-----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, WhW+L9YObgFFE7BXVqjUhBFClEFrwNP4PF7TjaH1ItgOkXgOgELUDsyl31r8iLMw nCBoh4A+gfiJ26GQwWNTOw== 0001047469-98-006029.txt : 19980218 0001047469-98-006029.hdr.sgml : 19980218 ACCESSION NUMBER: 0001047469-98-006029 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980213 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: GENERAL SURGICAL INNOVATIONS INC CENTRAL INDEX KEY: 0000890763 STANDARD INDUSTRIAL CLASSIFICATION: SURGICAL & MEDICAL INSTRUMENTS & APPARATUS [3841] IRS NUMBER: 973170244 STATE OF INCORPORATION: CA FISCAL YEAR END: 0630 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-28448 FILM NUMBER: 98538522 BUSINESS ADDRESS: STREET 1: 10460 BUBB RD CITY: CUPERTINO STATE: CA ZIP: 95014 BUSINESS PHONE: 4158129740 MAIL ADDRESS: STREET 1: 3172A PORTER DRIVE CITY: PALO ALTO STATE: CA ZIP: 94304 10-Q 1 FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 1997. Commission file number: 0-28448 GENERAL SURGICAL INNOVATIONS, INC. (Exact name of Registrant as specified in its charter) CALIFORNIA 97-3170244 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 10460 BUBB ROAD, CUPERTINO, CALIFORNIA 95014 (Address of principal executive offices) Registrant's telephone number, including area code: (408) 863-2500 Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO There were approximately 13,392,865 shares of Registrant's Common Stock issued and outstanding as of February 1, 1998. GENERAL SURGICAL INNOVATIONS, INC. AND SUBSIDIARY QUARTERLY REPORT ON FORM 10-Q FOR THE THREE MONTHS ENDED DECEMBER 31, 1997 TABLE OF CONTENTS Page ---- PART I. FINANCIAL INFORMATION Item 1. Consolidated Financial Statements (Unaudited) Consolidated balance sheets at December 31, 1997 and June 30, 1997. . . . . . . . . . . . . . . . . . . . . . 3 Consolidated statements of operations for the three months ended December 31, 1997 and December 31, 1996 and for the six months ended December 31, 1997 and December 31, 1996 . . 4 Consolidated statements of cash flows for the six months ended December 31, 1997 and December 31, 1996 . . . . . . . 5 Notes to consolidated financial statements . . . . . . . . . 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations . . . . . . . . . . . . . . . . . 7 PART II. OTHER INFORMATION Item 1. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . 21 Item 2. Changes in Securities and Use of Proceeds . . . . . . . . . 22 Item 3. Defaults Upon Senior Securities . . . . . . . . . . . . . . 22 Item 4. Submission of Matters to a Vote of Security Holders . . . . 22 Item 5. Other Information . . . . . . . . . . . . . . . . . . . . . 22 Item 6. Exhibits and Reports on Form 8-K. . . . . . . . . . . . . . 22 2 GENERAL SURGICAL INNOVATIONS, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA)
DECEMBER, 31 JUNE, 30 1997 1997 ------------ --------- (Unaudited) ASSETS Current assets: Cash and cash equivalents . . . . . . . . . . . . $ 7,374 $ 7,900 Available-for-sale securities . . . . . . . . . . 33,649 35,831 Accounts receivable, net of allowance for doubtful accounts of $54 on December 31, 1997 and $47 on June 30, 1997 . . . . . . . . . . . . 2,215 2,131 Inventories . . . . . . . . . . . . . . . . . . . 1,016 1,717 Prepaid expenses and other current assets . . . . 1,124 971 --------- --------- Total current assets. . . . . . . . . . . . 45,378 48,550 Property and equipment, net. . . . . . . . . . . . . . 2,287 2,251 Intangible and other assets, net . . . . . . . . . . . 227 261 --------- --------- Total assets. . . . . . . . . . . . . . . . $ 47,892 $ 51,062 --------- --------- --------- --------- LIABILITIES Current liabilities: Accounts payable. . . . . . . . . . . . . . . . . $ 579 $ 504 Accrued liabilities . . . . . . . . . . . . . . . 790 1,044 Bank borrowings . . . . . . . . . . . . . . . . . 146 167 --------- --------- Total current liabilities . . . . . . . . . 1,515 1,715 Bank borrowings, less current portion. . . . . . . . . 122 185 Other long-term liabilities. . . . . . . . . . . . . . 193 175 --------- --------- Total liabilities . . . . . . . . . . . . . 1,830 2,075 --------- --------- SHAREHOLDERS' EQUITY Preferred stock, $.001 par value: Authorized: 2,000,000 shares; issued and outstanding: none Common stock, $.001 par value: Authorized: 50,000,000 shares; issued and outstanding 13,385,657 on December 31, 1997 and 13,290,644 on June 30, 1997 . . . . . . . . . . . 13 13 Additional paid-in capital . . . . . . . . . . . . . . 65,219 65,089 Notes receivable from shareholders . . . . . . . . . . (87) (87) Deferred compensation, net . . . . . . . . . . . . . . (228) (297) Unrealized loss on available-for-sale securities . . . . . . . . . . . . . . . . . . . . . (5) (38) Accumulated deficit. . . . . . . . . . . . . . . . . . (18,850) (15,693) --------- --------- Total shareholders' equity. . . . . . . . . . . . 46,062 48,987 --------- --------- Total liabilities and shareholders' equity. $ 47,892 $ 51,062 --------- --------- --------- ---------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 3 GENERAL SURGICAL INNOVATIONS, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
THREE MONTHS ENDED SIX MONTHS ENDED DECEMBER 31, DECEMBER 31, ------------------- -------------------- 1997 1996 1997 1996 ------- ------ ------- ------- Sales. . . . . . . . . . . . . . . . . $ 1,408 $ 361 $ 2,975 $ 2,831 Guaranteed payments. . . . . . . . . . 860 1,500 1,635 1,500 ------- ------ ------- ------- Total revenue. . . . . . . . . . . . . 2,268 1,861 4,610 4,331 Cost of sales. . . . . . . . . . . . . 1,186 359 2,142 1,352 ------- ------ ------- ------- Gross profit. . . . . . . . . . . 1,082 1,502 2,468 2,979 ------- ------ ------- ------- Operating Expenses: Research and development. . . . . 658 484 1,423 946 Sales and marketing . . . . . . . 1,168 1,095 2,294 2,203 General and administrative. . . . 1,738 830 3,084 1,553 ------- ------ ------- ------- Total operating expenses. . . . 3,564 2,409 6,801 4,702 ------- ------ ------- ------- Operating loss. . . . . . . . (2,482) (907) (4,333) (1,723) Interest income. . . . . . . . . . . . 594 678 1,197 1,303 Interest expense . . . . . . . . . . . (9) (11) (21) (23) Other income (expense) . . . . . . . . - 3 - (23) ------- ------ ------- ------- Net loss . . . . . . . . . . $(1,897) $ (237) $(3,157) $ (466) ------- ------ ------- ------- ------- ------ ------- ------- Net loss per common share and per common share - assuming dilution . . $ (0.14) $(0.02) $ (0.23) $ (0.04) ------- ------ ------- ------- ------- ------ ------- ------- Shares used in computing net loss per common share and per common share - assuming dilution . . . . . . . . . . 13,355 13,183 13,334 13,165 ------- ------ ------- ------- ------- ------ ------- -------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 4 GENERAL SURGICAL INNOVATIONS, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (IN THOUSANDS)
Six Months Ended December 31, --------------------- 1997 1996 --------- -------- CASH FLOWS FROM OPERATING ACTIVITIES Net loss . . . . . . . . . . . . . . . . . . . . . . $ (3,157) $ (466) Adjustments to reconcile net loss to net cash used in operating activities: Amortization of deferred compensation. . . . . . . 69 100 Depreciation and amortization. . . . . . . . . . . 567 402 Provision for uncollectable accounts . . . . . . . 7 (41) Loss on write-off of fixed assets. . . . . . . . . - 26 Provision for excess and obsolete inventory. . . . (4) 68 Changes in operating assets and liabilities: Accounts receivable . . . . . . . . . . . . . . (91) (800) Inventory . . . . . . . . . . . . . . . . . . . 705 (747) Prepaid expenses and other current assets . . . (153) (125) Intangible and other assets . . . . . . . . . . (2) - Accounts payable . . . . . . . . . . . . . . . . 75 (69) Accrued and other liabilities . . . . . . . . . (267) (248) Deferred revenue . . . . . . . . . . . . . . . . - (100) -------- -------- Net cash used in operating activities . . . . . . . . . . . . . . . . . (2,251) (2,000) -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES Purchases of available-for-sale securities . . . . . (15,800) (37,305) Proceeds from sales and maturities of available-for-sale securities . . . . . . . . . . . 17,792 22,500 Acquisition of property and equipment. . . . . . . . (304) (124) -------- -------- Net cash provided by (used in) investing activities. . . . . . . . . . . . . 1,688 (14,929) -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from issuance of common stock . . . . . . . 130 106 Proceeds from payment on shareholders notes receivable . . . . . . . . . . . . . . . . . . . . - 18 Payments on capital lease obligations . . . . . . . (9) - Principal payments on bank borrowings . . . . . . . (84) (51) -------- -------- Net cash provided by financing activities . . . . . . . . . . . . . . . . . 37 73 -------- -------- Net decrease in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . (526) (16,856) Cash and cash equivalents, beginning of period . . . 7,900 28,339 -------- -------- Cash and cash equivalents, end of period . . . . . . $ 7,374 $ 11,483 -------- -------- -------- -------- Cash paid during the period for: Interest . . . . . . . . . . . . . . . . . . . . . $ 22 $ 27 Taxes. . . . . . . . . . . . . . . . . . . . . . . $ - $ - NONCASH INVESTING AND FINANCING ACTIVITIES Issuance of common stock for notes receivable. . . . $ - $ 11 Change in unrealized gain (loss) on available-for- sale securities . . . . . . . . . . . . . . . . . . $ 33 $ 30 Property acquired under capital leases . . . . . . . $ 40 $ -
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 5 GENERAL SURGICAL INNOVATIONS, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Basis of Presentation: The accompanying unaudited consolidated financial statements as of December 31, 1997 of General Surgical Innovations, Inc. (the "Company") and subsidiary have been prepared in accordance with generally accepted accounting principles for interim financial information and pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation have been included. Operating results for the three and six month periods ended December 31, 1997 are not necessarily indicative of the results that may be expected for the fiscal year ended June 30, 1998, or any future interim period. These financial statements and notes should be read in conjunction with the Company's audited financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended June 30, 1997. 2. Reclassification: Certain amounts in the financial statements have been reclassified to conform with current year's presentation. These reclassifications had no impact on previously reported working capital, operating income, or net income. 3. Net Loss Per Share: The Company adopted Financial Accounting Standards Board No. 128 "Earnings Per Share", and accordingly all prior periods have been restated. Net loss per common share and per common share-assuming dilution are computed using the weighted average number of common shares outstanding. Common equivalent shares from stock options are excluded from the computation of net loss per common share-assuming dilution as their effect is antidilutive. 4. Inventories: Inventories comprise (IN THOUSANDS):
Dec. 31, June 30, 1997 1997 ---- ---- (unaudited) Raw materials . . . . . . . . . . . . . $ 699 $ 706 Work in progress . . . . . . . . . . . 72 43 Finished goods . . . . . . . . . . . . 245 968 -------- -------- $ 1,016 $ 1,717 -------- -------- -------- --------
6 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the unaudited consolidated financial statements and notes thereto included in part I, Item I of this Quarterly Report and with Management's Discussion and Analysis of Financial Condition and Results of Operations contained in the Company's Annual Report on Form 10-K for the year ended June 30, 1997. The Company desires to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. Specifically, the Company wishes to alert readers that, except for the historical information contained in this Quarterly Report on Form 10-Q, the matters discussed herein are forward-looking statements that are subject to certain risks and uncertainties that could cause the actual results to differ materially from those projected. Factors that could cause actual results to differ materially include, but are not limited to, market demand for the Company's products, the Company's ability to shift market focus successfully, fluctuations in revenues among different product lines and markets, the timing and number of orders and shipments, distribution efforts by Ethicon-Endo Surgery, Inc. ("EES"), a Johnson & Johnson company, EES's success in achieving certain levels of sales growth, the performance of the Company's new corporate partnering relationships, the Company's ability to establish and develop other new corporate partnering relationships, the timely development and market acceptance of new products and surgical procedures, the impact of competitive products and pricing, results of ongoing litigation, the Company's ability to further expand into international markets, approval of its products by government agencies such as the United States Food and Drug Administration, and other risks detailed below and included from time to time in the Company's other SEC reports and press releases, copies of which are available from the Company upon request. The Company assumes no obligation to update any forward-looking statements contained herein. The factors listed below under "Factors Affecting Future Results," as well as other factors, have in the past affected, and could in the future affect, the Company's actual results and could cause the Company's results for future quarters to differ materially from those expressed in any forward-looking statements contained in the following discussion. References made in this Quarterly Report on Form 10-Q to "General Surgical Innovations, Inc.," the "Company" or the "Registrant" refer to General Surgical Innovations, Inc. and its subsidiary. The following General Surgical Innovations, Inc. trademarks are mentioned in this Quarterly Report: SPACEMAKER-Registered Trademark-, registered trademark of the Company; ENDOSAPH-TM-, SAPHtrak-TM-, SPACEKEEPER-TM- and Knotmaker-TM-, trademarks of the Company. OVERVIEW Since its inception in April 1992, GSI has been engaged in the development, manufacturing and marketing of balloon dissection systems and related minimally invasive surgical instruments. The Company began commercial sales of its balloon dissection systems for hernia repair in September 1993. To date, the Company has received from the FDA six 510(k) clearances for use of the Company's technology to perform dissection of tissue planes anywhere in the body using a broad range of balloon sizes and shapes. The Company currently sells products in the United States and certain other countries in Europe, Asia and South America for selected applications, such as hernia repair, subfascial 7 endoscopic perforator surgery, saphenous vein harvesting and breast reconstruction and augmentation surgery. In December 1996, the Company entered into a five year OEM supply agreement (the "Expanded EES Agreement") with EES, pursuant to which GSI granted EES worldwide sales and marketing rights to sell the SPACEMAKER-Registered Trademark- Balloon Dissection Systems in the laparoscopic hernia repair and urinary stress incontinence ("USI") markets. Under the Expanded EES Agreement, EES has begun selling GSI's dissector for hernia repair. EES made guaranteed payments of $4.9 million in fiscal year 1997, and additional payments in lieu of product purchases pursuant to a mutual agreement in the amount of $775,000 in the first quarter of fiscal year 1998 and $860,000 in the second quarter of fiscal year 1998. Additional sales in the United States (other than for hernia and USI applications) are currently made through distributors and a small direct sales force. The Company currently sells its products (other than for hernia and USI applications) in international markets through distributors, which resell to surgeons and hospitals. The Company plans to increase its direct sales force in the United States and may seek to establish a direct sales force in one or more other countries in the future. Any increase in the Company's direct sales force will require significant expenditures and additional management resources. To date, almost all of the sales to distributors and by the Company's direct sales force have been for use in hernia repair procedures. While the Company has developed or is developing balloon dissection systems for vascular, urinary stress incontinence and plastic surgery, sales of products for hernia repair are expected to provide a majority of the Company's revenues at least through fiscal 1998. The Company has acquired rights to a significant number of patents from third parties, including rights that apply to the Company's current balloon dissection systems. The Company has historically paid and is obligated to pay in the future to such third parties royalties equal to 4% of sales of such products. The Company has also acquired patent rights under royalty-bearing agreements with respect to certain surgical instruments, including the KnotMaker-TM- product and the balloon valve trocar. The payment of such royalty amounts will have an adverse impact on the Company's gross profit and results of operations. The Company has a limited history of operations and has experienced significant operating losses since inception. The Company expects such operating losses to continue at least through calendar year 1998. In order to support increased levels of sales in the future and to augment its long-term competitive position, including the development of balloon dissection systems for other applications, the Company anticipates that it will be required to make significant additional expenditures in sales and marketing and research and development (including marketing-related clinical evaluations). In addition, the Company has experienced higher administration expenses since its initial public offering resulting from its obligations as a public reporting company and defense of its patents. The Company anticipates that its results of operations may fluctuate for the foreseeable future due to several factors, including fluctuations in purchases of the Company's products by its distributors, its distributors' ability to achieve certain levels of sales growth, the status of the Company's relationship 8 with EES and other partners, the Company's ability to sell its line of cardiovascular products, fluctuations in revenues among different product lines and markets, the mix of sales among the distributors and the Company's direct sales force, timing of new product introductions or transitions to new products, the margins recognized from products for various surgical procedures, the progress of marketing-related clinical evaluations, sales of competitive products and the introduction of new products from competitors (including pricing pressures), activities related to patents and patent approvals (including litigation) and regulatory and third-party reimbursement matters, and the timing of research and development expenses (including marketing-related clinical evaluations). In addition, the Company's results of operations could be affected by the expansion of the Company's distributor network, the ability of the Company's distributors to effectively promote the Company's products and the ability of the Company to quickly and cost effectively increase its direct domestic sales force. The Company's limited operating history makes accurate prediction of future operating results difficult or impossible. The Company currently manufactures and ships product shortly after the receipt of orders, and anticipates that it will do so in the future. Accordingly, the Company has not developed a significant backlog and does not anticipate that it will develop a material backlog in the future. In January 1997, the Company entered into a new facility lease in Cupertino, California and relocated its headquarters and manufacturing operations to this new location in April 1997. The new facility's lease comprises approximately 30,460 square feet, and the monthly rent is approximately $52,000. In October 1997, the Company received its CE mark certification, pursuant to the Medical Devices Directive, which enables the Company to affix CE marking on its products and continue selling its products within the European Economic Area. RESULTS OF OPERATIONS REVENUE. Total revenue increased by 22% to approximately $2.3 million for the quarter ended December 31, 1997 from $1.9 million for the same period in 1996. This increase was mainly due to increased sales to EES of the SPACEMAKER-Registered Trademark- I and II platforms for the hernia market. Current quarter revenue includes an $860,000 payment from EES in lieu of product purchases pursuant to a mutual agreement, while the prior year quarter includes a $1.5 million guaranteed payment. Revenue for the six months ended December 31, 1997 increased 6% to approximately $4.6 million from $4.3 million for the six months ended December 31, 1996. COST OF SALES. Cost of sales increased by 230% to approximately $1.2 million for the quarter ended December 31, 1997 from $359,000 for the same period in 1996. Cost of sales decreased as a percentage of sales to 84% for the quarter ended December 31, 1997 from 99% for the quarter ended December 31, 1996. This increase in absolute dollars, as well as the improved gross margin, was related to increased unit sales, mostly to EES, as compared to the previous period. Cost of sales for the six months ended December 31, 1997 increased as a percent of sales to 72%, or approximately $2.1 million, as compared to 48% of sales, or approximately $1.4 million, for the six months ended December 31, 1996. This increase as a percent of sales is mainly due to the Company's increased capacity as a result of relocating its manufacturing facility during April 1997. 9 RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses, which include expenditures for marketing-related clinical evaluations and regulatory expenses, increased by 36% to approximately $658,000 in the quarter ended December 31, 1997 from $484,000 for the same period in 1996. R&D expenses for the six months ended December 31, 1997 were approximately $1.4 million as compared to $946,000 for the same period of the prior fiscal year, or a 50% increase. These increases are a result of the company dedicating more resources during the past six months to developing its cardiovascular products. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative expenses increased by 51% to approximately $2.9 million for the quarter ended December 31, 1997 from $1.9 million for the quarter ended December 31, 1996. For the six months ended December 31, 1997, SG&A expenses were $5.4 million compared to $3.8 million for the same period in 1996. These increases are primarily due to increased legal expenses related to intellectual property litigation. INTEREST INCOME, INTEREST EXPENSE AND OTHER INCOME (EXPENSE). Interest and other income (net of expense) decreased to approximately $585,000 for the quarter ended December 31, 1997 from $670,000 for the quarter ended December 31, 1996. For the six months ended December 31, 1997 interest and other income (net of expense) decreased to $1.2 million from $1.3 million for the same period in 1996. Decreases are due mainly to lower average cash, cash equivalents and available-for-sale securities balances. Interest earned in the future will depend on the Company's funding cycles and prevailing interest rates. LIQUIDITY AND CAPITAL RESOURCES Since inception, the Company's cash expenditures have significantly exceeded its sales, resulting in an accumulated deficit of approximately $18.9 million at December 31, 1997. The Company has funded its operations primarily through the sale of equity securities. From its inception through December 31, 1997 the Company raised approximately $62 million through the sale of equity securities. As of December 31, 1997 the Company's principal source of liquidity consists of cash, cash equivalents and available-for-sale securities of $41.0 million, as compared to $43.7 million at June 30, 1997. In addition, the Company has a bank line of credit available for $1,500,000. As of December 31, 1997, the Company has no amounts outstanding under this line. The Company also has an equipment loan with an outstanding balance of approximately $268,000. The Company expects to incur substantial additional costs, including costs related to patent litigation, increased sales and marketing activities, increased research and development, expenditures in connection with seeking regulatory approvals and conducting additional marketing-related clinical evaluations, capital equipment and other costs associated with expansion of the Company's manufacturing capabilities. The Company believes that its current cash balances and short-term investments along with cash generated from the future sales of products will be sufficient to meet the Company's operating and capital requirements through at least calendar 1998. The Company may seek additional equity or debt financing to address its working capital needs or to provide funding for capital expenditures. There can be no assurance that additional financing, if sought, will be available on satisfactory terms or at all. 10 RECENT PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 130 (SFAS 130), REPORTING COMPREHENSIVE INCOME. This statement establishes requirements for disclosure of comprehensive income and becomes effective for the Company for fiscal years beginning after December 15, 1997, with reclassification of earlier financial statements for comparative purposes. Comprehensive income generally represents all changes in shareholders' equity except those resulting from investments or contributions by shareholders. The Company is evaluating alternative formats for presenting this information, but does not expect this pronouncement to materially impact the Company's results of operations. In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 131 (SFAS 131), DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION. This statement establishes standards for disclosure about operating segments in annual financial statements and selected information in interim financial reports. It also establishes standards for related disclosures about products and services, geographic areas and major customers. This statement supersedes Statement of Financial Accounting Standards No. 14, FINANCIAL REPORTING FOR SEGMENTS OF A BUSINESS ENTERPRISE. The new standard becomes effective for fiscal years beginning after December 15, 1997, and requires that comparative information from earlier years be restated to conform to the requirements of this standard. The Company is evaluating the requirements of SFAS 131 and the effects, if any, on the Company's current reporting and disclosures. FACTORS AFFECTING FUTURE RESULTS LIMITED OPERATING HISTORY; ANTICIPATED FUTURE LOSSES. The Company has a limited operating history upon which an evaluation of the Company and its prospects can be based. As of December 31, 1997, the Company had an accumulated deficit of $18.9 million. The Company's net operating losses for the fiscal years ending June 30, 1995, 1996 and 1997 and for the quarters ended September 30, 1997 and December 31, 1997 were $4.1 million, $5.5 million, $1.9 million, $1.3 million and $1.9 million, respectively. The Company expects to continue to incur operating losses on a quarterly and annual basis through at least calendar year 1998. Due to the Company's limited operating history, there can be no assurance of sales growth or profitability in the future. The Company intends to increase its investments in research and development, sales and marketing, marketing-related clinical evaluations and related infrastructure. Due to the anticipated increases in the Company's operating expenses, the Company's operating results will be adversely affected if sales do not increase. The Company's prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in their early stage of development, particularly companies in rapidly evolving markets. To address these risks, the Company must respond to competitive developments, continue to attract, retain and motivate qualified persons and successfully commercialize products incorporating 11 advanced technologies. There can be no assurance that the Company will be successful in addressing such risks. DEPENDENCE UPON BALLOON DISSECTION PRODUCTS; RISK OF TECHNOLOGICAL OBSOLESCENCE. Nearly all of the Company's sales since inception have been derived from sales of its balloon dissection products, with a substantial portion derived from sales for hernia repair procedures. Failure of the Company to develop and successfully commercialize balloon dissection products for applications other than hernia repair could have a material adverse effect on the Company's business, financial condition and results of operations. The success of the Company's products depends on the market acceptance of and demand for the Company's products and related procedures, the nature of the technological advances inherent in the product designs, reduction in patient trauma or other benefits provided by such products, results of marketing-related clinical evaluations, continued adoption of minimally invasive surgery ("MIS") procedures by surgeons, reimbursement for the Company's products by health care payors and the Company's receipt of regulatory approvals. There can be no assurance that the Company's products will have the required technical characteristics, that the Company's products will provide adequate patient benefits, that marketing-related clinical evaluations results will be favorable, that surgeons will continue to adopt MIS procedures, that recently-introduced products or future products of the Company or related procedures will gain market acceptance, or that required regulatory approvals will be obtained. The failure to achieve any of the foregoing could have a material adverse effect on the Company's business, financial condition and results of operations. To the extent demand for the Company's balloon dissection systems for hernia repair declines and the Company's newly-introduced products are not commercially accepted or its existing products are not developed for new procedures, there could be a material adverse effect on the Company's business, financial condition and results of operations. DEPENDENCE ON KEY DISTRIBUTORS. In December 1996, the Company entered into a five year OEM supply agreement (the "Expanded EES Agreement") with EES, pursuant to which GSI granted EES worldwide sales and marketing rights to sell the SPACEMAKER-Registered Trademark- Balloon Dissection Systems in the laparoscopic hernia repair and urinary stress incontinence ("USI") markets. The Expanded EES Agreement supersedes the June 1996 licensing agreement between the Company and EES. Under the Expanded EES Agreement, EES was obligated to make $4.9 million in guaranteed payments to the Company during the year ended June 30, 1997, but is not obligated to make any further guaranteed payments. In lieu of product purchases, and pursuant to a mutual agreement, EES made additional payments in the amount of $775,000 in the first quarter of fiscal year 1998 and $860,000 in the second quarter of fiscal year 1998. There can be no assurance that EES's marketing or distribution efforts will be successful. EES's failure to achieve certain levels of sales growth or product orders could have a material adverse effect on the Company's business, financial condition and results of operations. In December 1997, the Company entered into a four year distribution agreement with Genzyme Surgical Products Corporation ("Genzyme"). Under the agreement, Genzyme, a biotechnology and health care products company, has exclusive rights to market and distribute GSI's surgical balloon dissectors worldwide for use in plastic surgery (reconstructive and aesthetic) procedures. The Company's products are sold internationally to hospitals, surgeons and specialists through EES and independent distributors in Europe, Asia, Latin America and the Middle East. In June 1997, GSI entered into an exclusive agreement with Japan Lifeline to market and 12 distribute in Japan GSI's balloon dissection systems for use in vascular procedures. Japan Lifeline is expected to begin distribution of the GSI balloon dissection systems following receipt of the Japanese Ministry of Health and Welfare approval, which the Company expects to occur in fiscal 1998. Although the Company expanded its international distribution network by adding several distributors to distribute its cardiovascular products, and although the Company intends to continue to establish additional distributorships in the United States and internationally for products in areas other than hernia repair, urinary stress incontinence and certain plastic surgery procedures, there can be no assurance that recently appointed distributors will be successful, or that efforts to establish additional distributors will be successful. Failure of current distributors to succeed or failure to add additional distributors to its distribution network could have a material adverse effect on the Company's business, financial condition and results of operations. LIMITED MARKETING AND DIRECT SALES EXPERIENCE. The Company has only limited experience marketing and selling its products through its direct sales force, and has sold its products in commercial quantities through its direct sales force to the hernia market and, to a lesser degree, to the cardiovascular and cosmetic and reconstructive surgery markets. Establishing marketing and sales capability sufficient to support sales in commercial quantities for the cardiovascular market targeted by the Company will require significant resources. There can be no assurance that the Company will be able to recruit and retain additional qualified marketing or sales personnel, or that future sales efforts of the Company will be successful. In markets other than cardiovascular, the Company intends to establish partnership relationships with additional distribution partners, and there can be no assurance that the Company will be successful in establishing such partnership relationships on commercially reasonable terms, if at all. The failure to establish and maintain an effective distribution channel for the Company's products, or establish and retain qualified and effective sales personnel to support commercial sales of the Company's products, could have a material adverse effect on the Company's business, financial condition and results of operations. UNCERTAINTY OF MARKET ACCEPTANCE; NO ASSURANCE OF CLINICAL ADVANTAGE. The Company's success is substantially dependent upon the success of its SPACEMAKER-Registered Trademark- balloon dissection products. The Company believes that market acceptance of the Company's products will depend on the Company's ability to provide evidence to the medical community of the safety, efficacy, clinical advantage and cost-effectiveness of its products and the procedures in which these products are intended to be used. Market acceptance is also dependent on the adoption of laparoscopic techniques generally and the conversion of non-balloon dissection techniques to balloon dissection techniques specifically. To date, the Company's products have only been used to treat a limited number of patients and the Company has limited long-term outcomes data. If the Company is not able to demonstrate consistent clinical benefits resulting from the use of its products (including reduced procedure time, reduced patient trauma and lower costs), the Company's business, financial condition and results of operations could be materially and adversely affected. The Company further believes that the ability of health care providers to obtain adequate third party reimbursement for procedures using the Company's SPACEMAKER-Registered Trademark- balloon dissector products and related instruments will be critical to market acceptance of the Company's products. Although the Company believes that procedures using its balloon dissection products currently may be reimbursed in the United States under certain existing procedure codes, there can be no assurance that such procedure codes will remain available or that reimbursement under these codes will be adequate. The Company has limited experience in obtaining third-party reimbursement, and the failure to obtain reimbursement for some or all 13 of its products could have a material adverse effect on the Company's business, financial condition and results of operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." The Company introduced its balloon dissectors in late 1993 and to date there has been relatively little education among surgeons about the benefits of balloon dissection technology. Further, due to the novelty of balloon dissection procedures, many surgeons and surgeons' assistants have not developed the requisite skills to perform balloon dissection procedures. To the extent that laparoscopic techniques are adopted slowly, that balloon dissectors are incorporated into laparoscopic techniques less often or that surgeons are unwilling or unable to develop the skills necessary to utilize balloon dissectors, the Company's business, financial condition and results of operations could be materially adversely affected. FLUCTUATIONS IN QUARTERLY RESULTS. Results of the Company's operations may fluctuate significantly from quarter to quarter and will depend on numerous factors, including (i) new product introductions by the Company and its competitors and fluctuations in revenues among different product lines and markets, (ii) purchases of the Company's products by its distributors, (iii) the rate of adoption by surgeons of balloon dissection technology in markets targeted by the Company, (iv) the sales efforts of the Company's distributors, (v) the mix of sales among distributors and the Company's direct sales force, (vi) timing of patent and regulatory approvals, if any, (vii) timing and growth of operating expenditures, (viii) timing of research and development expenses, including marketing-related clinical evaluation expenditures, (ix) intellectual property litigation and (x) general market conditions. In December 1996, the Company entered into the Expanded Ethicon Agreement, pursuant to which GSI granted EES worldwide sales and marketing rights to sell the SPACEMAKER-TM- Balloon Dissection Systems in the laparoscopic hernia repair and urinary stress incontinence markets. The Company's sales in any period will be highly dependent upon the marketing efforts and success of EES, which are not within the control of the Company. EES made approximately $4.9 million in guaranteed payments to the Company in fiscal year 1997, which constituted 54% of revenues for fiscal year 1997. Although EES is not obligated to make any such guaranteed payments in future quarters, EES made payments by mutual consent of $775,000 in the first quarter of fiscal year 1998 and $860,000 in the second quarter of fiscal year 1998. The Company anticipates that sales to EES may decrease in the future. Failure by EES to achieve certain levels of sales growth or purchases could adversely affect the Company's operating results. In addition, announcements or expected announcements by the Company, its competitors or its distributors of new products, new technologies or pricing changes could cause existing or potential customers of the Company to defer purchases of the Company's existing products and could alter the mix of products sold by the Company, which could have a material adverse effect on the Company's business, financial condition and results of operations. There can be no assurance that future products or product enhancements will be successfully introduced or that such introductions will not adversely affect the demand for existing products. As a result of these and other factors, the Company's quarterly operating results have fluctuated in the past, and the Company expects that such results may fluctuate in the future. Due to such quarterly fluctuations in operating results, quarter-to-quarter comparisons of the Company's operating results are not necessarily meaningful and should not be relied upon as indicators of likely future performance or annual operating results. In addition, the Company's limited operating history makes accurate prediction of future operating results difficult or impossible to make. There can be no assurance that in the future the Company will achieve sales growth or become profitable on a quarterly or annual basis, if at all, or that its growth, if any, will be consistent with predictions by securities analysts and investors. In such 14 event, the price of the Company's Common Stock would likely be materially and adversely affected. RELIANCE ON PATENTS AND PROPRIETARY TECHNOLOGY. The Company's success will depend on its ability to obtain patent protection for its products and processes, to preserve its trade secrets and proprietary technology and to operate without infringing upon the patents or proprietary rights of third parties. In May 1996, Origin MedSystems, Inc. ("Origin"), a unit of the Guidant Corporation and a competitor of the Company, filed an action against GSI in the U.S. District Court for the Northern District of California, alleging patent infringement of its patent entitled "Apparatus and Method for Peritoneal Retraction." In June, 1996, GSI filed an action against Origin in the U.S. District Court for the Northern District of California alleging patent infringement of its patent for a method of tissue plane dissection using balloon systems. In addition, on September 26, 1997, the Company filed another action against Origin alleging patent infringement of its patent for a method of serial inflation of tissue dissectors. A decision against the Company in any of these actions could have a material adverse effect on the Company's business, financial condition or results of operations. One of the patent applications filed by the Company, which is directed to a surgical method using balloon dissection technology, has been placed in interference with a patent application filed by Origin. The Company believes that the inventor named in its patent application was the first to invent this subject matter, and has asserted that the Origin patent application was filed after a disclosure made by such inventor to employees of Origin. Origin takes a contrary position. This interference is presently pending in the United States Patent and Trademark Office ("USPTO") and, as permitted by the rules of the USPTO, has been referred to an arbitrator for completion of the interference proceeding. A decision is expected in this interference proceeding in calendar year 1998. Failure of the Company to prevail in such interference proceeding could have a material adverse effect on the Company's business, financial condition and results of operations. Patent interference and infringement involve complex legal and factual issues and are highly uncertain, and there can be no assurance that any conclusion reached by the Company regarding patent interference or infringement will be consistent with the resolution of such issue by a court or the USPTO. In the event the Company's products are found to infringe patents held by competitors, there can be no assurance that the Company will be able to successfully modify its products to avoid infringement, or that any modified products will be commercially successful. Failure in such event to either develop a commercially successful alternative or obtain a license to such patent on commercially reasonable terms could have a material adverse effect on the Company's business, financial condition and results of operations. As discussed above, the Company is defending itself, and may in the future have to defend itself, against allegations of infringement of third-party patents. Patent litigation is expensive, requires extensive management time, and could subject the Company to significant liabilities, require disputed rights to be licensed from third parties or require the Company to cease selling its products. The validity and breadth of claims in medical technology patents involve complex legal and factual questions and, therefore, may be highly uncertain. No assurance can be given that any patents based on pending patent applications or any future patent applications will be issued, that the scope of any patent protection will exclude competitors or provide competitive advantages to the Company, that any of the Company's patents or patents to which it has licensed rights will be held valid under current 15 challenges or if subsequently challenged or that persons or entities in addition to Origin will not claim rights in or ownership of the patents and other proprietary rights held or licensed by the Company or that the Company's existing patents will cover the Company's future products. Furthermore, there can be no assurance that others have not developed or will not develop similar products, duplicate any of the Company's products or design around any patents issued to or licensed by the Company or that may be issued in the future to the Company. Since patent applications in the United States are maintained in secrecy until patents issue, the Company also cannot be certain that others did not first file applications for inventions covered by the Company's pending patent applications, nor can the Company be certain that it will not infringe any patents that may issue to others on such applications. Legislation has recently been enacted in Congress, the effect of which tends to immunize physicians and their employers from liability for alleged infringement of patent claims directed to medical procedures. The patent laws of European and certain other foreign countries generally do not allow for the issuance of patents for methods of surgery on the human body. Accordingly, the ability of the Company to gain foreign patent protection for its methods of tissue dissection may be significantly limited. As a result, there can be no assurance that the Company will be able to develop a patent portfolio in Europe or that the scope of any patent protection will provide competitive advantages to the Company. ROYALTY PAYMENT OBLIGATIONS. The Company has acquired a significant number of patent rights from third parties, including rights that apply to the Company's current balloon dissection systems. The Company has historically paid and is obligated to pay in the future to such third parties royalties equal to 4% of sales of such products. The Company has also acquired patent rights under royalty-bearing agreements with respect to certain surgical instruments. The payment of such royalty amounts will have an adverse impact on the Company's gross profit and results of operations. There can be no assurance that the Company will be able to continue to satisfy such royalty payment obligations in the future, and a failure to do so could have a material adverse effect on the Company's business, financial condition and results of operations. EARLY STAGE OF DEVELOPMENT AND COMMERCIALIZATION; NO ASSURANCE OF ABILITY TO MANAGE GROWTH. The Company began commercial sales of its balloon dissection products in September 1993 and, as a result, has limited experience in manufacturing, marketing and selling its products commercially. In addition, in January 1997 the Company entered into a real estate lease and has relocated its headquarters and manufacturing operations in April 1997 to a new facility. Moreover, the Company has experienced rapid growth in the number of products under development, the number and amount of products manufactured, and the geographic scope of its sales. In order to augment its long-term competitive position, the Company anticipates that it will be required to make significant additional expenditures in research and development and sales and marketing. The Company's inability to manage its growth effectively could have a material adverse effect on the Company's business, financial condition and results of operations. COMPETITION; UNCERTAINTY OF TECHNOLOGICAL CHANGE. Competition in the market for medical devices used in tissue dissection surgical procedures is intense and is expected to increase. The Company competes primarily with other producers of MIS tissue dissection instruments. Origin, a subsidiary of Guidant Corporation, and others currently compete against the Company in the development, production and marketing of MIS tissue dissection instruments and tissue dissection technology. To the extent that surgeons elect to use open surgical procedures rather than MIS, the Company also competes with producers 16 of tissue dissection instruments used in open surgical procedures, such as blunt dissectors or graspers. A number of companies currently compete against the Company in the development, production and marketing of tissue dissection instruments and technology for open surgical procedures. In addition, the Company indirectly competes with producers of therapeutic drugs, when such drugs are used as an alternative to surgery. Many of the Company's competitors have substantially greater capital resources, name recognition, expertise in research and development, manufacturing and marketing and obtaining regulatory approvals. There can be no assurance that the Company's competitors will not succeed in developing balloon dissectors or competing technologies that are more effective than products marketed by the Company or that render the Company's technology obsolete. Additionally, even if the Company's products provide performance comparable to competing products or procedures, there can be no assurance that the Company will be able to obtain necessary regulatory approvals or compete against competitors in terms of price, manufacturing, marketing and sales. Many of the alternative treatments for medical indications that can be treated by balloon dissection products and laparoscopic surgery are widely accepted in the medical community and have a long history of use. In addition, technological advances with other therapies could make such other therapies more effective or cost-effective than balloon dissectors and minimally invasive surgery, and could render the Company's technology non-competitive or obsolete. There can be no assurance that surgeons will use MIS to replace or supplement established treatments or that MIS will remain competitive with current or future treatments. The failure of surgeons to adopt MIS could have a material adverse effect on the Company's business, financial condition and results of operations. In addition to the Company's development of its balloon dissection systems, the Company has also developed surgical instruments for use in MIS. There can be no assurance that the Company's surgical instruments will successfully compete with those manufactured by other producers of such surgical instruments. The failure to achieve commercial market acceptance of such surgical instruments could have a material adverse effect on the Company's business, financial condition and results of operations. UNCERTAIN AVAILABILITY OF THIRD-PARTY REIMBURSEMENT. The Company's success will depend upon the ability of surgeons to obtain satisfactory reimbursement from healthcare payors for the Company's products. In the United States, hospitals, physicians and other healthcare providers that purchase medical devices generally rely on third-party payors, such as private health insurance plans, to reimburse all or part of the costs associated with the treatment of patients. Reimbursement in the United States for the Company's balloon dissection products is currently available from most third-party payors, including most major private health care insurance plans and Medicaid, under existing surgical procedure codes. The Company does not expect that third-party reimbursement in the United States will be available for use of its other products unless and until clearance or approval is received from the federal Food and Drug Administration (the "FDA"). If FDA clearance or approval is received, third-party reimbursement for these products will depend upon decisions by individual health maintenance organizations, private insurers and other payors. Many payors, including the federal Medicare program, pay a preset amount for the surgical facility component of a surgical procedure. This amount typically includes medical devices such as the Company's. Thus, the surgical facility or surgeon may not recover the added cost of the Company's products. In addition, managed care payors often limit coverage to surgical devices on a preapproved list or obtained from an exclusive source. If the Company's products are not on the list or are not available from the exclusive source, the facility or surgeon will need to obtain an exception from the payor or the patient will be required to pay for some or all of the cost of the Company's product. The Company believes that procedures using its balloon dissection products currently may be reimbursed in the United States under certain existing procedure codes. However, there can be no assurance that such procedure codes will 17 remain available or that the reimbursement under these codes will be adequate. Given the efforts to control and decrease health care costs in recent years, there can be no assurance that any reimbursement will be sufficient to permit the Company to increase revenues or achieve or maintain profitability. The unavailability of third party or other adequate reimbursement could have a material adverse effect on the Company's business, financial condition and results of operations. Reimbursement systems in international markets vary significantly by country, and by region within some countries, and reimbursement approvals must be obtained on a country-by-country basis. Many international markets have government-managed health care systems that govern reimbursement for new devices and procedures. In most markets, there are private insurance systems as well as government-managed systems. Large-scale market acceptance of the Company's balloon dissection systems and other products will depend on the availability and level of reimbursement in international markets targeted by the Company. Currently, the Company has been informed by its international distributors that the balloon dissectors have been approved for reimbursement in many of the countries in which the Company markets its products. Obtaining reimbursement approvals can require 12 to 18 months or longer. There can be no assurance that the Company will obtain reimbursement in any country within a particular time, for a particular amount, or at all. Failure to obtain such approvals could have a material adverse effect on the Company's business, financial condition and results of operations. Regardless of the type of reimbursement system, the Company believes that surgeon advocacy of its products will be required to obtain reimbursement. Availability of reimbursement will depend on the clinical efficacy of the procedure and the utility and cost of the Company's products. There can be no assurance that surgeons will support and advocate reimbursement for use of the Company's systems for all applications intended by the Company. Failure by surgeons, hospitals and other users of the Company's products to obtain sufficient reimbursement from health care payors or adverse changes in government and private third-party payors' policies toward reimbursement for procedures employing the Company's products could have a material adverse effect on the Company's business, financial condition and results of operations. GOVERNMENT REGULATION. The Company's SPACEMAKER-Registered Trademark- balloon dissection systems and other products are subject to extensive and rigorous regulation by the FDA and, to varying degrees, by state and foreign regulatory agencies. Under the Federal Food, Drug, and Cosmetic Act and as amended in the Safe Medical Devices Act of 1990, the FDA regulates the pre-production design controls, clinical testing, manufacture, labeling, packaging, marketing, distribution and record keeping for medical devices, in order to ensure that medical devices distributed in the United States are safe and effective for their intended use. Prior to commercialization, a medical device generally must receive FDA and foreign regulatory clearance or approval, which can be an expensive, lengthy and uncertain process. The Company is also subject to routine inspection by the FDA and state agencies, such as the California Department of Health Services ("CDHS"), for compliance with Good Manufacturing Practice requirements, Medical Device Reporting requirements and other applicable regulations. Noncompliance with applicable requirements can result in warning letters, import detentions, fines, civil penalties, injunctions, suspensions or losses of regulatory approvals, recall or seizure of products, operating restrictions, refusal of the government to approve product export applications or allow the Company to enter into supply contracts, and criminal prosecution. Delays in receipt of, or failure to obtain, regulatory clearances and approvals, if obtained, or any failure to comply with regulatory requirements could have a material adverse effect on the Company's business, financial condition and results of operations. 18 Labeling and promotional activities are subject to scrutiny by the FDA and, in certain circumstances, by the Federal Trade Commission. Current FDA enforcement policy prohibits the marketing of approved medical devices for unapproved uses. The SPACEMAKER-Registered Trademark- I platform, SPACEMAKER II-Registered Trademark- platform, SPACEMAKER-Registered Trademark- serial platform, combined SPACEMAKER-Registered Trademark- surgical balloon dissector/expander platform and KnotMaker-TM- product each have received 510(k) clearance for use during general, endoscopic, laparoscopic and cosmetic and reconstructive surgery, either when tissue dissection is required or, with respect to the KnotMaker-TM- product, when a surgical knot for suturing is required. The Company has promoted these products for surgical applications (E.G., hernia repair, treatment of stress urinary incontinence, subfascial endoscopic perforator surgery and breast augmentation and reconstruction), and may in the future promote these products for the dissection or knotmaking required for additional selected applications (E.G. saphenous vein harvesting, a variety of orthopaedic procedures such as anterior spinal fusion, and long bone plating). For any medical device cleared through the 510(k) process, modifications or enhancements that could significantly affect the safety or effectiveness of the device or that constitute a major change to the intended use of the device will require a new 510(k) submission. The Company has made modifications to its products which the Company believes do not affect the safety or effectiveness of the device or constitute a major change to the intended use and therefore do not require the submission of new 510(k) notices. There can be no assurance, however, that the FDA will agree with any of the Company's determinations not to submit a new 510(k) notice for any of these changes or will not require the Company to submit a new 510(k) notice for any of the changes made to the product. If such additional 510(k) clearances are required, there can be no assurance that the Company will obtain them on a timely basis, if at all, and delays in receipt of or failure to receive such approvals could have a material adverse effect on the Company's business, financial condition and results of operations. If the FDA requires the Company to submit a new 510(k) notice for any product modification, the Company may be prohibited from marketing the modified product until the 510(k) notice is cleared by the FDA. Sales of medical devices outside of the United States are subject to foreign regulatory requirements that vary widely from country to country. In October 1997, the Company received its CE mark certification, pursuant to the Medical Devices Directive which enables the Company to affix CE marking on its products and continue selling its products within the European Economic Area. The Company currently relies on its international distributors for the receipt of premarket approvals and compliance with clinical trial requirements in those countries that require them, and it expects to continue to rely on distributors in those countries where the Company continues to use distributors. In the event that the Company's international distributors fail to obtain or maintain premarket approvals or compliance in foreign countries where such approvals or compliance are required, the Company may be required to cause the applicable distributor to file revised governmental notifications, cease commercial sales of its products in the applicable countries or otherwise act so as to stop any ongoing noncompliance in such countries. Any enforcement action by regulatory authorities with respect to past or any future regulatory noncompliance could have a material adverse effect on the Company's business, financial condition and results of operations. LIMITED MANUFACTURING EXPERIENCE; UNCERTAINTY REGARDING FUTURE FACILITIES. The Company has only limited experience in manufacturing its products in commercial quantities. The Company intends to scale up its production of new products and to increase its manufacturing capacity for existing and new products. However, manufacturers often encounter difficulties in scaling up production of new products, including problems involving production yields, quality control and assurance, component supply and 19 shortages of qualified personnel. Difficulties experienced by the Company in manufacturing scale-up and manufacturing difficulties (including, in the event of low demand, over-capacity) could have a material adverse effect on its business, financial condition and results of operations. There can be no assurance that the Company will be successful in scaling up or that it will not experience manufacturing difficulties or product recalls in the future. In January 1997, the Company entered into a new facility lease in Cupertino, California, and relocated its headquarters and manufacturing operations to this new location during April 1997. The new facility's lease comprises approximately 30,460 square feet, and the monthly rent is approximately $52,000. DEPENDENCE ON SINGLE SOURCE SUPPLIERS; LACK OF CONTRACTUAL ARRANGEMENTS. The Company currently relies upon single source suppliers for several components of its balloon dissection products, and in most cases there are no formal supply contracts. There can be no assurance that the component materials obtained from single source suppliers will continue to be available in adequate quantities, if at all, or, if required, that the Company will be able to locate alternative sources of such component materials on a timely basis, if at all, to market its products. In addition, there can be no assurance that the single source suppliers will meet the Company's future requirements for timely delivery of products of sufficient quality and quantity. The failure to obtain sufficient quantities and qualities of such component materials, or the loss of any of the Company's single source suppliers, could cause a delay in GSI's ability to fulfill orders while it identifies and certifies a replacement supplier, if any, and could have a material adverse effect on the Company's business, financial condition and results of operations. PRODUCT LIABILITY RISK AND PRODUCT RECALL; LIMITED INSURANCE COVERAGE. The Company's business exposes it to potential product liability risks or product recalls that are inherent in the design, development, manufacture and marketing of medical devices, in the event the use of the Company's products causes or is alleged to have caused adverse effects on a patient or such products are believed to be defective. The Company's products are designed to be used in certain procedures where there is a high risk of serious injury or death. Such risks will exist even with respect to those products that have received, or may in the future receive, regulatory clearance for commercial sale. As a result, there can be no assurance that the Company's product liability insurance is adequate or that such insurance coverage will continue to be available on commercially reasonable terms or at all. Particularly given the lack of data regarding the long-term results of the use of balloon dissection products, there can be no assurance the Company will avoid significant product liability claims. Consequently, a product liability claim or other claim with respect to uninsured or underinsured liabilities could have a material adverse effect on the Company's business, financial condition and results of operations. RISKS ASSOCIATED WITH INTERNATIONAL SALES. There were no international sales in the first quarter of fiscal 1998 and $5,000 in the second quarter of fiscal 1998. Sales outside of the United States accounted for .5% and 4% of the Company's sales in fiscal 1997 and 1996, respectively. The Company expects that international sales will represent an increasing portion of revenue in the future. The Company intends to continue to expand its sales outside of the United States and to enter additional international markets, which will require significant management attention and financial resources and subject the Company further to the risks of selling internationally. These risks include unexpected changes in regulatory requirements, tariffs and other barriers and restrictions, reduced protection for intellectual property rights, and the burdens of complying with a variety of foreign laws. In addition, because all of the Company's sales are denominated in U.S. dollars, fluctuations in the U.S. dollar could increase the price in local currencies of the Company's products in foreign markets and make the Company's 20 products relatively more expensive than competitors' products that are denominated in local currencies. There can be no assurance that regulatory, currency and other factors will not adversely impact the Company's operations in the future or require the Company to modify its current business practices. DEPENDENCE ON MANAGEMENT AND OTHER KEY PERSONNEL. The Company is dependent upon a limited number of key management and technical personnel. The loss of the services of one or more of such key employees could have a material adverse effect on the Company's business, financial condition, and results of operations. In addition, the Company's success will be dependent upon its ability to attract and retain additional highly qualified sales, management, manufacturing and research and development personnel. The Company faces intense competition in its recruiting activities and there can be no assurance that the Company will be able to attract and/or retain qualified personnel. POTENTIAL VOLATILITY OF STOCK PRICE. The market prices of the Company's common stock and the stock of many other publicly held medical device companies have in the past been, and can in the future be expected to be, especially volatile. Announcements regarding competitive developments, product sales, clinical marketing trial results, release of reports by securities analysts, developments or disputes concerning patents or proprietary rights, regulatory developments, changes in regulatory or medical reimbursement policies, economic and other external factors, as well as period-to-period fluctuations in the Company's financial results, may have a significant impact on the market price of the Common Stock. In addition, the securities markets have from time to time experienced significant price and volume fluctuations that are unrelated to the operating performance of particular companies. YEAR 2000 COMPLIANCE. The Company is aware of the issues associated with the programming code in existing computer systems as the millenium (year 2000) approaches. The "year 2000" problem is pervasive and complex as virtually every computer operation will be affected in some way by the rollover of the two digit year value to 00. The issue is whether computer systems will properly recognize date sensitive information when the year changes to 2000. Systems that do not properly recognize such information could generate erroneous data or cause a system to fail. The Company is utilizing both internal and external resources to identify, correct or reprogram, and test the systems for the year 2000 compliance. It is anticipated that all reprogramming efforts will be completed by December 31, 1998 allowing adequate time for testing. Management believes that there will not be a material effect on the Company's earnings as a result of this compliance. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS In May 1996, Origin MedSystems, Inc., a unit of the Guidant Corporation, filed an action against GSI in the United States District Court for the Northern District of California, alleging patent infringement of its patent entitled "Apparatus and Methods for Peritoneal Retraction." In June, 1996, GSI filed a claim against Origin in the United States District Court for the Northern District of California, alleging patent infringement of its patent for a method of tissue plane dissection using balloon systems. In addition, on September 26, 1997, the Company filed another action against Origin alleging patent infringement of its patent for a method of serial inflation of tissue dissectors. A decision against the Company in any of these actions would have a material adverse effect on the Company's business, financial condition or results of operations. One of the patent applications filed by the Company, which is directed to a surgical method using balloon dissection technology, has been placed in interference with a patent application filed by Origin. The Company believes that the inventor named in its patent application was the first to invent this subject matter, and has asserted that the Origin patent application was filed after a disclosure made by such inventor to employees of Origin. Origin takes a contrary position. This interference is presently pending in the United States Patent and Trademark Office ("USPTO") and, as permitted by the rules of the USPTO, has been referred to an arbitrator for completion of the interference proceeding. A decision is not expected in the interference proceeding until calendar year 1998, and, while the Company believes it will be successful in this interference proceeding, there can be no assurance of such success. Failure of the Company to prevail in such interference proceeding or in either of the lawsuits described above would have a material adverse effect on the Company's business, financial condition and results of operations. 21 From time to time the Company may be exposed to litigation arising out of its products or operations. The Company is not engaged in any legal proceedings that are expected, individually or in the aggregate, to have a material adverse effect on the Company, except for the patent interference and infringement proceedings discussed herein. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS In connection with its initial public offering in 1996, the Company filed a Registration Statement on Form S-1, SEC File No. 333-02774 (the "REGISTRATION STATEMENT"), which was declared effective by the Commission on May 9, 1996. Pursuant to the Registration Statement, the Company registered and sold 3,450,000 shares of its Common Stock, $0.001 par value per share, for its own account. The offering commenced on May 10, 1996 and terminated when all of the registered shares had been sold. The aggregate offering price of the registered shares was $51,750,000. The managing underwriters of the offering were Cowen & Company and UBS Securities LLC. From May 10, 1996 to December 31, 1997, the Company incurred the following expenses in connection with the offering: Underwriting discounts and commissions $3,622,500 Other expenses $1,187,025 ---------- Total Expenses $4,809,525
All of such expenses were direct or indirect payments to others. The net offering proceeds to the Company after deducting the total expenses above were $46,940,475. From May 10, 1996 to December 31, 1997, the Company used such net offering proceeds, in direct or indirect payments to others, as follows: Construction of plant, building and facilities $ 1,164,154 Purchase and installment of machinery and equipment $ 1,189,779 Repayment of indebtedness $ 761,434 Working capital $24,389,526 ----------- Total $27,504,893
This use of proceeds does not represent a material change in the use of proceeds described in the prospectus of the Registration Statement. ITEM 3. DEFAULTS IN SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On November 10, 1997, at the Company's Annual Meeting of Shareholders for the Fiscal Year Ending June 30, 1997, the following matters were submitted and voted on by securityholders and were adopted: A. The election of directors to serve until their successors are elected and qualified. The results for the vote are as follows:
FOR WITHHELD --- -------- Gregory D. Casciaro 9,687,868 16,046 David W. Chonette 9,689,713 14,201 Thomas J. Fogarty 9,685,368 18,546 Paul Goeld 9,690,613 13,301 James R. Sulat 9,685,613 18,301 Mark A. Wan 9,690,613 13,301 Roderick A. Young 9,309,100 394,814
B. The approval of an amendment to the 1992 Stock Option Plan to increase the number of shares of Common Stock reserved for issuance thereunder by 500,000. The results for the vote are as follows:
FOR AGAINST ABSTAIN BROKER NON-VOTE --- -------- ------- --------------- 9,200,902 482,887 3,050 17,075
C. The ratification of Coopers & Lybrand, LLP as the Company's independent accountants for the fiscal year ended June 30, 1998. The results of the vote are as follows:
FOR AGAINST ABSTAIN --- -------- ------- 9,695,314 7,100 1,500
ITEM 5. OTHER INFORMATION None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 22 (a) Exhibits Exhibit Description ------- ----------- 27.1 Financial Data Schedule (b) Reports on Form 8-K The Company filed no reports on Form 8-K during the quarter ended December 31, 1997. 23 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. GENERAL SURGICAL INNOVATIONS, INC. By:/s/ STEPHEN J. BONELLI Stephen J. Bonelli Vice President, Finance and Administration Principal and Chief Financial Officer Date: February 13, 1998 24 EX-27.1 2 EXHIBIT 27.1
5 6-MOS JUN-30-1998 OCT-01-1997 DEC-31-1997 7,374 33,649 2,269 54 1,016 45,378 3,283 996 47,892 1,515 0 0 0 13 46,049 47,892 1,408 2,268 652 1,186 3,564 0 585 (1,897) 0 (1,897) 0 0 0 (1,897) (0.14) (0.14)
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