("Notice of Triggering Event") to each holder of Series A Preferred Stock. At any time after the earlier of a holder's receipt of a Notice of Triggering Event and such holder becoming aware of a Triggering Event, any holder of Series A Preferred Stock then outstanding may require the Company to redeem all of the Series A Preferred Stock by delivering written notice thereof via facsimile and overnight courier ("Notice of Redemption at Option of Buyer Upon Triggering Event") to the Company, which Notice of Redemption at Option of Buyer Upon Triggering Event shall indicate (i) the number of shares of Series A Preferred Stock that such holder is electing to redeem and (ii) the applicable Triggering Event Redemption Price, as calculated pursuant to Section 8(b) above. (g) Payment of Redemption Price. Upon the Company's receipt of a Notice(s) of Redemption at Option of Buyer Upon Triggering Event or a Notice(s) of Redemption at Option of Buyer Upon Major Transaction from any holder of Series A Preferred Stock, the Company shall immediately notify each holder of Series A Preferred Stock by facsimile of the Company's receipt of such Notice(s) of Redemption at Option of Buyer Upon Triggering Event or Notice(s) of Redemption at Option of Buyer Upon Major Transaction and each holder which has sent such a notice shall promptly submit to the Company such holder's Preferred Stock Certificates which such holder has elected to have redeemed. The Company shall have the sole option to pay the Redemption Price in cash or shares of Common Stock in accordance with Sections 8(a) and (b) of this Certificate of Designation. The Company shall deliver the applicable Major Transaction Redemption Price immediately prior to the consummation of the Major Transaction; provided that a holder's Preferred Stock Certificates shall have been so delivered to the Company; provided further that if the Company is unable to redeem all of the Series A Preferred Stock to be redeemed, the Company shall redeem an amount from each holder of Series A Preferred Stock being redeemed equal to such holder's pro-rata amount (based on the number of shares of Series A Preferred Stock held by such holder relative to the number of shares of Series A Preferred Stock outstanding) of all Series A Preferred Stock being redeemed. If the Company shall fail to redeem all of the Series A Preferred Stock submitted for redemption (other than pursuant to a dispute as to the arithmetic calculation of the Redemption Price), in addition to any remedy such holder of Series A Preferred Stock may have under this Certificate of Designation and the Purchase Agreement, the applicable Redemption Price payable in respect of such unredeemed Series A Preferred Stock shall bear interest at the rate of 2.0% per month (prorated for partial months) until paid in full. Until the Company pays such unpaid applicable Redemption Price in full to a holder of shares of Series A Preferred Stock submitted for redemption, such holder shall have the option (the "Void Optional Redemption Option") to, in lieu of redemption, require the Company to promptly return to such holder(s) all of the shares of Series A Preferred Stock that were submitted for redemption by such holder(s) under this Section 8 and for which the applicable Redemption Price has not been paid, by sending written notice thereof to the Company via facsimile (the "Void Optional Redemption Notice"). Upon the Company's receipt of such Void Optional Redemption Notice(s) and prior to payment of the full applicable Redemption Price to such holder, (i) the Notice(s) of Redemption at Option of Buyer Upon Major Transaction shall be null and void with respect to those shares of Series A Preferred Stock submitted for redemption and for which the applicable Redemption Price has not been -20- paid, (ii) the Company shall immediately return any Series A Preferred Stock submitted to the Company by each holder for redemption under this Section 8(d) and for which the applicable Redemption Price has not been paid and (iii) the Conversion Price of such returned shares of Series A Preferred Stock shall be adjusted to the lesser of (A) the Conversion Price and (B) the lowest Closing Bid Price during the period beginning on the date on which the Notice(s) of Redemption of Option of Buyer Upon Major Transaction is delivered to the Company and ending on the date on which the Void Optional Redemption Notice(s) is delivered to the Company; provided that no adjustment shall be made if such adjustment would result in an increase of the Conversion Price then in effect. A holder's delivery of a Void Optional Redemption Notice and exercise of its rights following such notice shall not effect the Company's obligations to make any payments which have accrued prior to the date of such notice. Payments provided for in this Section 8 shall have priority to payments to other stockholders in connection with a Major Transaction. (h) Company's Redemption Option. The Company may redeem all or a portion of the Series A Preferred Stock outstanding upon five (5) days prior written notice (the "Company's Redemption Notice") at a price per share of Series A Preferred Stock equal to 150% of the Liquidation Preference Amount plus any accrued but unpaid dividends and liquidated damages; provided, that if a holder has delivered a Conversion Notice to the Company or delivers a Conversion Notice within twenty-four (24) hours of receipt of the Company's Redemption Notice, up to fifty percent (50%) of the shares of Series A Preferred Stock designated to be redeemed may be converted by such holder; provided further that if during the period between delivery of the Company's Redemption Notice and the Redemption Date a holder shall become entitled to deliver a Notice of Redemption at Option of Buyer Upon Major Transaction, then the right of such holder shall take precedence over the previously delivered Company Redemption Notice. The Company's Redemption Notice shall state the date of redemption which date shall be the sixth (6th) day after the Company has delivered the Company's Redemption Notice (the "Company's Redemption Date"), the Company's Redemption Price and the number of shares to be redeemed by the Company. The Company shall not send a Company's Redemption Notice unless it has good and clear funds for a minimum of the amount it intends to redeem in a bank account controlled by the Company; provided that if the redemption is expected to be made contemporaneous with the closing of a public underwritten offering of the Company, then the Company may not have good and clear funds in the bank account at the time of the Company's Redemption Notice and may not send any such Company's Redemption Notice earlier than the day immediately prior to the date the public offering is priced. The Company shall deliver the Company's Redemption Price to the holder(s) within five (5) business days after the Company has delivered the Company's Redemption Notice, provided, that if the holder(s) delivers a Conversion Notice before the Company's Redemption Date, then the portion of the Company's Redemption Price which would be paid to redeem the shares of Series A Preferred Stock covered by such Conversion Notice shall be returned to the Company upon delivery of the Common Stock issuable in connection with such Conversion Notice to the holder(s). On the Redemption Date, the Company shall pay the Company's Redemption Price, subject to any adjustment pursuant to the immediately preceding -21- sentence, to the holder(s) on a pro rata basis, provided, however, that upon receipt by the Company of the Preferred Stock Certificates to be redeemed pursuant to this Section 8(e), the Company shall, on the next business day following the date of receipt by the Company of such Preferred Stock Certificates, pay the Company's Redemption Price to the holder(s) on a pro rata basis. If the Company fails to pay the Company's Redemption Price by the sixth (6th) business day after the Company has delivered the Company's Redemption Notice (or in the case of a public offering, the closing of the public offering), the redemption will be declared null and void and the Company shall lose its right to serve a Company's Redemption Notice in the future. 9. Inability to Fully Convert. (a) Holder's Option if Company Cannot Fully Convert. If, upon the Company's receipt of a Conversion Notice or on the Mandatory Conversion Date, the Company cannot issue shares of Common Stock registered for resale under the Registration Statement for any reason, including, without limitation, because the Company (w) does not have a sufficient number of shares of Common Stock authorized and available, (x) failed to call the Stockholder Meeting within the time period set forth in Section 7 hereof, (y) is otherwise prohibited by applicable law or by the rules or regulations of any stock exchange, interdealer quotation system or other self-regulatory organization with jurisdiction over the Company or its securities from issuing all of the Common Stock which is to be issued to a holder of Series A Preferred Stock pursuant to a Conversion Notice or (z) fails to have a sufficient number of shares of Common Stock registered for resale under the Registration Statement, then the Company shall issue as many shares of Common Stock as it is able to issue in accordance with such holder's Conversion Notice and pursuant to Section 5(b)(ii) above and, with respect to the unconverted Series A Preferred Stock, the holder, solely at such holder's option, can elect, within five (5) business days after receipt of notice from the Company thereof to: (i) require the Company to redeem from such holder those Series A Preferred Stock for which the Company is unable to issue Common Stock in accordance with such holder's Conversion Notice ("Mandatory Redemption") at a price per share equal to the Major Transaction Redemption Price as of such Conversion Date (the "Mandatory Redemption Price"); (ii) if the Company's inability to fully convert Series A Preferred Stock is pursuant to Section 9(a)(z) above, require the Company to issue restricted shares of Common Stock in accordance with such holder's Conversion Notice and pursuant to Section 5(b)(ii) above; (iii) void its Conversion Notice and retain or have returned, as the case may be, the shares of Series A Preferred Stock that were to be converted pursuant to such holder's Conversion Notice (provided that a holder's voiding its Conversion Notice shall not effect the Company's obligations to make any payments which have accrued prior to the date of such notice). -22- (b) Mechanics of Fulfilling Holder's Election. The Company shall immediately send via facsimile to a holder of Series A Preferred Stock, upon receipt of a facsimile copy of a Conversion Notice from such holder which cannot be fully satisfied as described in Section 9(a) above, a notice of the Company's inability to fully satisfy such holder's Conversion Notice (the "Inability to Fully Convert Notice"). Such Inability to Fully Convert Notice shall indicate (i) the reason why the Company is unable to fully satisfy such holder's Conversion Notice, (ii) the number of Series A Preferred Stock which cannot be converted and (iii) the applicable Mandatory Redemption Price. Such holder shall notify the Company of its election pursuant to Section 9(a) above by delivering written notice via facsimile to the Company ("Notice in Response to Inability to Convert"). (c) Payment of Redemption Price. If such holder shall elect to have its shares redeemed pursuant to Section 9(a)(i) above, the Company shall pay the Mandatory Redemption Price in cash to such holder within thirty (30) days of the Company's receipt of the holder's Notice in Response to Inability to Convert, provided that prior to the Company's receipt of the holder's Notice in Response to Inability to Convert the Company has not delivered a notice to such holder stating, to the satisfaction of the holder, that the event or condition resulting in the Mandatory Redemption has been cured and all Conversion Shares issuable to such holder can and will be delivered to the holder in accordance with the terms of Section 2(g). If the Company shall fail to pay the applicable Mandatory Redemption Price to such holder on a timely basis as described in this Section 9(c) (other than pursuant to a dispute as to the determination of the arithmetic calculation of the Redemption Price), in addition to any remedy such holder of Series A Preferred Stock may have under this Certificate of Designation and the Purchase Agreement, such unpaid amount shall bear interest at the rate of 2.0% per month (prorated for partial months) until paid in full. Until the full Mandatory Redemption Price is paid in full to such holder, such holder may (i) void the Mandatory Redemption with respect to those Series A Preferred Stock for which the full Mandatory Redemption Price has not been paid, (ii) receive back such Series A Preferred Stock, and (iii) require that the Conversion Price of such returned Series A Preferred Stock be adjusted to the lesser of (A) the Conversion Price and (B) the lowest Closing Bid Price during the period beginning on the Conversion Date and ending on the date the holder voided the Mandatory Redemption. (d) Pro-rata Conversion and Redemption. In the event the Company receives a Conversion Notice from more than one holder of Series A Preferred Stock on the same day and the Company can convert and redeem some, but not all, of the Series A Preferred Stock pursuant to this Section 9, the Company shall convert and redeem from each holder of Series A Convertible Preferred Stock electing to have Series A Preferred Stock converted and redeemed at such time an amount equal to such holder's pro-rata amount (based on the number shares of Series A Preferred Stock held by such holder relative to the number shares of Series A Preferred Stock outstanding) of all shares of Series A Preferred Stock being converted and redeemed at such time. -23- 10. Vote to Change the Terms of or Issue Preferred Stock. The affirmative vote at a meeting duly called for such purpose or the written consent without a meeting, of the holders of not less than three-fourths (3/4) of the then outstanding shares of Series A Preferred Stock, shall be required (a) for any change to this Certificate of Designation or the Company's Certificate of Incorporation which would amend, alter, change or repeal any of the powers, designations, preferences and rights of the Series A Preferred Stock or (b) for the issuance of shares of Series A Preferred Stock other than pursuant to the Purchase Agreement. 11. Lost or Stolen Certificates. Upon receipt by the Company of evidence satisfactory to the Company of the loss, theft, destruction or mutilation of any Preferred Stock Certificates representing the shares of Series A Preferred Stock, and, in the case of loss, theft or destruction, of any indemnification undertaking by the holder to the Company and, in the case of mutilation, upon surrender and cancellation of the Preferred Stock Certificate(s), the Company shall execute and deliver new preferred stock certificate(s) of like tenor and date; provided, however, the Company shall not be obligated to re-issue Preferred Stock Certificates if the holder contemporaneously requests the Company to convert such shares of Series A Preferred Stock into Common Stock. 12. Remedies, Characterizations, Other Obligations, Breaches and Injunctive Relief. The remedies provided in this Certificate of Designation shall be cumulative and in addition to all other remedies available under this Certificate of Designation, at law or in equity (including a decree of specific performance and/or other injunctive relief), no remedy contained herein shall be deemed a waiver of compliance with the provisions giving rise to such remedy and nothing herein shall limit a holder's right to pursue actual damages for any failure by the Company to comply with the terms of this Certificate of Designation. Amounts set forth or provided for herein with respect to payments, conversion and the like (and the computation thereof) shall be the amounts to be received by the holder thereof and shall not, except as expressly provided herein, be subject to any other obligation of the Company (or the performance thereof). The Company acknowledges that a breach by it of its obligations hereunder will cause irreparable harm to the holders of the Series A Preferred Stock and that the remedy at law for any such breach may be inadequate. The Company therefore agrees that, in the event of any such breach or threatened breach, the holders of the Series A Preferred Stock shall be entitled, in addition to all other available remedies, to an injunction restraining any breach, without the necessity of showing economic loss and without any bond or other security being required. 13. Specific Shall Not Limit General; Construction. No specific provision contained in this Certificate of Designation shall limit or modify any more general provision contained herein. This Certificate of Designation shall be deemed to be jointly drafted by the Company and all initial purchasers of the Series A Preferred Stock and shall not be construed against any person as the drafter hereof. 14. Failure or Indulgence Not Waiver. No failure or delay on the part of a holder of Series A Preferred Stock in the exercise of any power, right or privilege hereunder shall operate -24- as a waiver thereof, nor shall any single or partial exercise of any such power, right or privilege preclude other or further exercise thereof or of any other right, power or privilege. -25- IN WITNESS WHEREOF, the undersigned has executed and subscribed this Certificate and does affirm the foregoing as true this 28th day of June, 2002. ORTEC INTERNATIONAL, INC. By: /s/ Steven Katz -------------------------------- Name: Steven Katz Title: Chief Executive Officer -26- Exhibit I ORTEC INTERNATIONAL, INC. CONVERSION NOTICE Reference is made to the Certificate of Designation of the Relative Rights and Preferences of the Series A Preferred Stock of Ortec International, Inc. (the "Certificate of Designation"). In accordance with and pursuant to the Certificate of Designation, the undersigned hereby elects to convert the number of shares of Series A Preferred Stock, par value $.001 per share (the "Preferred Shares"), of Ortec International, Inc., a Delaware corporation (the "Company"), indicated below into shares of Common Stock, par value $.001 per share (the "Common Stock"), of the Company, by tendering the stock certificate(s) representing the share(s) of Preferred Shares specified below as of the date specified below. Date of Conversion: ___________________________ Number of Preferred Shares to be converted:_________ Stock certificate no(s). of Preferred Shares to be converted:_________ The Common Stock have been sold pursuant to the Registration Statement (as defined in the Purchase Agreement): YES ____ NO____ Please confirm the following information: Conversion Price: ________________________________ Number of shares of Common Stock to be issued: ________________________________ Please issue the Common Stock into which the Preferred Shares are being converted and, if applicable, any check drawn on an account of the Company in the following name and to the following address: Issue to: ________________________________ ________________________________ Facsimile Number: ________________________________ Authorization: ________________________________ By:_____________________________ Title:__________________________ Dated: PRICES ATTACHED -27- EX-99 4 ex99-1.txt EXHIBIT 99.1 EXHIBIT 99.1 CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER Pursuant to 18 U.S.C. Section 1350, the undersigned officer of Ortec International, Inc. ("Ortec") hereby certifies that Ortec's Quarterly Report on Form 10-Q for the quarter ended June 30, 2002 (the "Report") fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and that the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of Ortec. /s/ Steven Katz Dated: August 19, 2002 - --------------- Steven Katz, PhD Chairman and Chief Executive Officer Principal Executive Officer EX-99 5 ex99-2.txt EXHIBIT 99.2 EXHIBIT 99.2 CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER Pursuant to 18 U.S.C. Section 1350, the undersigned officer of Ortec International, Inc. ("Ortec") hereby certifies that Ortec's Quarterly Report on Form 10-Q for the quarter ended June 30, 2002 (the "Report") fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and that the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of Ortec /s/ Ron Lipstein Dated: August 19, 2002 - ---------------- Ron Lipstein Chief Financial Officer Principal Financial Officer -----END PRIVACY-ENHANCED MESSAGE-----