-----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, St/OzDu2vmppub5ac64kbfn676XCotRmPTpCuvNa2BeHhQuzvvTFd1VvWn1LUS1c 1tcCixCl1iZaCVXoFDq7lw== 0000891618-99-001334.txt : 19990403 0000891618-99-001334.hdr.sgml : 19990403 ACCESSION NUMBER: 0000891618-99-001334 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990331 FILER: COMPANY DATA: COMPANY CONFORMED NAME: VENTANA MEDICAL SYSTEMS INC CENTRAL INDEX KEY: 0000893160 STANDARD INDUSTRIAL CLASSIFICATION: SURGICAL & MEDICAL INSTRUMENTS & APPARATUS [3841] IRS NUMBER: 942976937 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-20931 FILM NUMBER: 99583712 BUSINESS ADDRESS: STREET 1: 3865 N BUSINESS CENTER DRIVE CITY: TUCSON STATE: AZ ZIP: 85705 BUSINESS PHONE: 5208872155 MAIL ADDRESS: STREET 1: 3865 N BUSINESS CENTER DR CITY: TUCSON STATE: AZ ZIP: 85705 10-K405 1 FORM 10-K405 1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K [x] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the calendar year ended December 31, 1998. OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the transition period from _________ to _________. Commission File Number: 000-20931 VENTANA MEDICAL SYSTEMS, INC. (Exact name of registrant as specified in its charter) Delaware 94-2976937 (State or other jurisdiction of (I.R.S. employer incorporation or organization) identification no.) 3865 North Business 85705 Center Drive (Zip Code) Tucson, AZ (Address of principal executive offices) Registrant's telephone number, including area code: (520) 887-2155 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.001 par value (Title of class) Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosures of delinquent filers pursuant to Item 405 of the Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in part III of this Form 10-K or any amendment to this Form 10-K. [X] The aggregate value of voting stock held by non-affiliates of the Registrant was approximately $166,581,268 based upon the average of the high and low prices of the Registrant's Common Stock reported for such date on the Nasdaq National Market. Shares of Common Stock have been excluded in that such persons may be deemed to be affiliates. The determination of affiliate status is not necessarily a conclusive determination for other purposes. As of December 31, 1998, the Registrant had outstanding 13,381,819 shares of Common Stock. DOCUMENTS INCORPORATED BY REFERENCE Not applicable ================================================================================ 2 VENTANA MEDICAL SYSTEMS, INC. INDEX Page Number ------ PART I............................................................... 1 Item 1. BUSINESS................................................. 1 Item 2. PROPERTIES............................................... 23 Item 3. LEGAL PROCEEDINGS........................................ 23 Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...... 24 PART II.............................................................. 25 Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.............................. 25 Item 6. SELECTED FINANCIAL DATA.................................. 26 Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS...................... 27 Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.............................................. 36 Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.............. 36 Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE...................... 36 PART III............................................................. 37 Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT....... 37 Item 11. EXECUTIVE COMPENSATION................................... 40 Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT............................................... 40 Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS........... 40 PART IV.............................................................. 41 Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.............................................. 41 3 PART I ITEM 1. BUSINESS THE COMPANY This Report on Form 10-K contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual events or results may differ materially from those projected in the forward-looking statements as a result of the factors described herein and in the documents incorporated herein by reference. Such forward-looking statements include, but are not limited to, statements concerning the risk of cancer; cancer screening; improvements in automated IHC; business strategy; development and introduction of new products; research and development; marketing, sales and distribution; manufacturing; competition; third-party reimbursement; government regulation; and operating and capital requirements. Ventana was incorporated in California in June 1985 and was reincorporated in Delaware in December 1993. As used in this Report on Form 10-K, the terms "Ventana" and the "Company" refer to Ventana Medical Systems, Inc. and its subsidiaries, Ventana Medical Systems, S.A., Ventana Medical Systems GmbH, Ventana Medical Systems Japan K.K., Biotechnology Tools, Inc., and BioTek Solutions, Inc. unless the context otherwise requires. The Company's principal executive offices are located at 3865 North Business Center Drive, Tucson, Arizona 85705. Its telephone number is (520) 887-2155. Overview Ventana develops, manufactures and markets instrument/reagent systems that automate tissue preparation and slide staining in histology laboratories worldwide. Tissue preparation involves removing water from the sample and embedding the sample in paraffin for tissue preservation and subsequent cutting prior to mounting on slides. Slide staining is used to perform immunohistochemistry ("IHC"), special stains ("SS"), and in situ hybridization ("ISH") tests for the analysis of cells and tissues on microscope slides. These tests are important tools used in diagnosing and selecting appropriate treatment for cancer and infectious diseases. The Company believes that it is the worldwide leader in the automated IHC testing market, as the Company estimates that its worldwide installed base is several times as large as the combined installed base of all of the Company's current competitors. Ventana has placed instruments with leading cancer centers, including the Mayo Clinic, the Dana Farber Cancer Institute, The Johns Hopkins University, the M.D. Anderson Cancer Center, the Fred Hutchinson Cancer Center, and Memorial Sloan-Kettering Cancer Center. Each Ventana proprietary system placed typically provides a recurring revenue stream as customers consume reagents and supplies with each test conducted. Consequently, two key elements of the Company's strategy are to increase the number of instrument placements and to maximize the recurring revenue stream per placement through increased sales of reagents and supplies. In late 1991, Ventana began commercial shipment of its first system, the Ventana 320 instrument and related reagents used for automated IHC tests. Since then, Ventana has developed and introduced the Ventana ES, the successor to the 320, the Ventana gen II, which is capable of performing ISH tests in addition to IHC tests, and the NexES as a successor to the ES. In October 1998, Ventana introduced the NexES Special Stains to automate the application of special stains to tissue to diagnose bacterial, viral or connective tissue disorders. These patient priority systems use Ventana's proprietary horizontal slide processing technology to perform multiple tests rapidly on a single patient biopsy. In February 1996, Ventana acquired BioTek Solutions, Inc. ("BioTek") which introduced its first automated IHC system, the TechMate 1000, in 1992, and has also introduced the successor TechMate 500 instrument as well as the TechMate 250 instrument. BioTek's batch processing systems use proprietary vertical slide processing technology to reliably and cost effectively process high volumes of single tests on multiple patient biopsies. These complementary product lines enable Ventana to serve a broad range of customers. Smaller hospitals, which generally do not handle a high volume of cancer patients, typically use patient priority systems to meet their automated testing needs. Reference and research laboratories that serve numerous institutions typically use batch-processing systems to process large volumes of tests. Large hospitals with a high volume of patients and a broad range of test requirements may use both patient priority and batch processing systems. Cancer is the second leading cause of death in the United States. According to the American Cancer Society estimates, 1.3 million new cancer cases were diagnosed in 1998 and 564,800 died of the disease in the United States. Currently, approximately 11 million people in the United States have a history of invasive cancer. 1 4 Recent studies have indicated that the mortality rates of certain types of cancer have decreased which may be attributed to, among other factors, earlier detection and selection of appropriate therapies. The vast majority of IHC testing associated with cancer diagnosis and treatment in the United States is conducted in an aggregate of approximately 2,200 clinical institutions and reference and research laboratories which the Company estimates creates the opportunity for the placement of as many as 2,500 automated IHC testing instruments. The Company estimates that the placement opportunities for SS instruments in the U. S. are slightly larger than for IHC instruments. The Company believes that less than 60% of such institutions and laboratories currently conduct IHC testing on an automated basis. The international market for automated IHC, SS and ISH testing is estimated by the Company to be approximately 1.5 times the size of the United States market, with Europe accounting for the majority of the international market potential. It is further estimated that automated IHC staining systems have penetrated less than 25% of European labs and less than 5% of the labs in Japan and the rest of the world. SS staining is performed manually on a worldwide basis. Currently, most IHC and all special stains testing is performed manually which often yields inconsistency of test results. As compared to manual IHC testing, Ventana's automated systems provide improved reliability, reproducibility and consistency of test results. The systems' economic advantages include faster turnaround time, increased test throughput and a reduced dependence on skilled laboratory technicians, thereby reducing costs per test. Additional benefits include the ability to perform new and emerging diagnostic tests and improved visual clarity, which aids the interpretation of test results and the ability to obtain maximum clinical information from minimally sized biopsies. The Company believes it will play a critical, expanding role in cancer science as researchers will use Ventana systems to accelerate the identification and development of new tests and that its installed base of instruments will speed the commercialization and clinical implementation of such new tests. The Company anticipates that its reagent test menu will expand due to the major emphasis of cancer research on the identification of new prognostic IHC and ISH indicators. In October 1998, Ventana acquired Biotechnology Tools, Inc. ("BTTI") a commercial manufacturer of microtomes and tissue processors. Tissue processors and microtomes are directly involved in the preparation of tissue specimens used by the NexES IHC, NexES SS, and ISH systems. BTTI introduced its first tissue processor, the PTP-1530 in late 1992. The PTP-1530 is a batch instrument that has a specimen chamber that serves as the site of fluid exchange. Within the specimen chamber, a series of fluids are passed that stabilize and infiltrate the tissue with paraffin wax. This overnight process is performed on every tissue specimen that is obtained in a clinical setting. The PTP-1530, introduced to Ventana customers as the Ventana Renaissance can process up to 350 specimens simultaneously. The PTP-1530 has a number of unique features that differentiate it from the competition including a pulse magnetic stirring system that significantly improves the quality of processed specimens. In addition to the PTP-1530, BTTI manufactured a series of manual, semi-automated, and automated microtomes for the histology and electron microscopy laboratory. Microtomes are precision devices that have to reproducibly cut thin slices from paraffin embedded blocks in the range of 2 - 20 millionths of a meter in thickness. Ventana has introduced three of the microtomes into the market as the Ventana 100, 200, and 300 Series. In November 1998, Ventana acquired substantially all of the oncology assets of Oncor, Inc. to control the delivery of certain gene-based tests in furtherance of the Company's ISH expansion strategy. INDUSTRY OVERVIEW Immunohistochemistry Cancer is the second leading cause of death in the United States. According to the American Cancer Society estimates, 1.3 million new cancer cases were diagnosed in 1998 and 564,800 died of the disease in the United States. Currently, approximately 11 million people in the United States have a history of invasive cancer. In the United States, the lifetime risk of developing invasive cancer is 47% for males and 38% for females. The risk of developing cancer increases with age. Among the principal forms of cancer are prostate, lung, breast, colon, rectal, urinary, ovarian and cervical cancer, along with leukemia and lymphoma. Early detection is one of the primary factors in increasing the long-term survival of cancer patients. It is believed to be at least partially responsible for decreases in mortality rates that have recently been observed for several types of cancer. Health care professionals are increasing their emphasis on and use of screening and early 2 5 detection programs for cancer because cancer treatments are generally significantly more effective and less costly the earlier that cancer is detected. Complementing screening and early detection are recent advances in less invasive biopsy methods that can obtain tissue samples from progressively smaller tumors. As a result of these developments, there has been a steady increase in the initial diagnosis of invasive cancer. However, smaller tissue samples are often difficult to analyze with traditional diagnostic tests, increasing the dependence of surgical pathologists on IHC for accurate diagnosis of early stage cancer. After preliminary screening of a biopsy to determine the presence of cancer, IHC is the principal diagnostic test method used for cancer diagnosis and therapy selection. IHC tests use specific antibodies to identify and detect antigens (proteins) in cells and tissues, which assist pathologists in assessing various aspects of a patient's cancer. IHC tests, or assays, have two major components: primary antibodies and detection chemistries. The primary antibody is the specific antibody used to bind to the antigen in question. Detection chemistries are composed of multiple reagents including secondary antibodies, enzyme conjugates/complexes and chromogenic enzyme substrates, which allow visualization of the primary antibody. IHC tests are performed on cells and tumor tissue to: - determine the type of cancer - determine the site of the primary tumor - determine the degree of malignancy - determine if the cancer has metastasized - assist in the selection of the most appropriate therapy - monitor patient progress - develop a prognosis Correct prognosis is essential in selecting the appropriate therapy regimen and monitoring program for individual cancer patients. IHC assays provide significant prognostic information such as cell cycle and hormone receptor status which, in many cases, cannot be obtained from other tests. This information allows the pathologist to improve risk assessment on an individual patient basis. IHC testing is therefore instrumental to controlling and reducing health care costs and improving cancer survival rates because earlier, more accurate diagnoses and prognoses can lead to earlier, more targeted therapy and may reduce the risk of use of an incorrect or inappropriate treatment. Manual IHC assays require skilled technical personnel to perform as many as 60 individual processes and can require several days to complete. For the assay to be successful, each process must be performed in the proper sequence and for the proper length of time. In addition, the length of time and the reagents used for each of the steps varies depending upon the primary antibody used in the assay. The complexity of manual IHC assays leads to poor reproducibility and inconsistency of results. Therefore, while IHC has been used routinely in clinical diagnosis for over 10 years, the requirement of skilled technical personnel, labor intensity (approximately 40 slides per day per technician) and lack of standardization has limited the growth of clinical IHC. The development of new diagnostic systems composed of instruments and reagents has resulted in the automation of tests in a number of diagnostic market segments. The trend toward automation of diagnostic testing began in the 1960s with the automation of hematology testing by Coulter Electronics Corporation and clinical chemistry testing by Technicon Instruments Corporation. In the 1980s, Abbott Laboratories, Inc. ("Abbott") introduced two instruments with proprietary prepackaged reagents to automate immunoassay tests performed on serum or urine. Ventana's systems are fundamental enabling technologies that overcome major obstacles, including the inherent limitations of manual processing, which have historically prevented both the broader use and growth of IHC. 3 6 Special Stains Special stains use a variety of dyes to stain specific tissue components. Special stains have had a long history of use in the diagnosis of cancer, the identification of specific tissue components, and the identification of infectious agents. Special stains tests are performed on cell and tissue specimens to: - Determine the type of cancer - Determine the site of primary tumor - Determine the degree of pathologic change - Identify tissue structures - Identify infectious agents - Assist in the selection of appropriate therapy Special stains are technically more difficult to perform than an IHC stain. This difficulty arises both during the preparation of reagents as well as in the performance of the assay. Each special stain may require different reagents, each of which may have limited stability. In addition to the difficulty involved with the preparation and management of reagents, producing a high quality special stain slide requires the technician to manage multiple reagents at a variety of temperatures for different lengths of time. The technical challenges associated with this procedure illustrate why performing quality special stains has been considered more an "art" than a "science." The Ventana NexES SS system was designed to overcome the technical challenges associated with manual special stains. The enabling technology associated with this system when combined with the prepackaged special stains reagents were designed to produce high quality, reproducible staining using an easy to use, automated platform. In Situ Hybridization ISH tests are advanced tests for infectious disease and cancer diagnosis and other applications that generate visual signals based on probes used to detect the presence of specific nucleic acids (DNA/RNA) contained in a cell. Over the next decade, Ventana believes that ongoing research and development in the field of molecular analysis will result in the continued introduction of new ISH tests. ISH assays are technically far more challenging and labor intensive than IHC assays. In addition to requiring a similar number of processes which must be performed in the proper sequence and for the proper length of time, ISH assays require multiple wash solutions, or buffers, and the temperature at which each of the steps must be executed typically ranges from 37 degrees C to 98 degrees C. Furthermore, the conditions for each of these processes is dependent upon the specific probe being used. Due to this extreme degree of technical difficulty, there are very few clinical laboratories capable of performing manual ISH assays. Ventana's gen II system represents a fundamental enabling technology for the rapid, accurate and cost effective identification of unique RNA and DNA (probe diagnostics) and is designed to overcome the inherent limitations of manual processing. Tissue Processors and Microtomes The preparation of surgical specimens in a laboratory requires the pathologist or physician's assistant (P.A.) to describe the specimen, and to sample appropriate regions for microscopic examination. In this process, tissue specimens are placed into a plastic cassette that is used to immobilize the tissue during tissue processing. The routine preparation of tissue samples occurs on a Tissue Processor, an automated batch instrument that facilitates the fixation, dehydration, clearing, and infiltration of the tissue specimen. This process results in the stabilization of the tissue specimen, and its infiltration in a supporting medium (paraffin). The paraffin infiltrated tissue specimen is 4 7 then oriented within a mold and embedded in fresh paraffin wax. The development of automated systems for tissue processing has significantly improved the quality of the prepared tissue. Since the quality of the processed specimen clearly impacts the sensitivity and reliability of the IHC, SS and ISH produced on the Ventana staining systems, Ventana's entry into tissue processing is an important step in assuring the quality of Ventana's core business. The Ventana Renaissance is a batch tissue processor that can process up to 350 specimens simultaneously. The Renaissance has a number of unique features that differentiate it from the competition including a pulse magnetic stirring system that significantly enhances processing quality, and a paraffin cleaning system that extends the life of the paraffin. In order to prepare slides for microscopic examination, the tissue blocks are placed onto a microtome, which is a precision device used to cut thin sections for microscopic examination. The quality of the prepared sections is critically important in the evaluation of surgical specimens. In addition to the tissue processor, BTTI manufactured a series of manual, semi-automated, and automated microtomes used in the preparation of microscopic sections. The three microtome lines are currently branded as the Ventana 100, 200, and 300 series. Since repetitive motion injuries pose significant risks to technicians who use microtomes, the semi-automated and automated microtomes were designed reduce the repetitive motions used in tissue sectioning. VENTANA STRATEGY The Company's strategy is to strengthen its worldwide leadership position in the automated IHC testing market and to develop and expand the automated SS and ISH testing markets. In order to implement this strategy, the Company intends to: Maximize Instrument Placements. The Company's strategy is to strengthen its competitive position in the automation of IHC testing by establishing a larger installed base of instruments that current or future market entrants must overcome. The Company estimates that its worldwide installed base is several times as large as the combined installed base of instruments of all of the Company's current competitors. The Company believes that its placement of instruments in 43 of the 58 cancer centers identified as principal cancer research centers by the National Cancer Institute provides a powerful reference tool for potential new customers. To facilitate instrument placements, the Company offers customers a wide selection of instruments, which address the patient priority needs of hospital clinical laboratories and the batch processing needs of large hospitals and reference and research laboratories. In order to satisfy the broad spectrum of customers' operational and financial criteria, the Company intends to continue to offer several instrument procurement options, including leases, direct sales, rentals and the Qualified Reagent Installed Base program ("QRIB") and to expand the range and price points of its instrument offerings. In a QRIB, the Company provides the customer with the use of an instrument for up to six months, provided the customer purchases a minimum of $3,000 in IHC or $2,500 in SS consumables. At the end of the six-month period, the customer must elect to purchase, rent or return the system. The Company believes it can accelerate the rate of expansion of its installed base by emphasizing the placement of instruments through QRIBs. Maximize Revenue Stream Per Placement. Each instrument placed typically provides the Company with a recurring revenue stream through the sale of reagents and supplies. The Company seeks to increase this revenue stream by converting all existing manual tests performed by the customer to full automation and by selling to the customer all reagents required for such tests. The Company then seeks to have the customer expand its test menu through the inclusion of all tests that are offered by Ventana as well as new tests as they are introduced. To meet these objectives, the Company's systems have been designed as broad enabling platforms, which permit customers to easily expand their test menu. The Company also has a comprehensive customer education program, which includes on-site technical training in instrument use, user group meetings and Company-sponsored national teleconferences with leading medical experts who regularly update customers on diagnostic and testing developments. Develop New and Enhanced Products. Since 1991, the Company has successfully introduced and commercialized the Ventana NexES SS, the Ventana NexES IHC, the Ventana ES, the gen II, the TechMate 500 and the TechMate 250, as well as systems to support all these instrument platforms. Ventana is also developing additional instruments to automate other labor-intensive activities in histology labs and is also developing next generation ISH instruments. The Company intends to continue to innovate in the field of automated cellular diagnostics through the development and introduction of new instruments, software and reagents. 5 8 Encourage Standardization of Clinical Diagnostic Practices. The Company intends to support efforts to standardize clinical practices in the diagnosis and complete characterization of various types of cancer through professional education programs for pathologists and research collaborations. Uniform practice guidelines for the laboratory diagnosis of cancer are just now beginning to be established and accepted. As an example, the American Society of Clinical Oncology recently released its recommendations for the use of selected hormone/protein markers in which it recommended that all breast cancer cases be tested for estrogen receptor and progesterone receptor in order to select the optimal course of therapy. The Company's automated systems allow for the widespread standardization of testing methods that could be clinically relevant in this effort. In addition, the Company's educational programs will be designed to disseminate these and other practice recommendations as they are developed and to assist clinicians and professional organizations in the formulation of additional guidelines. Expand Intellectual Property Position. The Company seeks to expand its intellectual property position by entering into strategic alliances, acquiring rights of first refusal on future commercial developments and licensing existing technologies. The Company evaluates and intends to pursue the licensing of nucleic acid probe technology for ISH applications from biopharmaceutical companies, research institutions and others. PRODUCTS The Company offers proprietary systems composed of instrumentation, reagents and consumable products which are designed to enable clinical and research laboratories to perform standardized IHC, SS and ISH testing. The proprietary nature of the Company's systems is based upon the interrelationship among the electronics and mechanical and software control of the instrument and the stabilization, composition, packaging and delivery of reagents. The Company's broad line of products includes patient priority systems targeted to hospital clinical laboratories and batch-processing systems targeted to large hospital clinical laboratories and reference and research laboratories. The Company's patient priority systems are "closed" in that customers must purchase detection chemistries from Ventana in order to operate the instruments. Although the Company's existing batch processing systems are "open," providing the customer with the ability to purchase reagents from either the Company or other sources, users of approximately 83% of the Company's United States installed batch processing systems regularly purchase reagents from the Company. The following are the principal benefits of automated cellular and tissue analysis using the Company's integrated systems as compared with manual methods: - improved reliability, reproducibility and consistency of test results - faster turnaround time for test results - increased test throughput for the testing laboratory - ability to perform new and emerging molecular tests - reduced dependence on skilled laboratory technicians - ability to perform special staining applications (batch processing instruments) - ability to obtain maximum clinical information from minimally-sized biopsies - ability to document processing protocols (patient priority instruments) - enhanced cellular differentiation through multiple staining on a single slide - standardization of slide preparation among institutions In addition to these critical clinical and operational advantages, the Company has determined that its automated approach has cost advantages as well. 6 9 Instrument Products Patient Priority Instruments. Ventana currently offers two patient priority systems, the Ventana NexES and the Ventana gen II. The Ventana patient priority systems provide a complete automated approach, requiring users to only prepare specimens and place them on microscope slides. The patient priority systems are barcode driven and are designed for multiple tests on a single patient biopsy with rapid turnaround time and walk-away convenience. A barcode label affixed to each slide positively identifies the slide and the test procedures to be performed. The instrument scans the barcodes on the slides and the reagent dispenses and processes each slide with the unique steps necessary to perform each test. The Company's proprietary software controls all aspects of the test procedures. The steps of dispensing, incubating (i.e. temperature and time control) and washing are performed by the instrument using a series of proprietary chemical/mechanical methods developed by Ventana. These methods are critical to obtaining precise, sensitive and rapid test results and make the system reliable and easy to use. Typically, the processing of slides on the instrument requires less than two hours. The Ventana NexES is based upon a modular design and an external personal computer operating under a Windows 95 environment for software control. Each module holds up to 20 slides in the reaction chamber and 25 reagents on its reagent carousel. The modular design of the NexES and external personal computer permits the linkage of up to eight NexES IHC or SS modules together, creating the capacity to process up to 160 slides. The NexES therefore offers users a significant degree of flexibility as users can purchase from one to eight modules depending upon their test volume requirements. The Special Stains System has a new enabling technology, the aspiration and dispense system (ADS) that provides flexibility in dispensing volume, while allowing the instrument to use reagents with different chemical properties. In addition to the ADS system, the kinetic heating system has been modified to provide for the 60 degree celsius heating that is required for quality Special Stains. The Ventana gen II uses the same basic architecture as the Ventana ES instrument and has additional functions enabling it to perform ISH tests. These functions are (i) an improved heating system which allows for incubation temperatures of up to 98 degrees C, (ii) rapid incubation temperature cycling and (iii) additional and improved wash stations which permit the use of multiple buffers and instrument controlled changes in the concentration of buffers. Ventana's gen II system represents a fundamental enabling technology for the rapid, accurate and cost effective identification of unique RNA and DNA (probe diagnostics) and is designed to overcome the inherent limitations of manual processing. Batch Processing Instruments. The Company's line of TechMate batch processing instruments are designed for large volume testing using a single antibody on multiple patient biopsies and research applications in which long incubation times and unique detection chemistries are required. The Company's batch processing instruments employ capillary action to perform IHC tests. Patient biopsies are placed on capillary gap slides, which maintain a space of predetermined width between adjacent slides when loaded into TechMate systems. Reagents are loaded into disposable reagent trays and programmable software directs the instrument to apply the reagents in the proper sequence. The instrument immerses the bottoms of the slides in the reagents as programmed and the reagents are drawn up the slide and over the tissue specimen by capillary action. After each reagent application and incubation, the instrument removes the reagent from the specimen by placing the slides onto disposable blotting pads. The Company's original batch instrument, the TechMate 1000, has a 300-slide capacity. This large capacity is suited to large reference laboratories, which run a limited number of antibody tests on vast numbers of patient biopsies. The Company has ceased production of the TechMate 1000. The successor instrument, the TechMate 500, has a 120-slide capacity, which is applicable to both large and moderately-sized reference laboratories and large research laboratories. The TechMate 250, which has a 40-slide capacity, is targeted primarily for the European and other international markets. Tissue Processor and Microtomes The Renaissance tissue processor is a batch instrument that can accommodate up to 350 specimens per run. This completely enclosed system can be configured as a floor or bench top unit. The Renaissance has easy to use software that has unlimited programmability. The Renaissance has a pulse magnetic stirrer that, in conjunction with kinetic technology significantly improves the quality of prepared tissue. The quality control system with the Renaissance allows the user to monitor the quality of their reagents using a reagent quality monitoring system, and 7 10 to extend the life of their reagents using a paraffin cleaning system. The Ventana series of microtomes offer a complete range of instruments including a fully manual, semi-automated, and automated system. The 100 Series manual microtome is a manual microtome designed for the budget-minded lab. The 200 Series microtome is a semi-automated microtome, which has an automated trim function reducing the repetitive motion, associated with trimming. The 300 Series Microtome is a fully automated microtome which features automated trimming and cutting, significantly reducing the repetitive motion involved in paraffin sectioning. Reagent and Consumable Products Reagent Products Reagent products are composed of primary antibodies and detection chemistries, each of which is required for an IHC test. Customers that have patient priority systems must use Ventana detection chemistries on all tests; such customers have the option of purchasing primary antibodies from Ventana or other sources. Customers who have the Company's batch processing systems have the option of purchasing both antibodies and detection chemistries from Ventana or other sources. Users of approximately 83% of the Company's United States installed batch processing systems regularly purchase reagents from the Company. Primary Antibodies. Ventana sells a line of in excess of 175 primary antibodies used to detect antigens in combination with detection chemistry kits on the Company's instruments. Ventana markets all of the antibodies used to perform the IHC tests that currently account for more than 90% of total IHC test volume. Detection Kits. Detection chemistries typically account for approximately 65-70% of the total expenditures for reagents required to perform IHC tests using the Company's instruments. Ventana produces a line of detection chemistries for use on both patient priority and batch processing systems which provide the user with standardized reagents, thereby giving the user convenient and rapid results. The detection chemistries have been developed by the Company using proprietary formulations which, when combined with the Company's primary antibodies and other reagents, optimize the results of tests performed on the Company's instruments. These kits generate the visual signal in an IHC reaction at the site where a primary antibody is bound to a specific antigen or molecule in the cell or tissue. The patient priority system utilizes detection kits which include (i) a DAB Kit which generates a brown color; (ii) an AEC Kit which generates a deep red color; (iii) an Alkaline Phosphatase Red Kit which generates a bright red color; and (iv) an Alkaline Phosphatase Blue Kit which generates a deep blue color. The Company currently sells DAB and Alkaline Phosphatase Red for use with its batch processing instruments. The detection kits are designed to perform tests on a wide variety of specimens, so a laboratory can, for example, perform tests on tissue preserved in paraffin and on frozen tissue simultaneously. The Company's detection chemistries have been formulated to provide long term stability for reproducibility and ease of use as well as a high signal to noise ratio for optimal sensitivity. Special Stain Kits. Ventana sells 10 Special Stain kits that perform greater than 85% of all the tests performed in the Histology laboratory. The Company's Special Stain Kits were developed using proprietary formulations. The Special Stains kit, when combined with the NexES Special Stains system, produce high quality, robust staining that is optimized for use on the system. The kits produce a visual signal at the site of dye binding allowing the pathologist to characterize pathologic changes of infectious agents. The kits have been formulated to provide long term stability while maintaining a high signal to noise ratio. Consumable Products Ventana offers a line of consumable ancillary products that are necessary for processing slides on the Company's instruments. These include buffers for optimizing the IHC reaction and counterstains for staining cell nuclei, which are used with both patient priority and batch processing instruments. The buffers ensure good morphology, low backgrounds and high signals. The counterstains provide additional convenience for the customer by eliminating the need for additional processing of the slides after staining on the instrument. For use with patient priority instruments, Ventana also supplies a proprietary liquid coverslip used to inhibit evaporation during processing in the instrument, fixatives for maintaining the morphology of cells or tissues, enzymes for unmasking antigens and slide barcodes for use in identifying the slide and its specific IHC reaction steps. For use with batch processing instruments, the Company also provides disposable reagent trays which are used to hold the reagents during IHC reactions, capillary gap slides and wicking pads used for reagent removal between applications. 8 11 MARKETS AND CUSTOMERS Immunohistochemistry There are approximately 4,200 acute care hospitals and clinics in the United States. Of these, there are approximately 1,900 hospitals with over 200 beds, which perform the vast majority of surgical and other medical procedures related to cancer diagnosis and treatment. In addition, there are approximately 200 reference and research laboratories and approximately 100 biotechnology and pharmaceutical companies, which also perform substantial numbers of IHC and ISH tests. These health care institutions represent a total instrument site potential of 2,200 locations. Ventana considers this to be its core market segment for cancer testing and focuses the bulk of its sales and marketing efforts on these institutions. The Company estimates there are as many as 2,500 IHC instrument placement opportunities in the 2,200 potential instrument site locations in the United States. The international market for instrument placements is estimated by the Company to be approximately 1.5 times the size of the United States market. Europe is estimated to account for the majority of the international market potential, and Japan, the Pacific Rim and Latin American markets constitute the balance of the international market opportunity. The Company believes that less than 60% of the United States potential instrument sites currently conduct IHC testing on an automated basis. The Company believes that its worldwide installed base is several times as large as the combined installed base of instruments of all of the Company's current competitors. Ventana has placed instruments with leading cancer centers, including the Mayo Clinic, the Dana Farber Cancer Institute, The Johns Hopkins University, the M.D. Anderson Cancer Center, the Fred Hutchinson Cancer Center, and Memorial Sloan-Kettering Cancer Center. Special Stains The Special Stains instrument market is larger than the IHC market, in that virtually all labs perform Special Stains. The Company estimates that there are greater than 8,000 labs worldwide performing Special Stains providing as many as 10,000 instrument placement opportunities. Tissue Processor and Microtome The tissue processor and microtome market is the largest market available in the histology laboratory with as many as 12,000 instrument placement opportunities in the tissue processor market and 48,000 instrument opportunities available in the microtome market. On an annual basis, 6 companies compete for the 1,000 tissue processor placements, and 9 companies compete for the 3,000 microtome placements per year. SALES, MARKETING AND CUSTOMER SUPPORT Ventana markets and sells its instruments and reagents through a direct sales force in North America, certain European countries, and Japan. It has also established distribution relationships in other countries and has a distribution arrangement with DAKO, a manufacturer and supplier of reagents used in manual IHC testing, which was inherited with the BioTek acquisition and only relates to batch processing systems for certain countries outside the United States. In the United States and Canada, Ventana's systems are sold through its direct sales force. The sales force is organized around geographic territories, which have been designed to provide each sales representative with an approximately equal number of sales opportunities. The sales force is also divided between a key account sales force, which is focused on large users, a U.S. hospital sales force, which calls on all other accounts, and a tissue processor/microtome sales force. The Company's sales representatives typically have technical backgrounds or prior medical capital equipment sales experience. The Company's sales representatives are incentivized to increase instrument placements. The sales representatives as well as the technical marketing representatives are incentivized to maximize recurring reagent sales. 9 12 Ventana's sales force in Europe markets and sells Ventana's patient priority systems directly in France, Germany, Austria, Switzerland, Benelux, Scandinavia, and the U. K. and markets and sells through distributor relationships in Italy, Spain and various former East Bloc countries. This sales force is geographically organized and is compensated in a manner similar to the United States sales force. Ventana expects to significantly expand its direct sales and marketing activities in Europe in 1999. Ventana's sales force in Japan consists of sales and support personnel. Ventana expects to significantly expand its direct sales and marketing activities in Japan after the Company receives import permits for its reagents. BioTek entered into its agreement with DAKO in September 1994. DAKO is a market leader in Europe in supplying reagents for use in manual IHC tests. The agreement provided DAKO with exclusive rights to distribute TechMate instruments and related accessories in Europe and several other territories. The agreement also permits DAKO to supply customers with its own reagents for the instruments in return for paying BioTek a fixed dollar royalty amount. For each TechMate 500 instrument installed at a customer site, the royalty is payable over a five-year term. For each TechMate 250 shipped to DAKO, a prepaid royalty amount of $7,000 is paid by DAKO. Under the agreement, DAKO is subject to certain minimum purchase requirements for instruments. In connection with BioTek's agreement with DAKO, DAKO made two loans secured by a pledge of substantially all of BioTek's assets. DAKO also made prepayments on future instrument sales and reagent royalties to BioTek. These loans and prepayments were used to fund TechMate 250 instrument development and working capital requirements. In May 1998, the Company and DAKO entered into an amended and restated distribution agreement for the purpose of addressing several matters including the pricing dispute for the TechMate 250. The new agreement provides for the aggregate amount of the negotiated reduction in the TechMate price to be added to the BioTek debt to DAKO and for the entire debt to be unsecured. The restated debt, which at December 31, 1998 was included as long-term debt in the Company's Consolidated Financial Statements in the amount of $1.6 million, accrues interest at 7% per annum payable quarterly commencing January 1, 2000. Principal payments on the debt are to be made in 16 quarterly installments, starting March 31, 2000. Ventana's sales and marketing strategy for its systems is focused on increasing its penetration of the hospital and laboratory market through several instrument placement options. The Company places instruments through direct sales including nonrecourse leases, instrument rentals and the Company's QRIBs. In a QRIB, the Company provides the customer with the use of an instrument for up to six months, provided the customer purchases a minimum of $3,000 IHC or $2,500 SS consumables. At the end of the six-month period, the customer must elect to purchase, rent or return the system. A key component of the Company's business strategy is to increase the sale of reagents into its installed instrument base through a high level of customer support. The Company's technical marketing representatives assist in training customers in the use of the Company's systems and seek to increase customer reagent utilization by facilitating the transfer of workload from manual procedures. Through direct customer contact, the Company's technical marketing representatives are able to promote sales of reagents and suggest new IHC test applications to customers. New customers receive initial training on the systems either in the field or at Ventana's facilities in Tucson, Arizona. The Company's technical marketing representatives then visit the customer to provide additional on-site training. Thereafter, Ventana actively supports customers with periodic product bulletins and provides 24-hour customer telephone support. Ventana actively markets its products through participation at industry trade shows, video and audio presentations by leading pathologists and direct mail. MANUFACTURING The Company manufactures its patient priority instruments at its facilities in Tucson, Arizona. The Company has recently expanded its patient priority instrument offering through the addition of NexES Special Stains, rotary microtomes and tissue processors. Manufacturing facilities and operations in Tucson have also expanded and the company believes that this expansion will provide the Company with sufficient manufacturing capacity to meet its anticipated requirements for patient priority instruments for approximately the next two years. Components for patient priority instruments are purchased from a variety of suppliers, subject to stringent quality specifications. The components are assembled by Ventana's highly skilled manufacturing technicians into finished products. A quality assurance group performs tests at regular intervals in the manufacturing cycle to verify compliance with the Company's specifications and regulatory requirements, including Good Manufacturing Practices ("GMP") requirements. 10 13 A number of the components used in the Ventana instrument families are fabricated on a custom basis to the Company's specifications and are currently obtained from a limited number of sources. To date, however, the Company has not experienced any material disruptions in the supply of such components. The Company continues to qualify and partner with additional suppliers. To date, the Company has not experienced significant difficulties with manufacturing yields and has experienced minimal manufacturing waste in the patient priority instrument manufacturing process. The Company has relationships with third-party manufacturers for the manufacture of batch processing instruments. The Company has contracted with Kollsman Manufacturing Company, Inc. for the manufacture of TechMate 500 instruments and with LJL Biosystems, Inc. for the manufacture of TechMate 250 instruments. Reagents sold for use with the Company's patient priority instruments are manufactured by Ventana, which purchases basic raw materials and performs value-added manufacturing processes, such as formulation, fill and packaging, at its facilities. Certain components and raw materials, primarily antibodies, used in the manufacturing of the Company's reagent products are currently provided by single source vendors. To date, the Company has not experienced any material disruptions in supply from these vendors and has experienced levels of manufacturing waste in the reagent manufacturing process that it believes to be below industry averages. Reagents sold for use with the Company's batch processing instruments have been manufactured at Ventana's Tucson facilities since September 1996. Probes are manufactured in Gaithersburg, Maryland. Ventana is positioned to capture margin and value added which was lost through payments to third-party manufacturers, to increase economies of scale in both raw material purchasing and manufacturing, to standardize procedures and processes, to increase control over scheduling and to improve manufacturing flexibility. The Company's current reagent manufacturing process at its Tucson, Arizona and Gaithersburg, Maryland facilities is semi-automated. The Company anticipates that as production volumes increase it will increase the level of automation. The Company currently has sufficient reagent manufacturing capacity to meet its anticipated needs for approximately the next two years. The Company's long-term plans are to build a new reagent manufacturing facility in the Tucson area to increase its reagent manufacturing capacity and increase the level of automation of the manufacturing process. The Company anticipates commencing construction of this facility in 1999. The Company's manufacturing operations are required to be conducted in accordance with GMP guidelines. GMP requires the Company to maintain documentation and process control in a prescribed manner with respect to manufacturing, testing and quality control. In addition, the Company is subject to FDA inspections to verify compliance with FDA requirements. The Company also intends to implement manufacturing policies and procedures, which will enable the Company to receive ISO 9000 certification. ISO 9000 standards are global standards for manufacturing process control and quality assurance. The Company will be required to obtain the CE mark for continued sale of its products in the countries comprising the European Union. The CE mark is an international symbol of quality assurance and compliance with applicable European Union medical device directives. RESEARCH & DEVELOPMENT AND ENGINEERING The Company has focused its research, development and engineering efforts on the development of innovative reagent and instrument systems. As of December 31, 1998, Ventana's Research & Development and Engineering groups consisted of 41 persons, many of whom have graduate degrees. Ventana's research and development activities are performed primarily in-house by Ventana employees. These efforts are supplemented by consulting services and assistance from Ventana's scientific advisors. The Company is developing reagents for existing instrument bases and new products. In addition, the Company is developing new instruments and enhancing existing instruments. During the fiscal years ended December 31, 1998, 1997 and 1996, Ventana spent $5.1 million, $3.1 million and $2.7 million, respectively, on research and development. 11 14 Reagent Development Projects Ventana's reagent development is divided into four principal areas. These include new antibody development, detection chemistries, special stain chemistries, and ISH chemistries. Ventana continues to monitor third-party development of new primary antibodies. Antibodies recognizing new prognostic markers for monitoring breast cancer patients were introduced in February 1998. These, in combination with other antibodies currently available from Ventana, constitute a panel of antibodies useful in determining therapeutic alternatives and predicting therapy outcomes for breast cancer patients. In addition, fluorescent-labeled antibodies have been developed which were first sold in March 1998. These antibodies are useful in determining the renal and dermatopathological status of patients. Ventana also continues to improve the sensitivity and specificity of detection chemistries. An amplification kit was introduced in the third quarter of 1997 which, when used in conjunction with any of Ventana's existing detection chemistries, allows smaller amounts of diagnostic markers to be visualized in tissues. In addition, projects are ongoing that will further improve the sensitivity of the present detection choices. Reagent development also supports the development of new instrument systems. A complete reagent product line was introduced in conjunction with the August 1997 market launch of the NexES instrument. Projects to provide reagents for instrument systems continue in two major new instrument system development areas - special stains and ISH. Development of nucleic acid probe and detection ISH kits, to detect the causative agents for numerous infectious diseases, is ongoing. An agreement with Chiron to utilize bDNA technology for HIV and other infectious disease agents was completed in the first quarter of 1998 and will provide the required sensitivity for ISH tests. The Company is currently in discussion with various universities, hospitals, and commercial organizations regarding other potential areas of opportunities for the ISH system. Instrumentation Development Projects Ventana's instrumentation development is focused on continuous product improvement and new product innovation. The Company believes that the platform used by the modular IHC system, NexES, will enable it to develop more rapidly new products, which achieve these goals. This strategy proved successful in 1998 with the NexES Special Stains system being developed and commercialized in less than 12 months. This modular development strategy is continuing in 1999 with two new modules under development, which will further automate and integrate the histology laboratory. In addition, the Company will be introducing in the first half of 1999, a microtome and tissue processor family of products developed from the platforms acquired from BTTI. These products are used in the front end of the histology lab prior to slide preparation for subsequent staining on Ventana's NexES modules. This system will use a proprietary label, which has been developed exclusively for Ventana's instrument system. Ventana continues to explore new opportunities in instrument systems, which add value to the customer. Plans are being developed for new systems to further capitalize on the Company's success with its patient priority and batch processing systems. PATENTS AND PROPRIETARY RIGHTS Ventana has pursued a strategy of patenting key technology as it relates to both the automation and the chemistry of analyzing cells and tissues on microscope slides. Ventana holds 16 United States patents and 20 foreign patents and has filed additional United States and foreign patent applications. Six of Ventana's United States patents were issued in 1997. Several of Ventana's issued United States patents relate to reagent formulations and methods, including a reagent formulation characterized by long-term stability and a method of inhibiting evaporation of reagents during processing. Other issued United States patents relate to a reagent dispenser, a tissue fixative and various aspects of the capillary gap technology and methods and devices for batch processing of slides. Pending applications relate to mechanical aspects of automated instruments for performing reactions on slides and processing methods used in these instruments. In addition, a patent application filed by the Company covers an evaporation inhibitor liquid that is effective for high temperature applications. The expiration dates of the Company's issued United States patents range from September 2005 to November 2013. There can be no assurance that the Company's patent applications will result in patents being issued or that any issued patents will provide adequate protection against competitive technologies or will be held valid if 12 15 challenged. Others may independently develop products or processes similar to those of the Company or design around or otherwise circumvent patents issued to the Company. Because patent applications in the United States are maintained in secrecy until patents are issued and since publication of discoveries in scientific literature tends to lag behind actual discoveries by several months, Ventana cannot be certain that it was the first creator of inventions covered by its patents or pending patent applications or that it was the first to file patent applications for such inventions. Moreover, the Company may have to participate in interference proceedings declared by the United States Patent and Trademark Office to determine the priority of inventions, which could result in substantial cost to the Company. In the event that any relevant claims of third-party patents are upheld as valid and enforceable, the Company could be prevented from practicing the subject matter claimed in such patents, or would be required to obtain licenses from the patent owners of each of such patents or to redesign its products or processes to avoid infringement. There can be no assurance that such licenses would be available or, if available, would be available on terms acceptable to the Company or that the Company would be successful in any attempt to redesign its products or processes to avoid infringement. If the Company does not obtain necessary licenses, it could be subject to litigation and encounter delays in product introductions while it attempts to design around such patents. Alternatively, the development, manufacture or sale of such products could be prevented. Litigation would result in significant cost to the Company as well as diversion of management time. The outcome of any such litigation cannot be predicted with any assurance. Adverse determinations in any such proceedings could have a material adverse effect on the Company's business, financial condition and results of operations. Ventana also relies upon trade secret protection for its confidential and proprietary information. There can be no assurance that others will not independently develop substantially equivalent proprietary information or techniques, gain access to Ventana's trade secrets or disclose such technology, or that Ventana can effectively protect its trade secrets. Litigation to protect Ventana's trade secrets would result in significant cost to the Company as well as diversion of management time. Adverse determinations in any such proceedings or unauthorized disclosure of Ventana trade secrets could have a material adverse effect on Ventana's business, financial condition and results of operations. Ventana's policy is to require its employees, consultants and significant scientific collaborators to execute confidentiality agreements upon the commencement of an employment or consulting relationship with Ventana. These agreements generally provide that all confidential information developed or made known to the individual during the course of the individual's relationship with Ventana is to be kept confidential and not disclosed to third parties except in specific circumstances. Agreements with employees provide that all inventions conceived by the individual in the course of rendering services to Ventana shall be the exclusive property of Ventana. There can be no assurance, however, that these agreements will not be breached or that they will provide meaningful protection or adequate remedies for unauthorized use or disclosure of Ventana's trade secrets. COMPETITION Competition in the diagnostic industry is intense and is expected to increase. Competition in the diagnostic industry is based on, among other things, product quality, performance, price and the breadth of a company's product offerings. Ventana's instrument and reagent systems for IHC tests compete with products offered by various manufacturers as well as with manual diagnostic methods. In addition, flow cytometry can be used for cellular testing and may, in certain markets, be competitive with the Company's products. The Company's competitors may succeed in developing products that are more reliable or effective or less costly than those developed by the Company and may be more successful than the Company in manufacturing and marketing their products. Although the Company plans to continue to develop new and improved products, there are other companies engaged in research and development of diagnostic devices or reagents, and the introduction of such devices or alternative methods for diagnostic testing could hinder the Company's ability to compete effectively and could have a material adverse effect on the Company's business, financial condition and results of operations. In the instrument market, several companies, including Leica (a division of Leitz Microscope GmbH), Shandon Scientific Limited (a division of Thermo Biosystems, Inc.), BioGenex Laboratories, Inc. ("BioGenex") and DAKO (U.S.), offer instruments that perform IHC tests and can be used with any supplier's reagents, which may be attractive to certain customers. The Company estimates that its installed base of instruments is more than four times the combined installed base of instruments of all of the Company's current competitors. The Company has included 13 16 semi-automated instruments manufactured by its competitors in arriving at its estimates of its market share. In addition, future growth in the market for automated IHC instruments may result in additional market entrants and increased competition, including more aggressive price competition. Many of the companies selling or developing diagnostic devices and instruments and many potential entrants in the automated IHC market have financial, manufacturing, marketing and distribution resources significantly greater than those of Ventana. In addition, many of these current and potential competitors have long-term supplier relationships with Ventana's existing and potential customers. These competitors may be able to leverage existing customer relationships to enhance their ability to place new IHC instruments. Competition in the market for automated IHC instruments, including the advent of new market entrants and increasing price competition, could have a material adverse effect on the Company's business, financial condition and results of operations. In the market for reagents, the Company encounters competition from suppliers of primary antibodies and detection chemistries. The major suppliers of primary antibodies in the anatomical pathology market in the United States are DAKO, BioGenex and Beckman Coulter. The principal suppliers of detection chemistries in the United States are Vector Laboratories, BioGenex and DAKO. The Company's patient priority instruments require the use of the Company's detection chemistries but can be used with primary antibodies supplied by third parties, and the Company's batch processing instruments can be used with both detection chemistries and primary antibodies supplied by third parties. Accordingly, the Company encounters significant competition in the sale of reagents for use on those of its instruments that can be used with reagents supplied by third parties. Lower prices for reagents used in manual IHC tests could also limit the growth of automation. Certain of the Company's current and potential competitors in the reagent market have financial, manufacturing, marketing and distribution resources greater than those of the Company. Competition in the market for reagents could also increase as a result of new market entrants providing more favorable reagent supply arrangements than the Company, including lower reagent prices. In particular, DAKO has introduced a lower cost semi-automated IHC instrument in the United States and is offering reagent supply arrangements that have resulted in increased competition for both instruments and reagents. In addition, new entrants in the instrument market may seek to enhance their competitive position through reduced reagent pricing or more favorable supply arrangements; the Company's current instrument customers may find it attractive to purchase primary antibodies for patient priority instruments and primary antibodies and detection chemistries for batch processing instruments from such competitors. Increased competition in the reagent market could have a material adverse effect on the Company's business, financial condition and results of operations. GOVERNMENT REGULATION The manufacturing, marketing and sale of the Company's products are subject to regulation by governmental authorities in the United States and other countries. In the United States, clinical diagnostic devices are subject to rigorous Food and Drug Administration ("FDA") regulation. The Federal Food, Drug and Cosmetic Act governs the design, testing, manufacture, safety, efficacy, labeling, storage, record keeping, approval, advertising and promotion of the Company's products. Obtaining regulatory approval for new products within this regulatory framework may take a number of years and involves the expenditure of substantial resources. In addition, there can be no assurance that this regulatory framework will not change or that additional regulation will not arise, which may affect approval of or delay an application or require additional expenditures by the Company. The FDA regulates, as medical devices, instruments, diagnostic tests and reagents that are traditionally manufactured and commercially marketed as finished test kits or equipment. Some clinical laboratories, however, choose to purchase individual reagents intended for specific analytes and develop and prepare their own finished diagnostic tests. Although neither the individual reagents nor the finished tests prepared from them by the clinical laboratories have traditionally been regulated by the FDA, the FDA has recently proposed a rule that, if adopted, would regulate the reagents sold to clinical laboratories as medical devices. The proposed rule would also restrict sales of these reagents to clinical laboratories certified under the Clinical Laboratory Improvement Amendments of 1988 ("CLIA") as high complexity testing laboratories. The Company intends to market some diagnostic products as finished test kits or equipment and others as individual reagents; consequently, some or all of these products will be regulated as medical devices. The Company's clinical diagnostic systems are regulated by the FDA under a 3-tier classification system -- Class I, II and III. The degree of regulation, as well as the cost and time required to obtain regulatory approvals, generally increases from Class I to Class III. Most diagnostic devices are regulated as Class I or Class II devices, although certain diagnostic tests for particular diseases may be classified as Class III devices. Prior to entering commercial distribution, most Class I, II, or III medical devices must undergo FDA review under one of two basic 14 17 review schemes depending upon the type of device or procedure. These review schemes are the 510(k) pre-market notification process and the pre-market approval ("PMA") process. A 510(k) notification is generally a filing submitted to demonstrate that the device in question is "substantially equivalent" to another legally marketed device. Approval under this procedure may be granted within 90 days, but generally takes longer, and in some cases up to a year or more. Class I and II devices, as well as certain Class III devices, for which the FDA has not called for a PMA, are reviewed under the 510(k) process. For all other Class III products, the manufacturer must file a PMA to show that the product is safe and effective based on extensive clinical testing and controlled trials among several diverse testing sites and population groups. These controlled trials may be conducted under an Investigational Device Exemption ("IDE") cleared by the FDA, or they may be conducted without FDA review if exempt from IDE requirements. The PMA process typically involves significantly more clinical testing than does the 510(k) procedure and could involve a significantly longer FDA review period after the date of filing. In responding to a PMA application, the FDA can either accept it for filing or reject it and require the manufacturer to include additional information in a resubmitted application. PMA applications that are accepted for filing may be reviewed by a FDA scientific advisory panel, which issues either a favorable or unfavorable recommendation regarding the device. The FDA is not bound by the panel's recommendation, but tends to give it significant weight. By law, the PMA process is to be completed within 180 days of acceptance of the PMA application for filing, although this time period can be, and typically is, extended by the FDA. A PMA application can take from one to several years to complete, and there can be no assurance that any submitted PMA application will ultimately be approved. Further, clearance or approval may place substantial restrictions on to whom and the indications for which the product may be marketed or to whom it may be marketed. Additionally, there can be no assurance that the FDA will not request additional data, or request that the Company conduct further clinical studies. With respect to automated IHC testing functions, the Company's instruments have been categorized by the FDA as automated cell staining devices and have been exempted from the 510(k) notification process. To date, ISH tests have not received FDA approval and, therefore, use of the gen II for ISH tests will be restricted to research applications. New instrument products that the Company may develop and introduce could require 510(k) notifications and clearances or PMA applications. All of the detection chemistries and most of the primary antibody products being sold by the Company are currently classified as Class II devices. Many of Ventana's detection chemistries have received 510(k) clearance from the FDA. Some of the antibodies being marketed by the Company are labeled for in vitro diagnostic use and have received 510(k) clearance from the FDA. The Company may wish to market certain antibodies with a label indicating that they can be used in the diagnosis of particular diseases, including cancer. These devices may be classified as Class III devices and may therefore require a PMA. After products have been cleared for marketing by the FDA, the Company will be subject to continuing FDA obligations. Clearances may be withdrawn or products may be recalled if compliance with regulatory standards is not maintained or if problems occur after the product reaches the market. The FDA may require surveillance programs to monitor the effect of products, which have been commercialized, and has the power to prevent or limit further marketing of the product based on the results of these post-marketing programs. The FDA enforces regulations prohibiting the marketing of products for unapproved uses. Further, if the Company wanted to make changes on a product after FDA clearance or approval, including changes in indications or intended use or other significant modifications to labeling or manufacturing, additional clearances or approvals would be required. The FDA has broad regulatory and enforcement powers including the ability to levy fines and civil penalties, suspend or delay issuance of approvals, seize or recall products, withdraw clearances or approvals, restrict or enjoin the marketing of products, and impose civil and criminal penalties, any one or more of which could have a material adverse effect upon the Company. The Company is subject to FDA GMP regulations. The Company is in the process of implementing policies and procedures which are intended to allow the Company to receive ISO 9000 certification. ISO 9000 standards are worldwide standards for manufacturing process control, documentation and quality assurance. There can be no assurance that the Company will be successful in meeting ISO 9000 certification requirements. Under GMP regulations and ISO 9000 standards, the Company is subject to ongoing FDA and international compliance inspections. Laboratories using the Company's diagnostic devices for clinical use in the United States are regulated under CLIA, which is intended to ensure the quality and reliability of medical testing. Regulations implementing CLIA establish requirements for laboratories and laboratory personnel in the areas of administration, participation 15 18 and proficiency testing, patient test management, quality control, personnel, quality assurance and inspection. Under these regulations, the specific requirements that a laboratory must meet depend on the complexity of the test being performed by the laboratory. Under CLIA regulations, all laboratories performing moderately complex or highly complex tests will be required to obtain either a registration certificate or certificate of accreditation from the Health Care Financing Administration. CLIA requirements may prevent some clinical laboratories from using certain of the Company's diagnostic products. Therefore, there can be no assurance that CLIA regulations and future administrative interpretations of CLIA will not have a material adverse impact on the Company by limiting the potential market for the Company's products. The Company sells products in certain international markets and plans to enter additional international markets. International sales of medical devices are subject to foreign government regulation, the requirements of which vary substantially from country to country. These range from comprehensive device approval requirements for some or all of the Company's medical device products to requests for product data or certifications. FDA approval is required for the export of Class III devices. In addition to the foregoing, the Company is subject to numerous federal, state and local laws and regulations relating to such matters as safe working conditions, laboratory and manufacturing practices, fire hazard control, disposal of hazardous or potentially hazardous substances and other environmental matters. To date, compliance with these laws and regulations has not had a material effect on the Company's financial position, and the Company has no plans for material capital expenditures relating to such matters. The Company currently uses third-party disposal services to remove and dispose of the hazardous materials used in its processes. The Company could in the future encounter claims from individuals, governmental authorities or other persons or entities in connection with exposure to or disposal or handling of such hazardous materials or violations of environmental laws by the Company or its contractors and could also be required to incur additional expenditures for hazardous materials management or environmental compliance. Costs associated with environmental claims, violations of environmental laws or regulations, hazardous materials management and compliance with environmental laws could have a material adverse effect on the business, financial condition or results of operations of the Company. Although the Company believes it will be able to comply with all applicable regulations regarding the manufacture and sale of diagnostic products, such regulations are always subject to change and depend heavily upon administrative interpretations. Delays in or failure to receive clearances or approvals of products the Company plans to introduce, or changes in the applicable regulatory climates could have a material adverse effect upon the business, financial condition or results of operations of the Company. THIRD-PARTY REIMBURSEMENT Third-party payors, such as governmental programs and private insurance plans, can indirectly affect the pricing or relative attractiveness of the Company's products by regulating the maximum amount of reimbursement they will provide to the Company's customers for diagnostic testing services. In recent years, health care costs have risen substantially, and third-party payors have come under increasing pressure to reduce such costs. In this regard, legislative proposals relating to health care reform and cost containment have been introduced at the state and federal levels. The cost-containment measures that health care payors are instituting and the impact of any health care reform could have a material adverse effect on the levels of reimbursement the Company's customers receive from third-party payors and as a result on the Company's ability to market and sell its products. Such factors could have a material adverse effect on the Company's business, financial condition and results of operations. PRODUCT LIABILITY AND RECALLS; PRODUCT LIABILITY INSURANCE The marketing and sale of the Company's diagnostic instruments and reagents entails risk of product liability claims. The Company has product liability insurance coverage with a per occurrence maximum of $2.0 million and an aggregate annual maximum of $5.0 million. There can be no assurance that this level of insurance coverage will be adequate or that insurance coverage will continue to be available on acceptable terms or at all. A product liability claim or recall could have a material adverse effect on the Company's business, reputation, financial condition and results of operations. 16 19 EMPLOYEES As of December 31, 1998, Ventana employed 352 persons full time. Of these employees, 167 were engaged in sales, marketing and service, 41 in research and development, 106 in manufacturing and 38 in general and administrative functions. None of Ventana's employees are covered by a collective bargaining agreement. Ventana considers its relations with its employees to be satisfactory. BACKLOG Ventana typically ships orders for instruments and reagents shortly after receipt, and accordingly does not maintain a significant backlog. ADDITIONAL RISK FACTORS Continuing Losses; Uncertainty of Future Profitability The Company has incurred significant cumulative losses from its inception in 1985 through December 31, 1998. The Company's ability to achieve and sustain profitability is dependent on a variety of factors including the extent to which its instrument and reagent systems continue to achieve market acceptance, the Company's ability to sell reagents to its customers, the Company's ability to compete successfully, the Company's ability to develop, introduce, market and distribute existing and new diagnostic systems, the level of expenditures incurred by the Company in investing in product development and sales and marketing, the Company's ability to expand manufacturing capacity as required and the receipt of required regulatory approvals for products developed by the Company. There can be no assurance that the Company will be successful in these efforts. Moreover, the level of future profitability, if any, cannot be accurately predicted and there can be no assurance that profitability will be sustained on a quarterly or annual basis, or at all, or that the Company will not incur operating losses in the future. Future Fluctuations in Operating Results The Company derives revenues from the sale of reagents and instruments. The initial placement of an instrument is subject to a longer, less consistent sales cycle than the sale of reagents, which begin and are typically recurring once an instrument is placed. The Company's future operating results are likely to fluctuate substantially from period to period because instrument sales are likely to remain an important part of revenues in the near future. The degree of fluctuation will depend on the timing, level and mix of instruments placed through direct sales and instruments placed through QRIBs and rentals. In addition, average daily reagent use by customers may fluctuate from period to period, which may contribute to future fluctuations in revenues. Other factors that may result in fluctuations in operating results include the timing of new product announcements and the introduction of new products and new technologies by the Company and its competitors, market acceptance of the Company's current or new products, developments with respect to regulatory matters, availability and cost of raw materials from its suppliers, competitive pricing pressures, increased research and development expenses, and increased marketing and sales expenses associated with the implementation of the Company's market expansion strategies for its instrument and reagent products. Future instrument and reagent sales could also be adversely affected by the configuration of the Company's patient priority systems, which require the use of the Company's detection chemistries, particularly if and to the extent that competitors are successful in developing and introducing new IHC instruments or if competitors offer reagent supply arrangements having pricing or other terms more favorable than those offered by the Company. Such increased competition in reagent supply could also adversely affect sales of reagents to batch processing instrument customers since those instruments do not require the use of the Company's reagents. In connection with future introductions of new products, the Company may be required to incur charges for inventory obsolescence in connection with unsold inventory of older generations of products. To date, however, the Company has not incurred material charges or expenses associated with inventory obsolescence in connection with new product introductions. In addition, a significant portion of the Company's expense levels is based on its expectation of a higher level of revenues in the future and are relatively fixed in nature. Therefore, if revenue levels are below expectations, operating results in a given period are likely to be adversely affected. 17 20 Rate of Market Acceptance and Technological Change Use of automated systems to perform diagnostic tests is relatively new. Historically, the diagnostic tests performed by the Company's systems have been performed manually by laboratory personnel. The rate of market acceptance of the Company's products will be largely dependent on the Company's ability to persuade the medical community of the benefits of automated diagnostic testing using the Company's products. Market acceptance and sales of the Company's products may also be affected by the price and quality of the Company's and its competitors' products. The Company's products could also be rendered obsolete or noncompetitive by virtue of technological innovations in the fields of cellular or molecular diagnostics. Failure of the Company's products to achieve market acceptance would have a material adverse effect on the Company's business, financial condition and results of operations. Risks Associated with Development and Introduction of New Products The Company's future growth and profitability will be dependent, in large part, on its ability to develop, introduce and market new instruments and reagents used in diagnosing and selecting appropriate treatment for cancer and additional disease states. The Company depends in part on the success of medical research in developing new antibodies, nucleic acid probes and clinical diagnostic procedures that can be adapted for use in the Company's systems. In addition, the Company will need to obtain licenses on satisfactory terms to certain of these technologies, for which there can be no assurance. Certain of the Company's products are currently under development, initial testing or preclinical or clinical evaluation by the Company. Other products are scheduled for future development. Products under development or scheduled for future development may prove to be unreliable from a diagnostic standpoint, may be difficult to manufacture in an efficient manner, may fail to receive necessary regulatory clearances, may not achieve market acceptance or may encounter other unanticipated difficulties. The failure of the Company to develop, introduce and market new products on a timely basis or at all could have a material adverse effect on the Company's business, financial condition and results of operations. Manufacturing Risks The Company has only manufactured patient priority instruments and reagents for commercial sale since late 1991, and manufacturing of the Company's batch processing instruments is performed by third parties. As the Company continues to increase production of such instruments and reagents and develops and introduces new products, it may from time to time experience difficulties in manufacturing. The Company must continue to increase production volumes of instruments and reagents in a cost-effective manner in order to be profitable. To increase production levels, the Company will need to scale-up its manufacturing facilities, increase its automated manufacturing capabilities and continue to comply with the current good manufacturing practices ("GMPs") prescribed by the United States Food and Drug Administration ("FDA") and other standards prescribed by various federal, state and local regulatory agencies in the United States and other countries, including the International Standards Organization ("ISO") 9000 Series certifications. There can be no assurance that manufacturing and quality problems will not arise as the Company increases its manufacturing operations or that such scale-up can be achieved in a timely manner or at a commercially reasonable cost. Manufacturing or quality problems or difficulties or delays in manufacturing scale-up could have a material adverse effect on the Company's business, financial condition and results of operations. 18 21 Dependence Upon Key Suppliers The Company's reagent products are formulated from both chemical and biological materials utilizing proprietary Ventana technology as well as standard processing techniques. Certain components and raw materials, primarily antibodies, used in the manufacturing of the Company's reagent products are currently provided by single-source vendors. There can be no assurance that the materials or reagents needed by the Company will be available in commercial quantities or at acceptable prices. Any supply interruption or yield problems encountered in the use of materials from these vendors could have a material adverse effect on the Company's ability to manufacture its products until a new source of supply is obtained. The use of alternative or additional suppliers could be time consuming and expensive. In addition, a number of the components used to manufacture instruments are fabricated on a custom basis to the Company's specifications and are currently available from a limited number of sources. Consequently, in the event the supply of materials or components from any of these vendors were delayed or interrupted for any reason or in the event of quality or reliability problems with such components or suppliers, the Company's ability to supply such instruments could be impaired, which could have a material adverse effect on the Company's business, financial condition and results of operations. Risks Associated with Past and Future Acquisitions Although the Company has no pending agreements or commitments, the Company may make additional acquisitions of complementary businesses, products or technologies in the future. Acquisitions of companies, divisions of companies, or products entail numerous risks, including (i) the potential inability to successfully integrate acquired operations and products or to realize anticipated synergies, economies of scale or other value, (ii) diversion of management's attention and (iii) loss of key employees of acquired operations. No assurance can be given that the Company will not incur problems with respect to any future acquisitions, and there can be no assurance that any future acquisitions will result in the Company becoming profitable or, if the Company achieves profitability, that such acquisition will increase the Company's profitability. Furthermore, there can be no assurance that the Company will realize value from any such acquisition, which equals or exceeds the consideration paid. Any such problems could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, any future acquisitions by the Company may result in dilutive issuances of equity securities, the incurrence of additional debt, large one-time write-offs and the creation of goodwill or other intangible assets that could result in amortization expense. These factors could have a material adverse effect on the Company's business, financial condition and results of operations. Risks Relating to Patents and Proprietary Rights The Company's success depends, in part, on its ability to obtain patents, maintain trade secret protection and operate without infringing the proprietary rights of others. There can be no assurance that the Company's patent applications will result in patents being issued or that any issued patents will provide adequate protection against competitive technologies or will be held valid if challenged. Others may independently develop products similar to those of the Company or design around or otherwise circumvent patents issued to the Company. In the event that any relevant claims of third-party patents are upheld as valid and enforceable, the Company could be prevented from practicing the subject matter claimed in such patents, or would be required to obtain licenses from the patent owners of each of such patents or to redesign its products or processes to avoid infringement. There can be no assurance that such licenses would be available or, if available, would be on terms acceptable to the Company or that the Company would be successful in any attempt to redesign its products or processes to avoid infringement. If the Company does not obtain necessary licenses, it could be subject to litigation and encounter delays in product introductions while it attempts to design around such patents. Alternatively, the Company's development, manufacture or sale of such products could be prevented by the patent holder. Litigation would result in significant cost to the Company as well as diversion of management time. Adverse determinations in any such proceedings could have a material adverse effect on the Company's business, financial condition and results of operations. 19 22 Ventana also relies upon trade secret protection for its confidential and proprietary information. There can be no assurance that others will not independently develop substantially equivalent proprietary information or techniques, gain access to Ventana's trade secrets or disclose such technology, or that Ventana can effectively protect its trade secrets. Litigation to protect Ventana's trade secrets would result in significant cost to the Company as well as diversion of management time. Adverse determinations in any such proceedings or unauthorized disclosure of Ventana trade secrets could have a material adverse effect on Ventana's business, financial condition and results of operations. Uncertainty of Future Funding of Capital Requirements The Company anticipates that its existing capital resources and available borrowing capacity under the Company's revolving credit line will be adequate to satisfy its capital requirements for the next 12 months. The Company's future capital requirements will depend on many factors, including the extent to which the Company's products gain market acceptance, the mix of instruments placed through direct sales or through QRIBs, progress of the Company's product development programs, competing technological and market developments, expansion of the Company's sales and marketing activities, the cost of manufacturing scale-up activities, possible acquisitions of complementary businesses, products or technologies, the extent and duration of operating losses, the Company's ability to sustain profitability and timing of regulatory approvals. The Company may require additional capital resources and there is no assurance such capital will be available to the extent required, on terms acceptable to the Company or at all. Any such future capital requirements could result in the issuance of equity securities, which would be dilutive to existing stockholders. Dependence on Key Personnel The Company is dependent upon the retention of principal members of its management, Board of Directors, scientific, technical, marketing and sales staff and the recruitment of additional personnel. The Company does not have an employment agreement with any of its executive officers. The Company does not maintain "key person" life insurance on any of its personnel. The Company competes with other companies, academic institutions, government entities and other organizations for qualified personnel in the areas of the Company's activities. The inability to hire or retain qualified personnel could have a material adverse effect on the Company's business, financial condition and results of operations. Uncertainties Related to Government Funding A portion of the Company's products are sold to universities, research laboratories, private foundations and other institutions where funding is dependent upon grants from government agencies, such as the National Institutes of Health. Research funding by the government could be significantly reduced. Any such reduction may materially affect the ability of many of the Company's research customers to purchase the Company's products. FDA and Other Government Regulation The manufacturing, marketing and sale of the Company's products are subject to extensive and rigorous government regulation in the United States and in other countries. In the United States and certain other countries, the process of obtaining and maintaining required regulatory approvals is lengthy, expensive and uncertain. In the United States, the FDA regulates, as medical devices, clinical diagnostic tests and reagents, as well as instruments used in the diagnosis of adverse conditions. The Federal Food, Drug, and Cosmetic Act governs the design, testing, manufacture, safety, efficacy, labeling, storage, record keeping, approval, advertising and promotion of the Company's products. There are two principal FDA regulatory review paths for medical devices: the 510(k) pre-market notification ("510(k)") process and the pre-market approval ("PMA") process. The PMA process typically requires the submission of more extensive clinical data and is costlier and more time-consuming to complete than the 510(k) process. The FDA regulates, as medical devices, instruments, diagnostic tests and reagents that are traditionally manufactured and commercially marketed as finished test kits or equipment. Some clinical laboratories, however, choose to purchase individual reagents intended for specific analyses and develop and prepare their own finished diagnostic tests. Although neither the individual reagents nor the finished tests prepared from them by the clinical laboratories have traditionally been regulated by the FDA, the FDA has recently proposed a rule that, if adopted, would regulate the reagents sold to clinical laboratories as medical devices. The proposed rule would also restrict 20 23 sales of these reagents to clinical laboratories certified under the Clinical Laboratory Improvement Amendments of 1988 ("CLIA") as high complexity testing laboratories. The Company intends to market some diagnostic products as finished test kits or equipment and others as individual reagents; consequently, some or all of these products may be regulated as medical devices. Medical devices generally require FDA approval or clearance prior to being marketed in the United States. The process of obtaining FDA clearances or approvals necessary to market medical devices can be time-consuming, expensive and uncertain, and there can be no assurance that any clearance or approval sought by the Company will be granted or that FDA review will not involve delays adversely affecting the marketing and sale of the Company's products. Further, clearances or approvals may place substantial restrictions on the indications for which the product may be marketed or to whom it may be marketed. Additionally, there can be no assurance that the FDA will not require additional data, require that the Company conduct further clinical studies or obtain a PMA causing the Company to incur further cost and delay. With respect to automated IHC testing functions, the Company's instruments have been categorized by the FDA as automated cell staining devices and have been exempted from the 510(k) notification process. To date, ISH tests have not received FDA approval or clearance and, therefore, use of the gen II for ISH tests will be restricted to research applications. New instrument products that the Company may introduce could require future 510(k) clearances. Certain antibodies that the Company may wish to market with labeling indicating that they can be used in the diagnosis of particular diseases may require PMA approval. In addition, the FDA has proposed that some of the antibody products that Ventana may wish to market be subjected to a pre-filing certification process. Certain of the Company's products are currently sold for research use and are labeled as such. Failure to comply with applicable regulatory requirements can, among other consequences, result in fines, injunctions, civil penalties, suspensions or loss of regulatory approvals, recalls or seizures of products, operating restrictions and criminal prosecutions. In particular, the FDA enforces regulations prohibiting the marketing of products for non-indicated uses. In addition, governmental regulations may be established that could prevent or delay regulatory approval of the Company's products. Delays in or failure to receive approval of products the Company plans to introduce, loss of or additional restrictions or limitations relating to previously received approvals, other regulatory action against the Company or changes in the applicable regulatory climate could individually or in the aggregate have a material adverse effect on the Company's business, financial condition and results of operations. The Company is also required to register as a medical device manufacturer with the FDA and is inspected on a routine basis by the FDA for compliance with its regulations. The Company's clinical laboratory customers are subject to CLIA, which is intended to ensure the quality and reliability of medical testing. In addition to these regulations, the Company is subject to numerous federal, state and local laws and regulations relating to such matters as safe working conditions and environmental matters. There can be no assurance that such laws or regulations will not in the future have a material adverse effect on the Company's business, financial condition and results of operations. Risks Relating to Availability of Third-Party Reimbursement and Potential Adverse Effects of Health Care Reform The Company's ability to sustain revenue growth and profitability may depend on the ability of the Company's customers to obtain adequate levels of third-party reimbursement for use of certain diagnostic tests in the United States, Europe and other countries. Currently, the availability of third-party reimbursement is limited and uncertain for some IHC tests. In the United States, the Company's products are purchased primarily by medical institutions and laboratories which bill various third-party payors, such as Medicare, Medicaid, other government programs and private insurance plans, for the health care services provided to their patients. Third-party payors may deny reimbursement to the Company's customers if they determine that a prescribed device or diagnostic test has not received appropriate FDA or other governmental regulatory clearances or approvals, is not used in accordance with cost-effective treatment methods as determined by the payor, or is experimental, unnecessary or inappropriate. The success of the Company's products may depend on the extent to which appropriate reimbursement levels for the costs of such products and related treatment are obtained by the Company's customers from government authorities, private health insurers and other organizations, such as health maintenance organizations ("HMOs"). Third-party 21 24 payors are increasingly challenging the prices charged for medical products and services. The trend towards managed health care in the United States and the concurrent growth of organizations such as HMOs could significantly influence the purchase of health care services and products. In addition, the federal government and certain members of Congress have proposed, and various state governments have adopted or are considering, programs to reform the health care system. These proposals are focused, in large part, on controlling the escalation of health care expenditures. The cost containment measures that health care payors are instituting and the impact of any health care reform could have a material adverse effect on the levels of reimbursement the Company's customers receive from third-party payors and the Company's ability to market and sell its products and consequently could have a material adverse effect on the Company's business, financial condition and results of operations. Environmental Matters Certain of the Company's manufacturing processes, primarily processes involved in manufacturing certain of the Company's reagent products, require the use of potentially hazardous and carcinogenic chemicals. The Company is required to comply with applicable federal, state and local laws regarding the use, storage and disposal of such materials. The Company currently uses third-party disposal services to remove and dispose of the hazardous materials used in its processes. The Company could in the future encounter claims from individuals, governmental authorities or other persons or entities in connection with exposure to or disposal or handling of such hazardous materials or violations of environmental laws by the Company or its contractors and could also be required to incur additional expenditures for hazardous materials management or environmental compliance. Costs associated with environmental claims, violations of environmental laws or regulations, hazardous materials management and compliance with environmental laws could have a material adverse effect on the Company's business, financial condition and results of operations. Potential Volatility of Stock Price The Company's Common Stock, like the securities of other medical device and life sciences companies, has exhibited price volatility, and such volatility may occur in the future. In addition, the stock market has from time to time experienced extreme price and volume fluctuations that have affected the market price of many companies and have often been unrelated to the operating performance of particular companies. Factors such as fluctuations in the Company's operating results, announcements of technological innovations or new products by the Company or its competitors, FDA and other government regulation, developments with respect to patents or proprietary rights, public concern as to the safety of products developed by the Company or others, changes in financial analysts' estimates or recommendations regarding the Company and general market conditions may have a material adverse effect on the market price of the Company's Common Stock. The Company's results of operations may, in future periods, fall below the expectations of public market analysts and investors and, in such event, the market price of the Company's Common Stock could be materially adversely affected. 22 25 ITEM 2. PROPERTIES Ventana's U. S. research laboratories, instrument and reagent manufacturing facilities and administrative offices are located in approximately 85,000 square feet of leased space in Tucson, Arizona and Gaithersburg, Maryland. The leases for these facilities expire at various times between November 1999 and March 2001, subject to renewal terms. The Company believes its facilities are adequate to meet its current requirements with new facility construction anticipated in 1999 under commercially reasonable lease terms. ITEM 3. LEGAL PROCEEDINGS In March 1995, BioGenex sued BioTek in the U.S. District Court for the Northern District of California for infringement of certain patent rights held by BioGenex relating to an antigen retrieval method used in IHC tests. BioGenex's claims included claims of both direct, indirect and contributory infringement. BioTek denied infringement and asserted several defenses, including the invalidity of the patent. In April 1995, BioTek ceased offering the products that were the subject of the alleged infringements. A court-mandated judicial settlement conference was held in January 1997 and no settlement was reached. In May 1997, a judgement for approximately $850,000 was rendered against BioTek, which BioTek appealed. In April 1998, the Court of Appeals denied the appeal and the Company promptly satisfied all obligations stemming from the judgment. In January 1997, four individuals who are former BioTek noteholders who held in the aggregate approximately $1.1 million in principal amount of BioTek notes filed an action, Tse, et al v. Ventana Medical Systems, Inc., et al. No. 97-37, against the Company and certain of its directors and stockholders in the United states District Court for the District of Delaware. The complaint alleges, among other things, that the Company violated federal and California securities laws and engaged in common law fraud in connection with the BioTek shareholders' consent to the February 1996 merger of BioTek into Ventana and the related conversion of BioTek notes into Ventana notes. Plaintiffs seek substantial compensatory damages several times in excess of the principal amount of their BioTek notes, as well as substantial punitive damages, and fees and costs. On April 25, 1997, plaintiffs filed an Amended Complaint. The Amended Complaint makes the same allegations as the original Complaint, and adds a claim under North Carolina securities laws. In May of 1997, the Company made a motion to transfer the action to the district of Arizona, or alternatively to the Central District of California, which was denied by the court. On December 16, 1997, the Company filed a motion to dismiss the Amended Complaint. This motion was partially accepted and partially denied by the Court. Based on the facts known to date, the Company believes that the claims are without merit and intends to vigorously contest this suit. After consideration of the nature of the claims and the facts relating to the merger and the BioTek note exchange, the Company believes that it has meritorious defenses to the claims and that resolution of this matter will not have a material adverse effect on the Company's business, financial condition and results of operations; however, the results of the proceedings are uncertain and there can be no assurance to that effect. On July 16, 1997, a shareholder demand to review and copy corporate documents pursuant to Section 220 of the Delaware General Corporation Law was denied by the Company. As a result, an action entitled, Leung v. Ventana Medical Systems, Inc., CA. No. 15812, was filed in the Court of Chancery for the State of Delaware. The plaintiff, who is related to the plaintiffs in the securities action, discussed in the preceding paragraph, seeks inspection of certain books and record of the Company. Defendants believe the plaintiff seeks the documents for an improper purpose and intend to defend this case vigorously. A trial on March 3, 1998 resulted in the judge ordering the parties to reach an agreement without a court order. The agreement provides for the plaintiff's attorney only to review the corporate documents supplied. In connection with the disagreement as to the price to be charged by BioTek to DAKO for the sale of TechMate 250 instruments, DAKO filed an arbitration request with the International Chamber of Commerce in July 1997. In May 1998, the parties resolved their differences and the arbitration proceedings were dropped. In May 1998, a former employee filed a lawsuit in the Northern District of California against the company, alleging sex discrimination retaliation and wrongful termination and other related wrongdoings. The Company has disputed the allegations. An Early Neutral Evaluation took place in November 1998. Depositions are scheduled and discovery continues. Based upon its review of the matter, the Company does not believe that its resolution will have a material adverse effect on the Company's business, financial condition or results of operations. 23 26 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 1998. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock has been traded on the Nasdaq National Market (ticker symbol VMSI) since July 26, 1996. The number of record holders of the Company's Common Stock at December 31, 1998 was 277. The Company has not paid any dividends since its inception and does not intend to pay any dividends in the foreseeable future. In addition the Company is precluded under its bank line of credit from paying dividends without the bank's consent. Quarterly high and low stock prices are as follows:
QUARTER ENDED HIGH LOW ----------------- ------- ------- December 31, 1998 $23.625 $14.125 September 30, 1998 $29.625 $13.625 June 30, 1998 $28.375 $23.125 March 31, 1998 $26.625 $15.25 December 31, 1997 $17.00 $13.125 September 30, 1997 $17.125 $13.00 June 30, 1997 $14.50 $ 9.00 March 31, 1997 $19.00 $13.50
25 27 ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The selected consolidated statement of operations data set forth below for the years ended December 31, 1998, 1997 and 1996 are derived from the Company's audited Consolidated Financial Statements included elsewhere in this Report on Form 10-K. The selected consolidated statement of operations data set forth below for the years ended December 31, 1995 and 1994, except for the components of net sales, are derived from audited financial statements of the Company not included in this Report on Form 10-K. The historical financial information for the periods presented are not necessarily indicative of the results which may be realized in the future. The selected consolidated financial data set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and Notes thereto included elsewhere in this Report on Form 10-K.
YEAR ENDED DECEMBER 31, ------------------------------------------------------------ 1994 1995 1996 1997 1998 -------- -------- -------- -------- -------- (IN THOUSANDS, EXCEPT PER SHARE DATA) STATEMENT OF OPERATIONS DATA(1): Sales: Instruments ......................... $ 2,588 $ 4,644 $ 8,591 $ 9,248 $ 15,737 Reagents and other ................ 3,339 5,969 15,538 22,905 31,967 -------- -------- -------- -------- -------- Total net sales ................ 5,927 10,613 24,129 32,153 47,704 Cost of goods sold .................. 2,531 4,282 10,632 11,138 14,542 -------- -------- -------- -------- -------- Gross profit ........................ 3,396 6,331 13,497 21,015 33,162 Operating expenses: Selling, general and administrative .................. 6,899 7,435 11,206 16,953 23,805 Research and development .......... 1,926 2,239 2,749 3,050 5,057 Nonrecurring expenses ............. -- -- 10,262 1,656 3,160 Amortization of acquisition costs ........................... -- -- 424 509 599 -------- -------- -------- -------- -------- Income (loss) from operations ....... (5,429) (3,343) (11,144) (1,153) 541 Other income (expense) .............. 59 74 (137) 781 1,089 -------- -------- -------- -------- -------- Net income (loss) ................... $ (5,370) $ (3,269) $(11,281) $ (372) $ 1,630 ======== ======== ======== ======== ======== Per share data (2): Net income (loss) per share, as adjusted, basic ................... $ (.80) $ (.43) $ (1.22) $ (.03) $ .12 ======== ======== ======== ======== ======== Net income (loss) per share, as adjusted, diluted ................. $ (.80) $ (.43) $ (1.22) $ (.03) $ .11 ======== ======== ======== ======== ======== Shares used in computing net income (loss) per share, as adjusted, basic ................... 6,725 7,571 9,243 12,778 13,320 ======== ======== ======== ======== ======== Shares used in computing net income (loss) per share, as adjusted, diluted .................. 6,725 7,571 9,243 12,778 14,627 ======== ======== ======== ======== ======== BALANCE SHEET DATA: Cash, cash equivalents and short-term investments ............ $ 2,511 $ 1,103 $ 11,067 $ 18,902 $ 2,424 Long-term debt and redeemable preferred stock ................... 30,237 35,180 12,500 471 1,907 Working capital ..................... 3,720 2,765 15,888 28,714 23,162 Total assets ........................ 7,279 7,378 32,410 48,352 56,280 Accumulated deficit ................. (24,275) (29,980) (33,410) (33,782) (32,152) Total stockholders equity (deficit) .................. (24,131) (29,856) 15,270 42,403 45,784
(1) See Notes 12, 13 and 14 to Consolidated Financial Statements in Form 10-K attached for information regarding the acquisitions of BioTek Solutions, Inc., Biotechnology Tools, Inc., and certain assets of Oncor, Inc. (2) See Note 1 to Consolidated Financial Statements in Form 10-K attached for information concerning the computation of 1996 net loss per share, as adjusted. 26 28 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of the financial condition and results of operations of Ventana should be read in conjunction with the Consolidated Financial Statements and related Notes thereto included elsewhere in this Form 10-K. This Report on Form 10-K contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual events or results may differ materially from those projected in the forward-looking statements as a result of the factors described herein and in the documents incorporated herein by reference. Such forward-looking statements include, but are not limited to, statements concerning the risk of cancer; cancer screening; improvements in automated IHC; business strategy; development and introduction of new products; research and development; marketing, sales and distribution; manufacturing; competition; third-party reimbursement; government regulation; and operating and capital requirements. OVERVIEW Ventana develops, manufactures and markets instrument/reagent systems that automate tissue preparation and slide staining in histology laboratories worldwide. Tissue preparation involves removing water from the sample and embedding the sample in paraffin for tissue preservation and subsequent cutting prior to mounting on slides. Slide staining is used to perform immunohistochemistry ("IHC"), special stains ("SS"), and in situ hybridization ("ISH") tests for the analysis of cells and tissues on microscope slides. These tests are important tools used in diagnosing and selecting appropriate treatment for cancer and infectious diseases. Each Ventana proprietary system placed typically provides a recurring revenue stream as customers consume reagents and supplies sold by the Company with each test conducted. IHC reagents consist of two components: a primary antibody and a detection chemistry that is used to visualize the primary antibody; SS reagents consist of various chemicals and dyes. Therefore, the principal economic drivers for the Company are the number, type and method of placement of instruments and the amount of reagents and consumables used by the customer. The Company's strategy is to maximize the number of instruments placed with customers and thereby increase its ongoing, higher margin reagent revenue stream. The Company expects that reagents will comprise a greater proportion of total revenues in the future as its installed base of instruments increases. Acquisition of Certain Oncor Assets On November 23, 1998, the Company acquired all of the oncology assets of Oncor, Inc. The acquisition provided the Company with a proprietary probe technology as well as facilities that have been approved for manufacturing PMA products. Ventana acquired the Oncor assets for $5.5 million, a significant portion of which related to intangible assets. These intangible assets included $2.9 million for acquired in-process research and development ("in process R&D") for projects that did not have future alternative uses. This allocation represents the fair market value based on risk-adjusted cash flows related to the in-process R&D projects. At the date of acquisition, the development of these projects had not yet reached technological feasibility and the in-process R&D had no alternative future uses. Accordingly, these costs were written off in the fiscal quarter ended December 31, 1998. Of the remaining purchase price of $2.3 million, approximately $1.6 million was allocated to identifiable intangibles and goodwill, and is being amortized over 5 to 15 years. The acquisition was paid for with existing cash equivalents. On the date of its acquisition, Oncor's in-process R&D value was comprised of two primary R&D programs that were expected to reach completion between late 1999 and 2000. These projects included the introduction of new probes aimed at detecting Her2 gene amplification and human papilloma virus ("HPV"). At the acquisition date, Oncor's R&D programs ranged in completion from 10% to 95%, and total continuing R&D commitments to complete the projects were expected to be approximately $1.0 million. These estimates are subject to change, given the uncertainties of the development process, and no assurance can be given that deviations from these estimates will not occur. Additionally, these projects will require maintenance expenditures when and if they reach a state of technological and commercial feasibility. 27 29 The Company believes that it is positioned to complete each of the major R&D programs acquired from Oncor. However, there is risk associated with the completion of the projects, and there is no assurance that any project will meet with either technological or commercial success. In the event the Company is unable to achieve the expected results, the Company is likely to experience delays in new product introductions with attendant reductions in revenues and margins. Value Assigned to Purchased In-Process R&D The value assigned to purchased in-process R&D was determined by estimating the costs to develop Oncor's purchased in-process R&D into commercially viable products, estimating the resulting net cash flows from the projects and discontinuing the net cash flows to their present value. The revenue estimates used to value the in-process R&D were based on estimates of relevant market sizes and growth factors, expected trends in technology and the nature and expected timing of new product introductions by the Company and its competitors. The rates utilized to discount the net cash flows to their present value are based on a 30% weighted average cost of capital. The estimates used by the Company in valuing in-process R&D were based upon assumptions the company believes to be reasonable but which are inherently uncertain and unpredictable. The Company's assumptions may be incomplete or inaccurate, and no assurance can be given that unanticipated events and circumstances will not occur. Accordingly, actual results may vary from the projected results. Acquisition of Biotechnology Tools, Inc. On October 14, 1998, the Company acquired all of the stock of BTTI for $6.5 million. The acquisition provided Ventana with competitive products in the tissue processing and microtome (tissue cutting) market. The BTTI products do not have a proprietary disposable or consumable element designed to be used with them. Ventana's objective will be to enhance the market position of these products as well as to design in a disposable or consumable element. Acquisition of BioTek Solutions, Inc. In February 1996, Ventana acquired BioTek for aggregate consideration of $19.1 million, consisting of cash, promissory notes and the assumption of liabilities. BioTek, founded in 1990, markets and sells automated diagnostic systems that perform reliable, high volume batch processing of a single IHC test on multiple patient biopsies. Ventana acquired BioTek for several strategic reasons including its installed instrument base and complementary product line. Historically, BioTek generated lower gross and operating margins than Ventana due to its employment of a different business strategy, which primarily involved the use of third parties for key components of its business operations. BioTek's instruments were produced by third-party manufacturers, which prevented BioTek from capturing manufacturing margin. BioTek's instruments have an open configuration, enabling the customer to use reagents purchased from BioTek or others, which impacted both the price and volume of reagents purchased, by customers from BioTek. In contrast, patient priority instruments have a closed configuration requiring the customer to use Ventana's prepackaged detection chemistries. BioTek also realized lower gross margins on reagents than Ventana due to its utilization of intermediate materials in the manufacturing process, which resulted in the capture of fewer value-added steps. BioTek used CMS and DAKO as third-party distributors in the United States and international markets, respectively, and supported its United States sales efforts with field sales and technical support personnel. As a result, BioTek experienced lower gross margins on United States sales than if it had sold its products directly as well as a higher level of selling expense than typically incurred in conjunction with third-party distribution arrangements. Ventana's strategy regarding BioTek has been to integrate the operations of BioTek into the Ventana business model, in which manufacturing, sales and marketing activities are performed by Company employees. The Company completed in 1997 the conversion of BioTek's reagent manufacturing activities to the process used by Ventana in which basic raw materials are used and important value-added steps are performed internally. The Company has manufacturing agreements with Kollsman for production of the TechMate 500 instrument and with LJL for production the TechMate 250 instrument. The Company and CMS agreed to terminate in October 1997 the United States distribution agreement between BioTek and CMS. The international distribution agreement with DAKO expires in December 1999. 28 30 Company Operations The Company places instruments through direct sales, including nonrecourse leases, instrument rentals and the Company's qualified reagent installed base program ("QRIB"). In a QRIB, the Company provides the customer with the use of an instrument for a period up to six months provided the customer purchases a minimum of $3,000 in IHC consumables and $2,500 in SS consumables. At the end of the six-month period, the customer must elect to purchase, rent or return the system. For QRIB placements, the Company incurs the cost of manufacturing or procuring instruments and recognizes revenues only at the time of the instrument is either sold or rented rather than at the time of instrument placement. The manufacturing cost of instruments placed through QRIBs or rentals is charged to cost of goods sold by depreciating standard costs over a period of four years. From its inception in 1985 through December 31, 1998, Ventana incurred aggregate net losses of $32.2 million. Although the Company achieved an operating profit in 1998, the level of future profitability, if any, cannot be accurately predicted and there can be no assurance that profitability will be sustained on a quarterly or annual basis, or at all, or that the Company will not incur operating losses in the future. The Company's future results of operations may fluctuate significantly from period to period due to a variety of factors. The initial placement of an instrument is subject to a longer, less consistent sales cycle than the sale of reagents which begin and typically are recurring once an instrument is placed. The Company's operating results are likely to fluctuate substantially from period to period because instrument sales are likely to remain an important part of revenues in the near future. The degree of fluctuation will depend on the timing, level and mix of instruments placed through direct sales and instruments rented. In addition, average daily reagent use by customers may fluctuate from period to period, which may contribute to future fluctuations in revenues. Sales of instruments may also fluctuate from period to period because sales to the Company's international distributors typically provide such distributors with several months of instrument inventory, which the distributors will subsequently seek to place with end-users. The Company's instrument installed base includes instruments shipped to DAKO and recognized as sales. Furthermore, due both to the Company's increased sales focus on smaller hospitals and laboratories and the relatively high reagent sales growth rates in recent fiscal periods, the rate of growth in reagent sales in future periods is likely to be below that experienced during the past several fiscal periods. Other factors that may result in fluctuations in operating results include the timing of new product announcements and the introduction of new products and new technologies by the Company and its competitors, market acceptance of the Company's current or new products, developments with respect to regulatory matters, availability and cost of raw materials purchased from suppliers, competitive pricing pressures, increased sales and marketing expenses associated with the implementation of the Company's market expansion strategies for its instruments and reagent products, and increased research and development expenditures. Future instrument and reagent sales could also be adversely affected by the configuration of the Company's patient priority systems, which require the use of the Company's detection chemistries, particularly if and to the extent that competitors are successful in developing and introducing new IHC instruments or if competitors offer reagent supply arrangements having pricing or other terms more favorable than those offered by the Company. Such increased competition in reagent supply could also adversely affect sales of reagents to batch processing instrument customers since those instruments do not require the use of the Company's reagents. In connection with future introductions of new products, the Company may be required to incur charges for inventory obsolescence in connection with unsold inventory of older generations of products. To date, however, the Company has not incurred material charges or expenses associated with inventory obsolescence in connection with new product introductions. In addition, a significant portion of the Company's expense levels is based on its expectation of a higher level of revenues in the future and is relatively fixed in nature. Therefore, if revenue levels are below expectations, operating results in a given period are likely to be adversely affected. Total net sales grew from $5.9 million in 1994 to $47.7 million in 1998, a compound annual growth rate of 68%. Instrument sales grew from $2.6 million in 1994 to $15.7 million in 1998, a compound annual growth rate of 57%. Reagent sales increased from $3.3 million in 1994 to $32.0 million in 1998, a compound annual growth rate of 76%. The growth in revenues is primarily attributable to the growth in instrument placements and the instrument installed base and the associated corresponding increase in the aggregate recurring reagent revenue stream. Gross margin increased from 57% in 1994 to 70% in 1998 as both instrument and reagent gross margins increased. Gross margin increased due to a higher level of revenues available to cover fixed costs and to economies of scale and efficiencies in purchasing and manufacturing activities. Research and development and selling, general and administrative expenses were maintained at levels that anticipated a higher level of revenues in the future, which 29 31 resulted in operating losses in each year between 1994 and 1996. The nonrecurring expenses of $1.7 million related to the litigation against BioTek were the primary reason for the Company experiencing an operating loss in 1997. RESULTS OF OPERATIONS Years Ended December 31, 1998, 1997 and 1996 Ventana acquired BioTek on February 26, 1996, BTTI on October 14, 1998 and certain assets of Oncor, Inc. on November 23, 1998. Net Sales. Presented below is a summary of net sales for each of the three years ended December 31, 1998, 1997 and 1996.
YEAR ENDED DECEMBER 31, ----------------------------------------------------------------- 1996 1997 1998 ----------------- ----------------- ----------------- % OF % OF % OF $ SALES $ SALES $ SALES ------- ----- ------- ----- ------- ----- (DOLLARS IN THOUSANDS) SALES SUMMARY: Instruments $ 8,591 36% $ 9,248 29% $15,737 33% Reagents and other 15,538 64% 22,905 71% 31,967 67% ------- ---- ------- ---- ------- ---- Total net sales $24,129 100% $32,153 100% $47,704 100% ======= ==== ======= ==== ======= ====
Net sales for the year ended December 31, 1998 increased by 48% to $47.7 million from $32.2 million for the year ended December 31, 1997. Net sales for the year ended December 31, 1997 increased by 33% to $32.2 million from $24.1 million for the year ended December 31, 1996. The increases in net sales were attributable to increases in instrument sales as well as increases in reagent sales. Instrument sales increased over the prior year by 70% in 1998 and 8% in 1997. Reagent sales increased over the prior year by 40% in 1998 and 47% in 1997. Instrument sales in 1998 increased due to the high demand for NexES IHC instrument introduced late in 1997, due to sales of the NexES Special Stains instrument introduced late in 1998, and due to sales of BTTI instruments acquired late in 1998. Instrument sales in 1997 increased due to a 40% increase in unit volume, which was partly attributable to the fact that BioTek's TechMate instruments were sold throughout 1997, but only for 10 months in 1996. However, this volume increase was partially offset by the relatively low unit prices received from DAKO. Reagent and other sales in 1998 increased due to sales of reagents to new customers from new instruments placed during the year, increased sales to existing customers, and service revenues from the growing installed base coming off warranty. The growth in reagent sales was limited by lower royalty revenues, stemming from fewer instruments shipped to DAKO in 1998 than 1997 on which the Company receives prepaid royalties. In 1997, reagent and other sales increased due to the increase in the installed base and higher reagent prices. The portion of the Company's sales generated by its European segment increased to 12% in the year ended December 31, 1998 from 10% in the year ended December 31, 1997, and 8% in the year ended December 31, 1996. The increase in the proportion of sales generated in Europe in 1997 and 1998 was attributable to major investments in European infrastructure. The Company has also begun to build an infrastructure in Japan, but sales in Japan represented less than 2% of total sales in that country through December 31, 1998. Gross Margin. Gross profit for the year ended December 31, 1998 increased to $33.2 million from $21.0 million in the year ended December 31, 1997 and $13.5 million in the year ended December 31, 1996. Gross margin was 70% in 1998 as compared to 65% in 1997 and 56% in 1996. The increase in gross margin from 1997 to 1998 was primarily due to the shipment of the NexES instrument, which has a lower manufacturing cost than the ES and due to higher margins on reagents due to the implementation of aggressive cost reduction programs and the integration of BioTek reagent manufacturing process into the Ventana model. The increase in gross margin from 1996 to 1997 was primarily due to the impact of the lower cost NexES instrument introduced in August 1997 to replace the higher cost ES and due to economies of scale in reagent costs. BioTek experienced lower gross margins than Ventana on a stand-alone basis because of BioTek's (i) use of third-party distributors, (ii) lower value-added 30 32 reagent manufacturing strategy and (iii) lower reagent volumes and pricing due to the open configuration of BioTek's instruments. The decline in gross margin caused by these factors was partially offset by increased economies of scale and manufacturing efficiencies brought about by the integration of batch processing and reagent manufacturing into Ventana's Tucson, Arizona manufacturing operations. Instrument gross margins declined slightly during 1996 as a result of the addition of the lower gross margin sales of TechMate instruments. Research and Development. Research and development expense in the year ended December 31, 1998 increased to $5.1 million from $3.1 million in the year ended December 31, 1997 and $2.7 million in the year ended December 31, 1996. Research and development expenses for 1998 related primarily to the development of new reagents and instruments, including the Special Stains instrument and new prognostic markers. Research and development expense in 1997 and 1996 related primarily to the development of new reagents and instruments, including the NexES instrument, the gen II instrument and development of additional primary antibodies. Selling, General and Administrative. Presented below is a summary of the components of SG&A expense and their respective percentages of net sales during the years ended December 31, 1998, 1997 and 1996.
YEAR ENDED DECEMBER 31, ----------------------------------------------------------------------------- 1996 1997 1998 ---------------------- --------------------- --------------------- $ % OF SALES $ % OF SALES $ % OF SALES ------- ---------- ------- ---------- ------- --------- (DOLLARS IN THOUSANDS) SG&A SUMMARY: Sales and marketing $ 8,387 35% $12,409 39% $18,536 39% Administration 2,819 11% 4,544 14% 5,269 11% ------- ---- ------- ---- ------- ---- Total SG&A $11,206 46% $16,953 53% $23,805 50% ======= ==== ======= ==== ======= ====
SG&A expense in the year ended December 31, 1998 increased to $23.8 million from $17.0 million in the year ended December 31, 1997 and $11.2 million in the year ended December 31, 1996. SG&A expense as a percentage of net sales was 50% of net sales in 1998, which was a decrease from 53% of net sales in 1997 and an increase from 46% of net sales in 1996. The fluctuation in SG&A expense from period to period reflects the growth of Ventana's internal sales and marketing organization to implement its market expansion strategy and a corresponding increase in infrastructure expenses to support a larger business base and ongoing clinical practice standardization programs. The growth in sales and marketing expense is the result of the decision by the Company to service the market through its own sales and marketing staff, expenses necessary to support the growth of the Company and in 1996 expenses associated with ongoing support activities resulting from the BioTek acquisition. The increase in administrative expense is associated with the Company's regulatory strategy, costs associated with supporting an expanding business base, particularly in Europe and Japan, and costs associated with new administrative systems and functions. INCOME TAXES Ventana and BioTek have neither provided for nor paid any ordinary federal income taxes since their respective inceptions because neither company generated taxable income in any fiscal year. Ventana was required to make estimated payments in 1998 for alternative minimum purposes. At December 31, 1998, Ventana had net operating loss carryforwards for federal and state purposes of approximately $1.5 and $0.4 million, respectively. These federal and state carryforwards will begin to expire in 1999, if not previously utilized. The Company also has research and development tax credit carryforwards of approximately $1.2 million which will begin to expire in 2005, if not previously utilized. Utilization of Ventana's net operating loss carryforwards will be subject to limitations due to the "change in ownership" provisions of the Internal Revenue Code of 1986, as amended (the "Code") as a result of the Company's prior issuances of equity securities. These carryforwards, therefore, may expire prior to being fully utilized. Future financings may cause additional changes in ownership and further limitations on the use of federal net operating loss carryforwards. Due to the losses incurred by Ventana since inception, deferred tax assets of approximately $8.8 million at December 31, 1998, related to these carryforwards, credits and temporary differences, have been fully reserved in accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"), except for certain alternative minimum tax credit carryforwards at December 31, 1998 for which management believes it is more likely than not that such benefits will be realized. 31 33 QUARTERLY CONSOLIDATED RESULTS OF OPERATIONS The following table contains summary unaudited quarterly consolidated statements of operations data for the four quarters ended December 31, 1998 and the four quarters ended December 31, 1997. Management has prepared the quarterly consolidated statements of operations data on the same basis as the Consolidated Statements of Operations contained in this Report on Form 10-K. The Company's results of operations have varied and may continue to fluctuate significantly from quarter to quarter. Results of operations in any period should not be considered indicative of the results to be expected for any future period. SUMMARY QUARTERLY CONDENSED CONSOLIDATED FINANCIAL DATA
1998 ---------------------------------------------- FIRST SECOND THIRD FOURTH QUARTER QUARTER QUARTER QUARTER ------- ------- ------- ------- (IN THOUSANDS, EXCEPT PER SHARE DATA) STATEMENT OF OPERATIONS DATA: Sales: Instruments ......................... $ 3,595 $ 3,827 3,047 5,268 Reagents and other .................. 6,760 7,755 8,061 9,391 ------- ------- ------- ------- Total net sales .................... 10,355 11,582 11,108 14,659 Cost of goods sold ..................... 3,453 3,477 3,303 4,309 ------- ------- ------- ------- Gross profit ........................... 6,902 8,105 7,805 10,350 Operating expenses: Selling, general and administrative ..................... 4,974 5,547 5,699 7,585 Research and development ............ 1,200 1,391 1,435 1,031 Nonrecurring expenses .................. -- -- -- (1)3,160 Amortization of intangibles ............ 127 127 128 217 ------- ------- ------- ------- Income (loss) from operations .......... 601 1,040 543 (1,643) Other income ........................... 210 262 594 23 ------- ------- ------- ------- Net income (loss) ...................... $ 811 $ 1,302 $ 1,137 $(1.620) ======= ======= ======= ======= Net income (loss) per share, basic .............................. $ .06 $ .10 $ .09 ($ .12) ======= ======= ======= ======= Net income (loss) per share, diluted ............................ $ .06 $ .09 $ .08 ($ .12) ======= ======= ======= ======= Shares used in computing net income (loss) per share, basic ......... 13,255 13,298 13,351 13,375 ======= ======= ======= ======= Shares used in computing net income (loss) per share, diluted ...... 14,557 14,847 14,742 13,375 ======= ======= ======= =======
32 34
1997 -------------------------------------------------- FIRST SECOND THIRD FOURTH QUARTER QUARTER QUARTER QUARTER ------- -------- -------- ------- (IN THOUSANDS, EXCEPT PER SHARE DATA) STATEMENT OF OPERATIONS DATA: Sales: Instruments ................................ $ 1,971 $ 1,919 2,142 3,216 Reagents and other ......................... 4,987 5,534 5,872 6,512 ------- -------- -------- ------- Total net sales ........................... 6,958 7,453 8,014 9,728 Cost of goods sold ............................ 2,701 2,780 2,511 3,146 ------- -------- -------- ------- Gross profit .................................. 4,257 4,673 5,503 6,582 Operating expenses: Selling, general and administrative ........ 3,378 3,630 4,555 5,390 Research and development ................... 729 714 702 905 Nonrecurring expenses ......................... -- (2)1,656 -- -- Amortization of intangibles ................... 127 127 128 127 ------- -------- -------- ------- Income (loss) from operations ................. 23 (1,454) 118 160 Interest income (expense) ..................... 186 76 (5) 524 Net income (loss) ............................. $ 209 $ (1,378) $ 113 $ 684 ======= ======== ======== ======= Net income (loss) per share Basic and diluted ......................... $ .02 $ (.11) $ .01 $ .05 ======= ======== ======== ======= Shares used in computing net income (loss) per share .................................... 12,924 12,924 13,989 14,176 ======= ======== ======== =======
(1) The non-recurring expenses in the fourth quarter of 1998 related to the write-off of in-process research and development costs associated with the acquisition of certain assets of Oncor ($2,900) and the costs of terminating a U.S.-based distributor ($260). The in-process research and development write-off is discussed more fully in Item 7 on page 27 and 28. Regarding the distributor costs, the Company agreed to buy back certain products from the distributor at the original prices paid by the distributor and consequently accrued the difference between those prices and the Company's manufacturing cost for those products. The Company has decided to distribute all its products in the U.S. through its direct sales force. (2) The $1,656 non-recurring expenses in the second quarter of 1997 related to the award in the BioGenex patent infringement lawsuit, including associated legal expenses. This is more fully discussed in Item 3 on page 23. LIQUIDITY AND CAPITAL RESOURCES Since inception, the Company's expenses have significantly exceeded its revenues, resulting in accumulated losses of $32.2 million as of December 31, 1998. The Company has funded its operations primarily through the private placement of approximately $31.6 million in equity and debt securities, its July 1996 initial public offering which resulted in net proceeds to the Company of $17.0 million and its February 1997 follow-on offering which resulted in net proceeds to the Company of $26.1 million. As of December 31, 1998 the Company's principal source of liquidity consisted of cash and cash equivalents of $2.4 million and borrowing capacity under its $5.0 million bank revolving line of credit. As of December 31, 1998, none of the line of credit had been utilized. Borrowings under the Company's bank credit facility are secured by a pledge of substantially all of the Company's assets and bear interest at the bank's prime rate. The Company recently increased its revolving line of credit to $10 million. The Company's liquidity was greatly impacted in 1998 by three events: (1) the decision to purchase for cash 100% of the common stock of BTTI, (2) the decision to purchase for cash certain assets of Oncor, Inc., and (3) the decision to repurchase 40,000 shares of the Company's own common stock. All transactions occurred in the fourth quarter and together reduced available cash by almost $14 million ($8 million for BTTI, $5 million for certain assets of Oncor, and $0.6 million for the stock repurchase). Expenditures for BTTI and the Oncor assets included the impact of planned efficiency moves such as reducing accounts payable, purchasing additional inventory and the partial integration of operations. As a consequence of these actions, the Company expects cash and interest income to remain at low levels for the foreseeable future. 33 35 During the year ended December 31, 1998, the Company used for operations and investing activities approximately $18.2 million in cash versus $4.5 million for the year ended December 31, 1997. During the second half of 1998, a deterioration in accounts receivable collections was experienced due to pricing errors on invoices, extension of payment terms and insufficient collection follow-up activities. The Company has focused on improving the accuracy of pricing, stronger controls on extension of terms and added collection personnel, which is expected to result in an improvement in the collection trend. Significant financial commitments over the next 18 months include implementing a major upgrade of the Company's management information system ("MIS") and contracting for a new facility. The MIS upgrade will cost between $1.5 million and $2.0 million and is expected to be completed in 1999. About 50% of this cost was spent in 1998. The new facility, for which construction is anticipated to commence in 1999, will be a "build-to-suit" facility financed by the landlord. The Company's commitment will consist of a long-term lease with costs per square foot comparable to existing Company facilities. The building design will allow for reasonable expansion opportunities over the lease term. Overall facilities costs are expected to increase over time in relation to the Company's growth rate. The new facility should be at least partially occupied by Company personnel by early 2001. The Company believes that cash generated from product sales and available borrowing capacity under bank credit facilities will be sufficient to satisfy its working capital requirements for the next 12 months. The Company's future capital requirements will depend on many factors, including the extent to which the Company's products gain market acceptance, the mix of instruments placed through direct sales, QRIBs or Rentals, progress of the Company's product development programs, competing technological and market developments, expansion of the Company's sales and marketing activities, the cost of manufacturing scale up activities, possible acquisitions of complementary businesses, products or technologies, the extent and duration of operating losses and the timing of regulatory approvals. The Company may be required to raise additional capital in the future through the issuance of either debt instruments or equity securities, or both. There is no assurance that such capital will be available to the extent required or on terms acceptable to the Company, or at all. FOREIGN EXCHANGE RISK The Company does not currently hedge against foreign currency fluctuations, because it does not believe that it runs a serious risk of experiencing permanent impairment to any material assets denominated in foreign currency, but intends to re-evaluate this situation from time to time. To the extent local currency revenues and expenses in the Company's foreign subsidiaries are translated into U.S. dollars at differing rates over time, the Company may experience fluctuations in its operating results. In addition, to the extent that the Company's European subsidiaries have receivables and liabilities in non-local currencies, unrealized gains and losses may be recorded in other income (expense) as a result of currency rate fluctuations. The Company conducts a relatively small but growing portion of its business in the following currencies: (1) the French franc, (2) the Japanese yen, and (3) the Italian lira. The Company reported as other income (expense) a foreign exchange gain of $.3 million in 1998 and a loss of $.3 million in 1997. There were no material foreign exchange gains or losses in any previous year. IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS In March 1998, the AICPA issued SOP 98-1, Accounting for the Costs of Computer Software Developed for or Obtained for Internal Use. The Company will adopt the SOP on January 1, 1999. The SOP requires the capitalization of certain costs incurred after the date of adoption in connection with the developing or obtaining software for internal use. As the Company already has a policy of capitalizing internal use software, the Company does not believe that the adoption of this SOP will have a material effect on the Company's consolidated results of operations or financial position. READINESS FOR THE YEAR 2000 The Company is engaged in a company-wide project to prepare its business for the change in date from the year 1999 to 2000. The Company has assembled a Year 2000 project team consisting of Company employees and third-party consultants. The goal of the Year 2000 project is to assure that there are no major interruptions in the Company's business operations relating to the transition to the year 2000. The scope of the Company's Year 2000 project includes (i) identifying and taking appropriate corrective action to remedy the Company's software, hardware and embedded technology, (ii) working with the payroll service, with which the Company communicates, electronically, to help protect such activity from being adversely affected by the Year 2000, and (iii) contacting key 34 36 vendors and service providers and requesting assurances that such third parties will be Year 2000 compliant. The status of the Year 2000 project is reported regularly to senior management and the Board of Directors. The Year 2000 project team has implemented a compliance process to address Year 2000 issues in the Company's software and hardware systems and embedded technology consisting of the following nine steps: (1) inventory, (2) risk assessment, (3) prioritization, (4) impact analysis, (5) remediation, (6) testing, (7) certification, (8) deployment, and (9) approval. The Company's critical systems have been the project team's top priority. The Company's critical systems include those systems which are the most essential to the Company to continue its operations without interruption. The Company believes it has completed its compliance process beyond the deployment and testing phases for approximately 90 percent of its critical software and hardware systems, with approximately 80 percent of its critical software and hardware systems having been tested and 20 percent currently being tested. With regard to embedded technology, the Company has completed the remediation and testing phases for 60 percent of its facilities. The business software and hardware of recently acquired companies and assets is not compliant and will be replaced by the implementation of the new Oracle ERP System. The Company's target for completing its compliance process for all of its critical systems is mid 1999. The Company's target for completing its compliance process for its non-critical systems is the end of 1999. The Company is directly working with certain key third parties to remediate and test affected systems where practicable. The Company sent surveys to key vendors and service providers requesting information regarding the status of their Year 2000 readiness. The Company is also in the process of reviewing the public Year 2000 disclosures of key customers. Based upon this information, the Company is in the process of identifying potential critical Year 2000 issues involving key third parties, if any, and either resolving those issues or developing contingency plans to the extent practicable. All costs and expenses incurred to address the Year 2000 issue are charged against income on a current basis. The total cost of the project is expected to be approximately $30,000. These costs include costs of internal employees and third-party consultants involved in the project and the costs of software and hardware. The Company does not expect these costs and expenses to have a material adverse effect on the Company's financial condition. While the Company continues to focus on solutions for Year 2000 issues, and expects to complete its Year 2000 project in a timely manner, the Company is in the process of identifying potential major business interruptions that could reasonably likely result from Year 2000 issues and will develop contingency plans designed to address such potential interruptions. The Company may also develop contingency plans designed to generally help protect the Company from unanticipated Year 2000 business interruptions. Contingency plans are anticipated to include, for example, the identification of alternate suppliers or service providers, increases in safety levels of raw material and finished goods inventories, and the development of alternate procedures. The Company's contingency plans will be developed and modified over time as it receives better information regarding the Year 2000 status of its systems and embedded technology and third party readiness. The most reasonably likely worst case scenario which could result from the failure of the Company or its customers, vendors or other key third parties to adequately address Year 2000 issues would include a temporary interruption or curtailment in the Company's manufacturing or distribution operations at one or more of its facilities. Such failures could also cause a delay or curtailment in the processing of orders and invoices and the collection of revenues, as well as the inability to maintain accurate accounting records, and lead to increased costs and loss of sales. If these failures would occur, depending upon their duration and severity, they could have a material adverse effect on the Company's business, results of operations and financial condition. Management's estimates regarding expected completion dates and costs involved in the Company's Year 2000 project are based upon various assumptions regarding future events, including the availability of resources, the success of third parties in addressing their Year 2000 issues, and other factors. While management believes the Company is addressing the Year 2000 issue, there is no guarantee that these estimated completion dates and costs will be achieved. In the event that the estimated completion dates and costs differ materially from the actual completion dates and costs, such could have a materially adverse effect on the Company's financial condition and results of operations. In addition, the Company cannot reasonably estimate the impact of Year 2000 on the Company if key third parties, including financial institutions, suppliers, customers, service providers, public utilities and governments, are unsuccessful in completing their Year 2000 efforts. 35 37 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's interest rate risk is very limited, as it has only a minimal amount of fixed-rate (7%) long-term debt. Future cash outflows relating to the Company's long-term debt follow ($000): 1999 - $ 59 2000 - 460 2001 - 474 2002 - 509 2003 - 464
Although the Company has foreign currency risk, to date the Company has not entered into any foreign currency contracts to hedge such exposures. Additional discussion applicable to this matter is contained at page 34. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Independent Auditors' Report, Consolidated Financial Statements and Notes to Consolidated Financial Statements begin on page F-1. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. 36 38 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth certain information regarding the directors and executive officers of the Company as of March 31, 1999:
NAME AGE POSITION ---- --- -------- Jack W. Schuler (1) (3) (III) 58 Chairman of the Board of Directors John Patience (2) (III) 51 Vice Chairman of the Board of Directors Henry T. Pietraszek (I) 52 President, Chief Executive Officer and Director Christopher M. Gleeson 49 Executive Vice President and Chief Operating Officer Michael K. Cusack 41 Vice President, International Kendall B. Hendrick 39 Vice President, Engineering Carl B. Kunkleman 39 Vice President, Sales Johnny D. Powers, Ph.D. 37 Vice President, Operations and GM Molecular Diagnostics Bernard O. C. Questier 45 Vice President, European Operations Russell Richerson, Ph.D. 47 Vice President, Research & Development Pierre H. Sice 55 Vice President, Chief Financial & Administrative Officer and Secretary Tamaki Tateiwa 59 Vice President, Japan Operations Stephen A. Tillson, Ph.D. 58 Vice President, Scientific Affairs and Quality Assurance Rex J. Bates (2) (II) 75 Director Edward M. Giles (1) (3) (II) 63 Director Thomas M. Grogan, M.D. (2) (III) 53 Director James R. Weersing (1)(2)(3)(I) 59 Director
- ---------------- (1) Member of the Compensation Committee. (2) Member of the Audit Committee. (3) Member of the Nominating Committee (I) Class I director. (II) Class II director. (III) Class III director. MR. SCHULER has served as a director of Ventana since April 1991 and as Chairman of the Board of Directors since November 1995. Mr. Schuler has been Chairman of the Board of Directors of Stericycle, Inc., a specialized medical waste management company, since March 1990. Mr. Schuler is also a partner in Crabtree Partners, a Chicago based venture capital firm. Prior to joining Stericycle, Mr. Schuler held various executive positions at Abbott from December 1972 through August 1989, serving most recently as President and Chief Operating Officer. He is currently a director of Medtronic, Inc., Somatogen, Inc. and Chiron Corporation. Mr. Schuler received a B.S. in Mechanical Engineering from Tufts University and an M.B.A. from Stanford University. MR. PATIENCE has served as a director of Ventana since July 1989 and as Vice Chairman since January 1999. Mr. Patience was a co-founder and served as a General Partner of Marquette Venture Partners, a venture capital investment firm, from January 1988 until March 1995. Since April 1995, Mr. Patience has been a partner in Crabtree Partners, a Chicago-based venture capital firm. Mr. Patience was previously a partner in the consulting firm of McKinsey & Co., specializing in health care. He is currently a director of TRO Learning, Inc. and Stericycle, Inc. Mr. Patience received a B.A. in Liberal Arts and an L.L.B. from the University of Sydney, Australia and an M.B.A. from the University of Pennsylvania Wharton School of Business. 37 39 MR. PIETRASZEK became President, Chief Executive Officer and a director in March 1997. Prior to joining the Company, Mr. Pietraszek served as President and Chief Executive Officer of Biostar, Inc., a medical diagnostic company. From 1975 to 1994, Mr. Pietraszek held a variety of executive positions at Abbott Laboratories and Takeda Chemical Industries. From 1982 to 1986, he served as President of Dainabot K.K., a joint venture between Abbott and Dainippon Pharmaceutical Company of Japan and from 1980 to 1982 he was Vice President of Field Service Operations for Abbott's Diagnostic Division. He is a director of Specialty Laboratories. Mr. Pietraszek received a B.S. in Marketing from Gannon University. MR. GLEESON joined Ventana as Executive Vice President and Chief Operating Officer in March 1999. Prior to joining the Company, Mr. Gleeson was Senior Vice President of Bayer Diagnostics and General Manager of its Critical Care Division. From 1993 to 1996, he served as General Manager of the U. S. Commercial Operations for Chiron Diagnostics, and prior to that, the founder, owner and Managing Director of Australian Diagnostics Corporation, a leading diagnostics distributor in Australia. He is a director of Pharmanetics, Inc. Mr. Gleeson attended Monash University in Melbourne, Australia. MR. CUSACK joined Ventana as Vice President of Marketing in September 1994 and assumed responsibility as Vice President, International in June 1996. Mr. Cusack has also served as President Directeur General of Ventana Medical Systems, S.A., a wholly owned subsidiary of Ventana, since September 1995. From November 1992 until joining Ventana, Mr. Cusack acted as General Manager, Europe and Mideast for CYTYC S.A.R.L., a medical diagnostics company with operations in the United States and abroad. Prior to CYTYC, Mr. Cusack held various marketing and managerial positions with Abbott's Diagnostics Division. Mr. Cusack received a B.S. from the University of Delaware and an M.B.A. from Temple University. MR. HENDRICK joined Ventana as Vice President of Engineering in August 1998. From April 1990 to August 1998, Mr. Hendrick held various product development management positions with Abbott Laboratories, Diagnostics Division, most recently as the Director of the Architect(TM) Research & Development Program. Mr. Hendrick holds a B.S. in Mechanical Engineering from Virginia Polytechnic Institute. MR. KUNKLEMAN joined Ventana as Vice President of Sales in June 1997. From April 1990 to June 1997 Mr. Kunkleman held various sales and marketing positions at TAP Pharmaceuticals, a joint venture between Abbott Laboratories and Takeda Chemical. Mr. Kunkleman received a B.S. in Marketing from the University of Maryland. DR. POWERS joined Ventana as Vice President of Operations in November 1996. From June 1990 until joining Ventana, Dr. Powers held various management positions with Organon Teknika Corporation, a medical diagnostic company, serving most recently as Director of Manufacturing Technologies. Dr. Powers holds a Ph.D. in Chemical Engineering from North Carolina State University, an M.S. in Chemical Engineering from Clemson University, an M.B.A. from Duke University and a B.A. in Chemistry from Wake Forest University. MR. QUESTIER has served as Vice President of European Operations of Ventana since February 1996. From October 1990 until joining Ventana in October 1995, Mr. Questier held a number of management positions in E.I. DuPont de Nemours, most recently as Business Manager for NEN Life Science Products in Europe. Mr. Questier received a degree in Chemical Engineering from the Technical Institute in Oostende, Belgium. DR. RICHERSON joined Ventana as Vice President, Research and Development in June 1997. From 1986 until joining Ventana, Dr. Richerson held various research and management positions with Abbott Laboratories' Diagnostics Division, most recently as the Director of the AxSym Product Development and as the Director of Probe Development. Dr. Richerson holds a Ph.D. in Biochemistry from the University of Texas at Austin and a B.S. in Medical Technology from Louisiana State University. MR. SICE joined Ventana as Vice President, Chief Financial Officer and Chief Administrative Officer in March 1997. Mr. Sice was Executive Vice President and Chief Financial Officer from 1994 until 1997, and Vice President and Chief Financial Officer from 1988 until 1994 at SensorMedics Corporation, a medical device company. From 1986 until 1988 Mr. Sice served as Senior Vice President and Chief Financial Officer of Datalin 38 40 Service Company. From 1978 until 1986 Mr. Sice was employed at MAI Basic Four Inc. in various financial management capacities. Mr. Sice received a B.S. in Mechanical Engineering from Illinois Institute of Technology and a M.B.A. from the University of Michigan. MR. TATEIWA has served as President of Ventana's wholly owned subsidiary in Japan. Ventana Medical Systems Japan K.K. in Tokyo, since August 1997. From 1977 to 1997, Mr. Tateiwa held various management positions with Dainabot K.K. Mr. Tateiwa received a B.S. in Engineering from the University of Electro-Communications in Japan. DR. TILLSON has served as Vice President of Scientific Affairs and Quality Assurance since August 1995. From the time of his joining Ventana in May 1992 until July 1995, Dr. Tillson served as Director of Scientific Affairs and Quality Assurance. From January 1990 to May 1992, Dr. Tillson served as a principal of Ticon Company Consulting. He has 25 years experience in the diagnostic and pharmaceutical industry. Dr. Tillson holds a Ph.D. from Purdue University and received a B.S. from California State Polytechnic University and an M.B.A. from St. Mary's College of California. MR. BATES has served as a director of Ventana since April of 1996. From August 1991 to May 1995, Mr. Bates served on the Board of Directors of Twentieth Century Industries and was a member of its compensation committee. Prior to Twentieth Century Industries, Mr. Bates served as the Vice-Chairman of the Board of Directors of the State Farm Mutual Automobile Insurance Company. Mr. Bates also served as State Farm's Chief Investment Officer. In March of 1991, Mr. Bates retired from State Farm. Prior to Mr. Bates' employment with State Farm, he was a partner in the investment firm of Stein, Roe & Farnham in Chicago. Mr. Bates received a B.S. and an M.S. from the University of Chicago. MR. GILES has served as a director of Ventana since September 1992. Mr. Giles has served as Chairman of The Vertical Group, Inc., a venture capital investment firm, since January 1989. Mr. Giles was previously President of F. Eberstadt & Co., Inc., a securities firm, and Vice Chairman of Peter B. Cannell & Co., Inc., an investment management firm. He is currently a director of McWhorter Technologies, Inc. and Synthetech, Inc. Mr. Giles received a B.S.Ch.E. in Chemical Engineering from Princeton University and an M.S. in Industrial Management from the Massachusetts Institute of Technology. DR. GROGAN is a founder, a director and Chairman Emeritus of Ventana. He has served as a director since the founding of the Company in June 1985 and as Chairman of the Board of Ventana from June 1985 to November 1995. He is currently a professor of pathology at the University of Arizona, College of Medicine, where he has taught since 1979. He received a B.A. in Biology from the University of Virginia and an M.D. from George Washington School of Medicine. Dr. Grogan completed a post-doctorate fellowship at Stanford University. MR. WEERSING has served as a director of Ventana since October 1994. Since 1984, Mr. Weersing has been a Managing Director of MBW Venture Partners, a venture capital investment firm. Mr. Weersing has also served as President of JRW Technology, Inc., a consulting firm. Mr. Weersing served as a director of Circadian, Inc., an asthma dosage management company, from December 1993 until January 1996. Circadian filed a petition under Chapter 7 of the federal bankruptcy laws in January 1996. Mr. Weersing received an B.S.M.E. and an M.B.A. from Stanford University. 39 41 Item 11. EXECUTIVE COMPENSATION The information required by this item is incorporated by reference to the information under caption "Executive Compensation" in the Proxy Statement. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is incorporated by reference to the information under caption "Record Date and Stock Ownership" in the Proxy Statement. Item 13. CERTAIN TRANSACTIONS The information required by this item is incorporated by reference to the information under the caption "Certain Transactions" in the Proxy Statement. 40 42 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 10K 1. FINANCIAL STATEMENTS The following Financial Statements of Ventana Medical Systems, Inc. and Report of Ernst & Young LLP, Independent Auditors, are in this Form 10-K.
PAGE ---- VENTANA MEDICAL SYSTEMS, INC. Report of Ernst & Young LLP, Independent Auditors F-1 Audited Consolidated Financial Statements Consolidated Balance Sheets as of December 31, 1997 and 1998 F-2 Consolidated Statements of Operations for the years ended December 31, 1996, 1997 and 1998 F-3 Consolidated Statements of Convertible Redeemable Preferred Stock and Stockholders' Equity (Deficit) for the years ended December 31, 1996, 1997 and 1998 F-4 Consolidated Statements of Cash Flows for the years ended December 31, 1996, 1997 and 1998 F-5 Notes to Consolidated Financial Statements F-6
2. FINANCIAL STATEMENT SCHEDULES FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996: Schedule II - Valuation and Qualifying Accounts has been provided on page 44. All other schedules are omitted, because the information required to be set forth therein is not applicable or is shown in the Financial Statements or notes thereto. 3. EXHIBITS
Exhibit Number Exhibits ------ -------- 3.1(i)(b)(1) Restated Certificate of Incorporation of Registrant. 3.1(ii)(b)(1) Bylaws of Registrant. 4.1(1) Specimen Common Stock Certificate. 10.1(a)(1)+ DAKO Distribution Agreement dated September 27, 1994. 10.1(b)(1)+ First Amendment to DAKO Distribution Agreement dated March 24, 1995. 10.1(c)(1)+ Further amendments to First Amendment to DAKO Distribution Agreement dated March 24, 1995. 10.1(d)(2)++ Second amendment to DAKO Distribution Agreement dated September 25, 1996. 10.1(e)(3)++ Amended and Restated DAKO Distribution Agreement dated May 18, 1998. 10.2(a)(1) Kollsman Secured Promissory Note dated December 4, 1994. 10.2(b)(1) Development Secured Promissory Note dated March 24, 1995. 10.3(1)+ Curtin Matheson Scientific, Inc. Distribution Agreement dated January 18, 1993. 10.4(a)(1) Restricted Stock Purchase Agreement with Jack W. Schuler dated April 19, 1996 -- Tranche 1. 10.4(b)(1) Restricted Stock Purchase Agreement with Jack W. Schuler dated April 19, 1996 -- Tranche 2. 10.4(c)(1) Restricted Stock Purchase Agreement with Jack W. Schuler dated April 19, 1996 Tranche 3. 10.4(d) Services Extension Agreement with Jack W. Schuler dated January 26, 1998. 10.5(a)(1) Restricted Stock Purchase Agreement with John Patience dated April 19, 1996 Tranche 1. 10.5(b)(1) Restricted Stock Purchase Agreement with John Patience dated April 19, 1996 Tranche 2. 10.5(c) Services Extension Agreement with John Patience dated January 26, 1998. 10.6(1) Form of Indemnification Agreement for directors and officers. 10.7(a)(1) 1988 Stock Option Plan and forms of agreements thereunder. 10.7(b)(1) 1996 Stock Option Plan and forms of agreements thereunder. 10.8(a)(1) 1991 Employee Stock Purchase Plan. 10.8(b)(1) 1996 Employee Stock Purchase Plan. 10.8(c)(1) 1996 Directors Option Plan. 10.9(1) Questier Employment Agreement dated October 20, 1995. 10.10(1) Restated Investors Rights Agreement dated February 20, 1996.
41 43 10.11(1) Sublease of Premises between the Registrant and Jerry R. Jones &Associates, Inc., dated February 29, 1996, with attached Master Lease, dated October 26, 1988. 10.12(1) Master Lease Purchase Agreement between the Registrant and Copelco Leasing Corporation dated April 13, 1994. 10.13(a)(1) Agreement and Plan of Reorganization dated January 19, 1996. 10.13(b)(1) Agreement and Plan of Merger dated February 26, 1996. 10.13(c)(1) Escrow Agreement dated February 26, 1996. 10.14(a)(1) Form of Stock Purchase Warrant to Purchase shares of Series D Preferred Stock. 10.14(b)(1) Form of Preferred Stock Purchase Warrant. 10.14(c)(1) MBW and Marquette Warrants dated August 21, 1992. 10.14(d)(1) Schuler Warrant dated September 30, 1992. 10.15(a)(1) Form of Convertible Unsecured Promissory Note. 10.15(b)(1) Form of Convertible Unsecured Promissory Note. 10.17(1)+ NovoCastra Laboratories Ltd. Distribution Agreement dated August 19, 1992 10.18(1)+ LJL BioSystems, Inc. TechMate 250 Production Agreement dated May 1, 1996. 10.19(a)(1) Silicon Valley Bank Loan and Security Agreement dated February 20, 1995. 10.19(b)(1) Amendment to Silicon Valley Bank Loan and Security Agreement dated March 28, 1996. 10.19(c) Amendment to Silicon Valley Bank Loan and Security Agreement dated August 15, 1997. 10.20(a) Bank of America Business Loan Agreement dated June 9, 1998. 10.20(b) Amendment to Bank of America Business Loan Agreement dated October 1, 1998. 10.20(c) Amendment to Bank of America Business Loan Agreement dated March 17, 1999. 10.21(4) Acquisition of Biotechnology Tools, Inc. dated October 14, 1998. 10.21(5) Amendment No. 1 to Acquisition of Biotechnology Tools, Inc. dated October 14, 1998. 13.1(3) The Registrant's Quarterly Report on Form 10-Q for the period ended September 30, 1998. 21.1(1) Subsidiaries of the Registrant. 23.1 Consent of Ernst & Young LLP, Independent Auditors. 27.1 Financial Data Schedule.
(1) Incorporated by reference to the like-numbered exhibit to Registrant's Registration Statement on Form S-1 (Commission File No. 333-4461), declared effective by the Commission July 26, 1996. (2) Incorporated by reference to the like-numbered exhibit to Registrant's Registration Statement on Form S-1 (Commission File No. 333-18471), declared effective by the Commission February 11, 1997. (3) Incorporated by reference to Form 10Q filed August 14, 1998 (Commission File No. 000-20931). (4) Incorporated by reference to Form 8K filed October 29, 1998 (Commission File No. 2-20931). (5) Incorporated by reference to Form 8K-A filed December 28, 1998 (Commission File No. 2-20931). + Confidential Treatment has been granted for certain portions of this Exhibit. ++ Confidential Treatment has been requested for certain portions of this Exhibit. 42 44 SIGNATURES Pursuant to the requirements of the Securities Act, the registrant certifies that it has reasonable grounds to believe that it meets all of the requirements for filing on Form 10-K and has duly caused this registration statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Tucson, State of Arizona, on this 30th day of March, 1998. VENTANA MEDICAL SYSTEMS, INC. By: /s/ Pierre H. Sice ----------------------------------- Pierre H. Sice Vice President and Chief Financial Officer POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Pierre H. Sice and Christopher D. Mitchell, and each of them acting individually, as his attorney-in-fact, each with full power of substitution, for him in any and all capacities, to sign any and all amendments to this Annual Report on 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that said attorney-in-fact, or his substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Act of 1933, this Registration Statement has been signed by the following persons in the capacities indicated:
Signature Title Date --------- ----- ---- /s/ Henry T. Pietraszek President and March 30, 1999 - --------------------------- Chief ExecutiveOfficer (Henry T. Pietraszek) (Principal Executive Officer) /s/ Pierre H. Sice Vice President and March 30, 1999 - --------------------------- Chief Financial Officer (Pierre H. Sice) (Principal Financial and Accounting Officer) /s/ Edward M. Giles Director March 30, 1999 - --------------------------- (Edward M. Giles) /s/ Thomas M. Grogan Director March 30, 1999 - --------------------------- (Thomas M. Grogan) /s/ John Patience Director March 30, 1999 - --------------------------- (John Patience) /s/ Jack W. Schuler Director March 30, 1999 - --------------------------- (Jack W. Schuler) /s/ James R. Weersing Director March 30, 1999 - --------------------------- (James R. Weersing) /s/ Rex J. Bates Director March 30, 1999 - --------------------------- (Rex J. Bates)
43 45 SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS DECEMBER 31, 1998 (IN THOUSANDS)
BALANCE AT ADD. CHARGES ADD. CHARGES BEGINNING OF TO COSTS AND TO OTHER BALANCE AT DESCRIPTION PERIOD EXPENSES ACCOUNTS DEDUCTIONS END OF PERIOD - ----------- ------------ ------------ ------------- ---------- ------------- Year Ended December 31, 1998 Deducted from asset accounts: Allowance for doubtful accounts $ 300 $ 392 $ 41 $ 39 $ 694 ===== ===== ===== ===== ===== (1) (3) Year Ended December 31, 1997 Deducted from asset accounts: Allowance for doubtful accounts $ 47 $ 251 $ 11 $ 9 $ 300 ===== ===== ===== ===== ===== (1) (3) Year Ended December 31, 1996 Deducted from asset accounts: Allowance for doubtful accounts $ 31 $ 14 $ 17 $ 15 $ 47 ===== ===== ===== ===== ===== (2) (3)
(1) Charged to revenue (2) Opening balance of acquired company (3) Uncollectible accounts written off, net of recoveries 44 46 EXHIBIT INDEX
Exhibit No. Description - ----------- ----------- 10.4(d) Services Extension Agreement with Jack W. Schuler dated January 26, 1998. 10.5(c) Services Extension Agreement with John Patience dated January 26, 1998. 10.20(a) Bank of America Business Loan Agreement dated June 9, 1998. 10.20(b) Amendment to Bank of America Business Loan Agreement dated October 1, 1998. 10.20(c) Amendment to Bank of America Business Loan Agreement dated March 17, 1999. 23.1 Consent of Ernst & Young LLP, Independent Auditors 27.1 Financial Data Schedule
45 47 Report of Ernst & Young LLP, Independent Auditors Board of Directors Ventana Medical Systems, Inc. We have audited the accompanying consolidated balance sheets of Ventana Medical Systems, Inc., at December 31, 1998 and 1997, and the related consolidated statements of operations, convertible redeemable preferred stock and stockholders' equity (deficit), and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Ventana Medical Systems, Inc., at December 31, 1998 and 1997, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. Tucson, Arizona February 2, 1999 F-1 48 Ventana Medical Systems, Inc. Consolidated Balance Sheets (In thousands, except share data)
DECEMBER 31, ---------------------- 1998 1997 -------- -------- ASSETS Current assets: Cash and cash equivalents $ 2,424 $ 18,902 Trade accounts receivable, net of allowance for doubtful accounts of $694 and $300, respectively 16,531 8,047 Inventories 11,009 5,134 Prepaid expenses 645 846 Other current assets 1,142 1,263 -------- -------- Total current assets 31,751 34,192 Property and equipment, net 9,937 6,105 Intangibles, net 14,592 8,055 -------- -------- Total assets $ 56,280 $ 48,352 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 3,536 $ 2,584 Other current liabilities 5,053 2,894 -------- -------- Total current liabilities 8,589 5,478 Long-term debt 1,907 471 Commitments and Contingencies Stockholders' equity: Common stock - $.001 par value; 50,000,000 shares authorized, 13,421,819 and 13,247,226 shares issued and outstanding at December 31, 1998 and 1997, respectively 13 13 Additional paid-in-capital 78,716 76,313 Accumulated deficit (32,152) (33,782) Accumulated other comprehensive income (193) (141) Treasury stock - 40,000 shares in 1998, at cost (600) -- -------- -------- Total stockholders' equity 45,784 42,403 -------- -------- Total liabilities and stockholders' equity $ 56,280 $ 48,352 ======== ========
See accompanying notes. F-2 49 Ventana Medical Systems, Inc. Consolidated Statements of Operations (In thousands, except per share data)
YEARS ENDED DECEMBER 31, ---------------------------------- 1998 1997 1996 ------- -------- -------- Sales: Instruments $15,737 $ 9,248 $ 8,591 Reagents and other 31,967 22,905 15,538 ------- -------- -------- 47,704 32,153 24,129 Cost of goods sold 14,542 11,138 10,632 ------- -------- -------- Gross profit 33,162 21,015 13,497 Operating expenses: Selling, general and administrative 23,805 16,953 11,206 Research and development 5,057 3,050 2,749 Non-recurring expenses 3,160 1,656 10,262 Amortization of acquisition costs 599 509 424 ------- -------- -------- Income (loss) from operations 541 (1,153) (11,144) Interest and other income (expense) 1,089 781 (137) ------- -------- -------- Income (loss) before income taxes 1,630 (372) (11,281) Provision for income taxes -- -- -- ------- -------- -------- Net income (loss) $ 1,630 $ (372) $(11,281) ======= ======== ======== Net income (loss) per share: Basic $ .12 $ (.03) $ (1.22) ======= ======== ======== Diluted $ .11 $ (.03) $ (1.22) ======= ======== ======== Shares used in computing net income (loss) per share: Basic 13,320 12,778 9,243 ======= ======== ======== Diluted 14,627 12,778 9,243 ======= ======== ========
See accompanying notes. F-3 50 Ventana Medical Systems, Inc. Consolidated Statements of Convertible Redeemable Preferred Stock and Stockholders' Equity (Deficit) (In thousands, except share data)
CONVERTIBLE REDEEMABLE PREFERRED STOCK -------------------------------------- SERIES A SERIES C SERIES D TOTAL -------------------------------------- Balance at January 1, 1996 $ 536 $ 10,696 $ 23,948 $ 35,180 Net loss -- -- -- -- Translation adjustment -- -- -- -- Comprehensive loss -- -- -- -- Sale of Series D preferred stock -- -- 413 413 Accretion of preferred stock redemption requirement -- 328 1,027 1,355 Conversion of preferred stock upon completion of initial public offering (536) (11,024) (25,388) (36,948) Proceeds of initial public offering, net of expenses $1,221 -- -- -- -- Conversion of debt into common stock -- -- -- -- Sale of common stock - other -- -- -- -- ------------------------------------- Balance at December 31, 1996 -- -- -- -- Net loss -- -- -- -- Translation adjustment -- -- -- -- Comprehensive loss -- -- -- -- Proceeds from public offering, net of expenses $530 -- -- -- -- Sale of common stock - other -- -- -- -- ------------------------------------- Balance at December 31, 1997 -- -- -- -- Net income -- -- -- -- Translation adjustment -- -- -- -- Comprehensive income -- -- -- -- Sale of common stock - other -- -- -- -- Repayment of director's loans -- -- -- -- Purchase of common stock -- -- -- -- ------------------------------------- Balance at December 31, 1998 $ -- $ -- $ -- $ -- =====================================
STOCKHOLDERS' EQUITY (DEFICIT) -------------------------------------------------------------------------- COMMON STOCK ----------------- ACCUMULATED OTHER ADDITIONAL COMPREHEN- PAID-IN ACCUMULATED SIVE TREASURY SHARES AMOUNT CAPITAL DEFICIT INCOME STOCK TOTAL -------------------------------------------------------------------------- Balance at January 1, 1996 1,020,164 $ 1 $ 243 $(29,980) $(120) $ -- $(29,856) Net loss -- -- -- (11,281) -- -- (11,281) Translation adjustment -- -- -- -- (96) -- (96) -------- Comprehensive loss -- -- -- -- -- -- (11,377) -------- Sale of Series D preferred stock -- -- -- -- -- -- -- Accretion of preferred stock redemption requirement -- -- -- (1,355) -- -- (1,355) Conversion of preferred stock upon completion of initial public offering 6,716,997 7 27,735 9,206 -- -- 36,948 Proceeds of initial public offering, net of expenses $1,221 1,963,975 2 17,042 -- -- -- 17,044 Conversion of debt into common stock 222,973 -- 3,016 -- -- -- 3,016 Sale of common stock - other 1,054,129 1 849 -- -- -- 850 --------------------------------------------------------------------------- Balance at December 31, 1996 10,978,238 11 48,885 (33,410) (216) -- 15,270 Net loss -- -- -- (372) -- -- (372) Translation adjustment -- -- -- -- 75 -- 75 -------- Comprehensive loss -- -- -- -- -- -- (297) -------- Proceeds from public offering, net of expenses $530 1,881,066 2 26,132 -- -- -- 26,134 Sale of common stock - other 387,922 -- 1,296 -- -- -- 1,296 --------------------------------------------------------------------------- Balance at December 31, 1997 13,247,226 13 76,313 (33,782) (141) -- 42,403 Net income -- -- -- 1,630 -- -- 1,630 Translation adjustment -- -- -- -- (52) -- (52) -------- Comprehensive income -- -- -- -- -- -- 1,578 -------- Sale of common stock - other 174,593 -- 1,502 -- -- -- 1,502 Repayment of director's loans -- -- 901 -- -- -- 901 Purchase of common stock -- -- -- -- -- (600) (600) --------------------------------------------------------------------------- Balance at December 31, 1998 13,421,819 $13 $78,716 $(32,152) $(193) $(600) $ 45,784 ===========================================================================
See accompanying notes. F-4 51 Ventana Medical Systems, Inc. Consolidated Statements of Cash Flows (In thousands)
YEARS ENDED DECEMBER 31, ------------------------------------ 1998 1997 1996 -------- -------- -------- OPERATING ACTIVITIES: Net income (loss) $ 1,630 $ (372) $(11,281) Adjustments to reconcile net income (loss) to net cash used in operating activities: Depreciation and amortization 2,850 2,029 1,052 Purchased in-process research and development 2,900 -- 7,900 Provision for deferred taxes 145 -- -- Gain on early extinguishment of debt -- -- 300 Changes in operating assets and liabilities net of effects from acquisitions: Accounts receivable (6,340) (4,017) (2,598) Inventories (4,160) (1,862) (1,377) Other assets 198 (1,065) (288) Accounts payable (63) 846 181 Other current liabilities 296 (643) (1,626) -------- -------- -------- Net cash used in operating activities (2,544) (5,084) (7,737) INVESTING ACTIVITIES: Purchase of property and equipment (5,377) (4,263) (815) Purchase of intangible assets (5) (44) (192) Acquisition of certain Oncor, Inc. assets (5,000) -- -- Acquisition of Biotechnology Tools, Inc. (5,257) -- -- Acquisition of BioTek Solutions, Inc. -- -- (2,500) Sales (purchases) of short-term investments available for sale activities -- 4,877 (4,877) Net cash (used in) provided by investing activities (15,639) 570 (8,384) -------- -------- -------- FINANCING ACTIVITIES: Repayments of notes payable -- (10,279) -- Net proceeds from public offering -- 26,134 17,044 Issuance of debt (including amounts from related parties) and stock 2,403 1,296 7,624 Purchase of common stock (600) -- -- Repayment of debt, net of gain on extinguishment (46) -- (3,364) -------- -------- -------- Net cash provided by financing activities 1,757 17,151 21,304 Effect of exchange rate changes on cash (52) 75 (96) -------- -------- -------- Net (decrease) increase in cash and cash equivalents (16,478) 12,712 5,087 Cash and cash equivalents, beginning of year 18,902 6,190 1,103 -------- -------- -------- Cash and cash equivalents, end of year $ 2,424 $ 18,902 $ 6,190 ======== ======== ========
See accompanying notes. F-5 52 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (In thousands, except per share data) December 31, 1998 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES Organization: Ventana Medical Systems, Inc. (the "Company") develops, manufactures, and markets proprietary instruments and reagents that automate diagnostic procedures used for molecular analysis of cells. At present, the Company's principal markets are North America, Europe, and Japan. Use of Estimates: The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Principles of Consolidation: The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Ventana Medical Systems, S.A., Ventana Medical Systems GmbH, Ventana Medical Systems Japan K.K., BioTek Solutions, Inc. (BioTek) and BioTechnology Tools, Inc. (BTTI). All significant intercompany accounts and transactions have been eliminated. Cash and Cash Equivalents: Cash equivalents include investments (primarily money market accounts and overnight reverse repurchase agreements) with maturities of three months or less from the date of purchase. Inventories: Inventories, principally chemical, biological and instrument parts and reagents and finished instruments, are stated at the lower of cost (first-in first-out basis) or market. Property and Equipment: Property and equipment are stated at cost. Depreciation is computed using the straight-line method over estimated useful lives of three to ten years. Amortization of leasehold improvements is calculated using a straight-line method over the term of the lease. Maintenance and repairs are charged to operations as incurred. Property and equipment includes diagnostic instruments used for sales demonstrations or placed with customers under several types of arrangements, including cancelable reagent plans (RPs), qualified reagent installed bases (QRIBs) and rentals. New instruments are no longer placed into the RP program. However, certain long-standing agreements continue on a month-to-month basis, wherein the customer is required to purchase a minimum quantity of reagents in order to keep the instrument. QRIB instruments are placed with customers for evaluation periods of up to six months. The customer is required to purchase a minimum amount of reagents and at the end of the evaluation period must purchase, rent or return the instrument. The manufacturing cost of demonstration, RP, QRIB and rental instruments is amortized over a period of 36 to 48 months to cost of goods sold. F-6 53 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (continued) (In thousands, except per share data) Intangibles: Intangible assets consist primarily of goodwill, customer base, developed technology, workforce in place and supply agreements acquired in the acquisitions of BioTek (see Note 12), BTTI (see Note 13) and of certain assets and technology from Oncor, Inc. (see Note 14) and patents. Such assets are amortized on a straight-line basis over estimated useful lives ranging from 5 to 20 years. Impairment is recognized in operating results if a permanent decline in value occurs. The Company measures possible impairment of its intangible assets periodically by comparing the cash flows generated by those assets to their carrying values. The Company periodically evaluates the useful lives assigned to the various categories of intangible assets considering such factors as (i) demand, obsolescence, competition, market share, and other economic factors; (ii) legal and regulatory provisions; and (iii) the periods expected to be benefited. Revenue Recognition: Sales of instruments and reagents are generally recognized upon shipment. Revenues from reagents sold under RPs and similar leasing arrangements are recognized when reagents are shipped. Service revenue is recognized as service is rendered. For the year ended December 31, 1997, sales to DAKO A/S, a European distributor for the Company, represented approximately 20% of consolidated net sales. For the year ended December 31, 1996, sales to DAKO A/S and Curtin Matheson Scientific, a subsidiary of Fischer Scientific, Inc. represented 17% and 16% of consolidated net sales, respectively. No single customer accounted for 10% or more of the Company's 1998 net sales. Concentration of Credit Risk: The Company sells its instruments and reagent products primarily to hospitals, medical clinics, reference laboratories, and universities. Credit losses have been minimal to date. The Company invests its excess cash primarily in U.S. government securities and bank money market accounts and has an established policy relating to diversification and maturities that is designed to maintain safety and liquidity. The Company has not experienced any material losses on its cash equivalents or short-term investments. Non-recurring Expenses: The 1998 non-recurring expenses primarily relate to the cost of research and development in process acquired from Oncor, Inc. (see Note 14). The 1997 non-recurring expenses relate primarily to a legal judgment against BioTek. Non-recurring expenses in 1996 consisted of the estimated costs of integrating BioTek's operations into Ventana's and the cost of research and development in process acquired from BioTek (see Note 12). Foreign Currency Translations: Foreign currency financial statements of the Company's foreign subsidiaries are converted into United States dollars by translating balance sheet accounts at the current exchange rate at year end and statement of operations accounts at F-7 54 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (continued) (In thousands, except per share data) the average exchange rate for the year, with resulting translations adjustments included in accumulated other comprehensive income. The effect on the statements of operations of transaction gains and losses is insignificant for all years presented. Income Taxes: The Company accounts for income taxes using the liability method. Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using enacted tax rates and laws expected to be in effect when the differences are expected to reverse. Valuation allowances are established when necessary to reduce the carrying amount of deferred tax assets to their net realizable value. Fair Value of Financial Instruments: The Company's cash equivalents, accounts receivable, accounts payable and long-term debt represent financial instruments as defined by Statement of Financial Accounting Standards No. 107, Disclosures About Fair Value of Financial Instruments. The carrying value of these financial instruments is a reasonable approximation of fair value, due to their current maturities. The fair value of the Company's borrowings is estimated using discounted cash flow analyses, based upon the current incremental borrowing rates for similar arrangements. Stock-Based Compensation: The Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB No. 25") and related Interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation ("SFAS No. 123"), requires the use of option valuation models that were not developed for use in valuing employee stock options. Under APB No. 25, because the exercise price of the Company's stock options equals or exceeds the fair market value of the underlying stock on the dates of grant, no compensation expense is recognized. Accumulated Other Comprehensive Income: As of January 1, 1998, the Company adopted Financial Accounting Standards Board Statement No. 130, Reporting Comprehensive Income (SFAS No. 130). SFAS No. 130 establishes new rules for the reporting and display of comprehensive income and its components; however, the adoption of SFAS No. 130 had no impact on the Company's consolidated results of operations, financial position, stockholders' equity or cash flows. SFAS No. 130 requires the foreign currency translation adjustments, which prior to adoption were reported separately in stockholders' equity, to be included in other comprehensive income. Prior year financial statements have been reclassified to conform to the requirements of SFAS No. 130. Accumulated other comprehensive income at December 31, 1998, 1997 and 1996 consists exclusively of foreign currency translation adjustments. Income (loss) per Share: In February 1997, the Financial Accounting Standards Board issued SFAS No. 128, Earnings per Share (SFAS No. 128). SFAS No. 128 replaced the F-8 55 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (continued) (In thousands, except per share data) calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. Income (loss) per share amounts for all periods have been presented, and where appropriate, restated to conform to the requirements of SFAS No. 128, as well as Staff Accounting Bulletin No. 98 (issued by the Securities and Exchange Commission in February 1998), which amends the determination of and accounting for "cheap stock" in periods prior to an initial public offering. The effect of dilutive securities is computed using the treasury stock method. Loss per share in both 1997 and 1996 is computed using the weighted average number of shares of common stock outstanding; common equivalent shares from stock options and warrants are excluded from the computation in those years as their effect is antidilutive. The following tables sets forth the components of the computation of 1998 basic and diluted earnings per share: Numerator: Net income $ 1,630 ======= Denominator: Basic: Weighted average shares 13,320 Effect of dilutive securities: Employee stock options 776 Warrants 531 ------- 14,627 =======
The 1996 net loss per share, historical basis, was as follows: Net loss $(11,281) Less accretion of preferred stock dividends (1,355) -------- Net loss applicable to common stock $(12,636) ======== Net loss per common share $ (2.14) ======== Weighted average shares outstanding 5,907 ========
F-9 56 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (continued) (In thousands, except per share data) The as adjusted calculation of 1996 net loss per share presented in the consolidated statements of operations has been computed as described above, but also gives effect to the conversion of all outstanding shares of convertible redeemable preferred stock into common stock upon closing of the Company's initial public offering (determined using the if-converted method) and the exercise of warrants to purchase Series D preferred stock which would otherwise have expired upon completion of the Offering. Impact of Recently Issued Accounting Standards: In March 1998, the AICPA issued SOP 98-1, Accounting for the Costs of Computer Software Developed for or Obtained for Internal Use. The Company will adopt the SOP on January 1, 1999. The SOP requires the capitalization of certain costs incurred after the date of adoption in connection with developing or obtaining software for internal use. As the Company already has a policy of capitalizing internal use software, the Company does not believe that the adoption of this SOP will have a material effect on the Company's consolidated results of operations or financial position. 2. INVENTORIES Inventories consist of the following:
DECEMBER 31, ----------------------- 1998 1997 ------- ------ Raw materials and work-in-process $ 5,165 $4,033 Finished goods 5,844 1,101 ------- ------ $11,009 $5,134 ======= ======
3. PROPERTY AND EQUIPMENT Property and equipment consist of the following:
DECEMBER 31, ------------------------ 1998 1997 ------------------------ Diagnostic instruments $ 7,267 $ 4,830 Machinery and equipment 4,835 2,684 Computers and related equipment 2021 1,970 Leasehold improvements 561 472 Furniture and fixtures 305 177 ------------------------ 14,989 10,133 Less accumulated depreciation and amortization 5,759 4,028 Projects in progress 707 -- ------------------------ $ 9,937 $ 6,105 ========================
F-10 57 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (continued) (In thousands, except per share data) 4. INTANGIBLE ASSETS Intangible assets consist of the following:
DECEMBER 31, ----------------------- 1998 1997 ----------------------- Customer base $ 4,100 $4,100 Developed technology 2,800 2,800 Goodwill 7,637 1,756 Supply contract 1,200 -- Workforce in place 100 -- Patents 492 488 ----------------------- 16,329 9,144 Less amortization 1,737 1,089 ----------------------- $14,592 $8,055 =======================
5. OTHER CURRENT LIABILITIES Other current liabilities consist of the following:
DECEMBER 31, ------------------------ 1998 1997 ------------------------ Accrued payroll and payroll taxes $ 1,161 $ 421 Accrued commissions 385 146 Deferred revenue 1,037 334 Accrued legal or settlement reserves 338 946 Contingent purchase consideration 900 -- Sales tax (receivable) payable (95) 410 Long-term debt, current portion 59 -- Other accrued expenses 1,268 637 ------------------------ $ 5,053 $2,894 ========================
F-11 58 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (continued) (In thousands, except per share data) 6. LINE OF CREDIT The Company had $5,000 available under a line of credit arrangement with a bank which is subject to renewal in May 1999. Borrowings under the line are collateralized by the Company's receivables, inventories, machinery and equipment, and intellectual property. The line contains certain financial covenants (measured quarterly) with which the Company must comply, prohibits the payment of dividends on the Company's stock and limits the number of treasury shares the Company may purchase. No borrowings were outstanding under the line at December 31, 1998. The bank waived non-compliance with the Company's financial covenants as of the December 31, 1998 measurement date. 7. LONG-TERM DEBT Long-term debt consists of the following:
DECEMBER 31, -------------------- 1998 1997 -------------------- Note payable to a customer over 16 quarters beginning March 31, 2000, interest accruing at 7% beginning January 1, 2000 $1,588 $ -- Capital lease obligations, various terms and interest rates 378 -- Note payable to a customer, rolled-into new note in 1998 -- 471 -------------------- 1,966 471 Less current portion 59 -- -------------------- $1,907 $471 ====================
Future payments under the above obligations are as follows at December 31, 1998: 1999 $ 59 2000 460 2001 474 2002 509 2003 464 ------ $1,966 ======
The note payable to a customer at December 31, 1998 is net of imputed interest of $63 relating to the period through January 1, 2000 during which no interest accrues. The Company issued Exchange Notes in connection with the BioTek acquisition. On March 25, 1996, approximately $3,016 of the Exchange Notes were converted into F-12 59 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (continued) (In thousands, except per share data) common stock. On October 18, 1996, the Company redeemed for $3,400 Exchange Notes with a face value of $3,700. The resulting gain on extinguishment of debt was reflected in operating results in the fourth quarter of 1996. All Exchange Notes were repaid by February 1997. In accordance with the note terms, all interest was forgiven, as the Exchange notes were repaid prior to February 26, 1997. The reversal of the $603 of previously accrued interest expense is included in operating results in the first quarter of 1997. 8. STOCKHOLDERS' EQUITY During 1997, the Company granted options to purchase a total of 300 shares at $12.625 per share, fair market value on the date of the grant, to two Directors of the Company for consulting services to be performed through February 2000. On February 26, 1996, the Company sold 647 shares of common stock to two directors of the Company and a related partnership at a price of $1.62 per share for their efforts and assistance in completing the BioTek acquisition and assisting management with its integration of the acquired company. Receivables of $901 due from the directors have been netted against Common Stock at December 31, 1997 and 1996. These loans, including interest at the rate of 6%, were repaid on February 26, 1998. Upon closing of the Company's initial public offering on July 26, 1996, all outstanding shares of its Series A, C and D redeemable Convertible Preferred stock were converted into 6,717 shares of Common Stock. Warrants for the purchase of 719 shares of Common Stock were outstanding and fully exercisable at December 31, 1998, at an exercise price of $5.82 per share. These warrants may be exercised on a net basis and will begin to expire in February 2001, to the extent not previously exercised. Under the Company's 1988 Stock Option Plan ("the 1988 Plan"), up to 1,340 shares of common stock have been reserved for grant to employees and directors. In order to be incentive stock options (ISOs), options must be granted at not less than 100% of fair market value of the Company's stock on the date of grant. Options generally vest over a four year period and expire five to ten years after the date of grant. However, the Board of Directors, at its discretion, may decide the period over which options become exercisable and their expiration dates. In April 1996, the Company's Board of Directors authorized the 1996 Stock Option Plan ("the 1996 Plan"). A total of 1,750 shares of common stock have been reserved for issuance under the 1996 Plan. In order to be ISOs, options must be granted at not less than 100% of the fair market value of the Company's stock on the dates of grant. Options generally vest over four years (grants made prior to 1998) or five years (1998 grants) and expire in ten years. F-13 60 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (continued) (In thousands, except per share data) In April 1996, the Board of Directors authorized the 1996 Employee Stock Purchase Plan ("the 1996 Purchase Plan"). A total of 200 shares of common stock have been reserved for issuance under the 1996 Purchase Plan. A total of 100 shares of common stock have been issued under the 1996 Purchase Plan at a prices ranging from $8.18 per share to $18.38 per share. The 1996 Purchase Plan permits eligible employees to purchase common stock through payroll deductions, subject to certain limitations. The price at which stock may be purchased under the 1996 Purchase Plan is equal to 85% of the fair market value of the common stock on the lower of the first day of each 24 month offering period or the last day of each subsequent purchase period. In June 1996, the Company adopted the 1996 Director Stock Option Plan (the "Director Plan") and reserved a total of 250 shares of common stock for issuance thereunder. Commencing with the Company's 1997 annual meeting of stockholders, each nonemployee director was to be granted a nonstatutory option to purchase an amount of shares of the Company's common stock equal to 5 shares multiplied by a fraction, the numerator of which shall be $15.00 and the denominator of which shall be the fair market value of one share of the Company's common stock on the dates of grant. The exercise price of options granted under the Director Plan are equal to the fair market value of one share of the Company's common stock on the dates of grant. A total of 60 shares were issued under the Plan at $10.125 - $26.37 per share. Effective November 1998, the Director Plan was modified such that options are granted on a discretionary basis at fair value on the date of grant. 99 shares were issued under this version of the Plan in 1998, bringing the total shares issued under the prior and current version of the Director Plan to 159. Each option granted under the Director Plan vests on a cumulative monthly basis over a one-year period and has a 10-year term. The Director Plan will terminate in June 2001, unless terminated earlier. In September 1998, the Company's Directors approved the repurchase of up to 750 shares of the Company's common stock. A total of 40 shares were repurchased under this authorization in 1998. On March 9, 1998, the Company's Board of Directors approved the establishment of a rights plan. Pursuant to this plan, the Board of Directors declared a dividend distribution of one Preferred Shares Purchase Right on each outstanding share of the Company's Common Stock for shareholders of record on May 8, 1998. Each right entitled stockholders to buy 1/1000th of a share of the Company's Series A Participating Preferred Stick at an exercise price of eighty-five dollars ($85.00). The Rights become exercisable following the tenth day after a person or group announces an acquisition of 20% or more of the Company's Common Stock or announces commencement of a tender offer the consummation of which would result in ownership by the person or group of 20% or more of the Common Stock. The Company is entitled to redeem the Rights at $0.01 per Right at any time on or before the tenth day following acquisition by a person or group of 20% or more of the Company's Common Stock. If, prior to redemption of the Rights, a person or group acquires 20% or more of the Company's Common Stock, each Right not owned by a holder of 20% or more of the Common Stock will entitle its holder to purchase, at the Right's then current exercise price, that number of shares of Common Stock of the Company (or, in certain circumstances as determined by the Board of Directors, cash, other property or other securities) having a market value at that time of twice the Right's exercise price. If, after the tenth day following acquisition by a person or group of 20% or more of the Company's Common Stock, the Company sells more than 50% of its assets or earning power or is acquired in a merger or other business combination transaction, the acquiring person must assume the obligation under the Rights and the Right will become exercisable to acquire Common Stock of the acquiring person at the discounted price. At any time after an event triggering exercisability of the Rights at a discounted price and prior to the acquisition by the acquiring person of 50% or more of the outstanding Common Stock, the Board of Directors of the Company may exchange the Rights (other than those owned by the acquiring person or its affiliates) for Common Stock of the Company at an exchange ratio of one share of Common Stock per Right. F-14 61 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (continued) (In thousands, except per share data) Pro forma information regarding net income and earnings per share is required by SFAS No. 123, and such information has been determined as if the Company had accounted for its employee stock option and employee stock purchase plan under the fair value method of that statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions for 1998, 1997 and 1996: risk-free interest rate of 6.0% and 6.28% divided yield of 0$. volatility factor of the expected market price of the Company's common stock of .619 an .726 and .755, and an expected life of the options of 5 years. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its stock options. F-15 62 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (continued) (In thousands, except per share data) For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the related vesting period. The Company's pro forma information follows:
YEAR ENDED DECEMBER 31 ---------------------------------------- 1998 1997 1996 ---------------------------------------- As reported $ 1,630 $ (372) $(11,281) Pro forma compensation expense (3,640) (2,188) (411) ---------------------------------------- Pro forma net income (loss) (2,010) $(2,560) $(11,692) ======================================== Pro forma net income (loss) per share $ (0.14) $ (0.20) $ (1.26) ========================================
Pro forma compensation expense presented may not be representative of future pro forma expense, when amortization of multiple years of awards may be reflected. A summary of the Company's stock option activity, and related information is as follows:
OUTSTANDING STOCK OPTIONS -------------------------------- WEIGHTED AVERAGE NUMBER OF EXERCISE OPTIONS PRICE PER SHARE -------------------------------- Balance at January 1, 1996 650 $ 0.95 Granted 271 9.65 Exercised (183) 0.89 Canceled (23) 0.84 --------------------------- Balance at December 31, 1996 715 3.89 Granted 1,436 11.89 Exercised (224) 1.71 Canceled (300) 5.92 --------------------------- Balance at December 31, 1997 1,627 10.88 Granted 540 19.68 Exercised (121) 7.52 Canceled (126) 11.76 --------------------------- Balance at December 31, 1998 1,920 $ 13.52 ===========================
F-16 63 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (continued) (In thousands, except per share data) The weighted average fair values of stock options granted during 1998, 1997, and 1996, for which the exercise price was equal to the fair market value of the stock were $10.12, $7.55, and $7.42 per share, respectively. The weighted average fair value of stock options granted during 1996 for which the exercise price exceeded the fair market value of the stock was $0.89 per share.
STOCK OPTIONS AT DECEMBER 31, 1998 ------------------------------------------------------------- OPTIONS OUTSTANDING OPTIONS EXERCISABLE ------------------------------------------------------------- WEIGHTED WEIGHTED AVERAGE AVERAGE REMAINING WEIGHTED NUMBER OF EXERCISE CONTRACTUAL AVERAGE RANGE OF EXERCISE OPTIONS PRICE LIFE NUMBER EXERCISE PRICES OUTSTANDING OUTSTANDING (YEARS) EXERCISABLE PRICE ---------------------------------------------------------------------------------- $0.60 - $1.62 127 $ .92 6.0 108 $ .93 $10.00 - $10.15 269 $10.02 8.1 126 $10.04 $12.25 - $14.63 904 $12.43 8.3 107 $12.45 $15.00 - $17.00 343 $16.32 9.0 100 $16.09 $20.13 - $27.38 277 $21.81 9.4 64 $26.97 --------------------------------------------------------- Totals 1,920 $13.52 8.1 505 $11.96 =========================================================
9. INCOME TAXES The Company's deferred tax assets consist of the following:
DECEMBER 31, -------------------- 1998 1997 -------------------- Non-current: In-process R&D write-off $ 1,154 $ -- Net operating loss carryforwards 525 5,206 Capitalized research and development 3,506 2,755 General business credit carryforwards 1,247 968 Depreciation expense 968 360 Other 211 - Current: AMT credit carryforward 145 - Miscellaneous 1,021 1,002 -------------------- Total deferred tax assets 8,777 10,291 Valuation reserve (8,632) (10,291) -------------------- Net deferred tax assets $ 145 $ -- ====================
The valuation allowance for deferred tax assets decreased by $1,659 and increased by $574 in the years ended December 31, 1998 and 1997, respectively to fully offset all deferred tax assets except those pertaining to AMT credit carryforwards for which management believes it is more likely than not that such benefits will be utilized. The 1998 deferred tax benefit of $145 exactly offset the 1998 current expense of $145, and thus no 1998 tax provision is reflected in the accompanying consolidated statement of operations. F-17 64 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (continued) (In thousands, except per share data) Temporary differences between the net operating losses for financial reporting and income tax purposes primarily relate to the deferral of research and development expenses for tax purposes. At December 31, 1998, the Company has net operating loss carryforwards for federal and state income tax purposes of approximately $1,466 and $444, respectively. These federal and state carryforwards will begin to expire in 1999 if not previously utilized. The Company also has research and development tax credit carryforwards of approximately $1,200 which will begin to expire in 2005, if not previously utilized. Utilization of the Company's net operating loss carryforwards will be subject to limitations due to the "change in ownership" provisions of the Internal Revenue Code of 1996, as amended, as a result of the Company's prior issuances of equity securities. These carryforwards, therefore, may expire prior to being fully utilized. Future financings may cause additional changes in ownership and further limitations on the use of federal net operating loss carryforwards. In addition, the Company has certain foreign net operating loss carryforwards approximating $3,800 which begin to expire in 2001. 10. COMMITMENTS AND CONTINGENCIES The Company conducts its corporate operations from leased facilities. In addition to monthly rental payments, the Company is responsible for certain monthly operating and maintenance expenses of such facilities. The lease expires in 2001. The future minimum rental payments under this and other operating lease arrangements at December 31, 1998 are as follows: 1999 $ 995 2000 639 2001 410 2002 255 2003 20 ------ $2,319 ======
Rent expense totaled $548, $580 and $448 for the years ended December 31, 1998, 1997 and 1996, respectively. In July 1997, the U.S. District Court in San Jose, California awarded a judgment of approximately $850 to a competitor based on alleged patent infringement by a subsidiary of the Company. This amount was fully expensed by the second quarter of 1997. The matter was appealed by the Company, with such appeals denied in April 1998. Accordingly, a total of $881 (including interest) was paid by the Company in May 1998 to extinguish this judgment. F-18 65 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (continued) (In thousands, except per share data) DAKO initiated binding arbitration with the Company in 1997 regarding the pricing of the Company's TechMate 250 product. The dispute was settled in 1998 with the Company agreeing to pay DAKO a total of $1,651 beginning January 2000 (see Note 7). Four former BioTek noteholders have filed an action against the Company and certain of its directors and stockholders alleging the Company violated federal and California securities law and engaged in common law fraud in connection with the BioTek acquisition and conversion of BioTek notes. The Company filed a motion to dismiss this action, which was granted in part in September 1998. The Company is also involved in various other actions arising in the normal course of business. Management, in conjunction with outside counsel, periodically reviews such matters and makes any accruals deemed necessary. Management is of the opinion that the disposition of all claims outstanding will not have a material effect on the Company's financial position, cash flows or results of operations. 11. OPERATING SEGMENT AND ENTERPRISE DATA The Company has three reportable segments: North America (primarily the United States), Europe (primarily France and Germany) and Japan (formed in 1998). These operating segments are the segments of the Company for which separate financial information is available and for which operating profit/loss amounts are regularly evaluated by the Company's Chief Operating Decision Maker (its Board of Directors) in deciding how to allocate resources and in assessing performance. The Company's Chief Operating Decision Maker evaluates performance and allocates resources based on profit or loss from operations. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies. Inventory transfers to foreign subsidiaries are made at standard cost. The North America operations include corporate activity (including all interest income) that benefits the Company as a whole. The following summary includes both net sales to unaffiliated customers and transfers between geographic areas. Net sales are attributed to segments based on the location from which the shipment to the customer was made; reagents and instruments are sold in each segment. F-19 66 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (continued) (In thousands, except per share data)
YEAR ENDED DECEMBER 31, 1998 -------------------------------------------------------- NORTH ELIMINA- AMERICA EUROPE JAPAN TIONS TOTALS ------- ------- ------- ------ ------- Sales to external customers $41,469 $ 5,633 $ 602 $ -- $47,704 Non-recurring expenses 3,160 -- -- -- 3,160 Depreciation and amortization expense 2,565 263 22 -- 2,850 Segment profit (loss) 3,147 (821) (810) 114 1,630 Segment assets 74,724 7,220 1,037 (26,701) 56,280 Expenditures for long-lived assets 12,154 238 166 -- 12,558
YEAR ENDED DECEMBER 31, 1997 ---------------------------------------------- NORTH ELIMINA- AMERICA EUROPE TIONS TOTALS ---------------------------------------------- Sales to external customers $28,808 $ 3,345 $ -- $ 32,153 Non-recurring expenses 1,656 -- -- 1,656 Depreciation and amortization expense 1,934 95 -- 2,029 Segment profit (loss) 852 (876) (348) (372) Segment assets 52,831 3,842 (8,321) 48,352 Expenditures for long-lived assets 3,985 278 -- 4,263
YEAR ENDED DECEMBER 31, 1996 ------------------------------------------------- NORTH ELIMINA- AMERICA EUROPE TIONS TOTALS ------------------------------------------------- Sales to external customers $ 22,257 $ 1,872 $ -- $ 24,129 Non-recurring expenses 10,262 -- -- 10,262 Depreciation and amortization expense 932 120 -- 1,052 Segment profit (loss) (10,410) (871) -- (11,281) Segment assets 49,530 1,525 (18,645) 32,410 Expenditures for long-lived assets 9,635 135 -- 9,770
F-20 67 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (continued) (In thousands, except per share data) 12. BIOTEK ACQUISITION The Company acquired BioTek for $19,100 on February 26, 1996. The acquisition has been accounted for as a purchase. The results of BioTek are included in the accompanying consolidated financial statements from the date of acquisition. The purchase price for BioTek consisted of:
Cash consideration 2,500 Stock issued to BioTek noteholders 3,016 Exchange Notes issued 8,968 Note payable - escrow for contingencies 234 Net historical liabilities assumed 4,389 ------- $19,107 =======
The purchase price was allocated as follows: Tangible net assets $ 2,252 In-process research and development 7,900 Goodwill and other intangibles 2,055 Developed technology 2,800 Customer base 4,100 ------- Total purchase price $19,107 =======
The Company charged to expense at the date of the acquisition $7,900 relating to the portion of the purchase price allocated to those in-process research and development projects where technological feasibility had not yet been established and where there are no alternative future uses. This amount is included as a component of non-recurring expenses in the accompanying consolidated statements of operations. The remaining non-recurring expenses of $2,400 consist of integration and other indirect acquisition costs. Unaudited pro forma results of operations for the year ended December 31, 1996, assuming consummation of the purchase as of January 1, 1996 and as adjusted to reflect the sale of common stock by the Company and the application of the net proceeds therefrom, are as follows:
YEAR ENDED DECEMBER 31, 1996 ------------ Net sales $25,211 Net loss $(2,353) Net loss per share $ (0.22)
F-21 68 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (continued) (In thousands, except per share data) 13. ACQUISITION OF BTTI The Company acquired BTTI on October 14, 1998 for $6,457. The acquisition has been accounted for as a purchase. The results of operations of BTTI are included in the accompanying consolidated financial statements from the date of acquisition. BTTI manufactures and markets a wide range of microtome products, tissue processors, cryogenic hardware and peripheral equipment, primarily for research and educational institutions in the United States, Europe and Japan. The purchase price for BTTI consisted of: Cash consideration $3,800 Cash to BTTI shareholders, infused into BTTI 1,457 Escrow for contingencies 1,200 ------ $6,457 ======
The purchase price for BTTI was allocated as follows: Tangible net assets $ 391 Goodwill 5,566 ------ $5,957 ======
The Company has recorded $700 of the possible $1,200 in contingent consideration at December 31, 1998, as that represents management's best estimate of the amount which will ultimately be paid in 1999. Should any or all of the additional $500 be paid in 1999, it will be classified as additional goodwill. Goodwill recorded in connection with this transaction is being amortized on a straight-line basis over a 15-year period. Unaudited pro forma results of operations for the years ended December 31, 1998 and 1997, assuming consummation of the purchase by January 1, 1997, are as follows
1998 1997 --------------------- Net sales $51,628 $37,379 Net income (loss) $ 859 $(1,068) Net income (loss) per share $ .06 $ (.08)
F-22 69 Ventana Medical Systems, Inc. Notes to Consolidated Financial Statements (continued) (In thousands, except per share data) 14. ACQUISITION OF CERTAIN TECHNOLOGY AND ASSETS FROM ONCOR, INC. The Company acquired certain oncology diagnostic technology and assets from Oncor, Inc. on November 23, 1998 for $5,500, $5,000 of which was paid in cash. The Company plans to incorporate certain aspects of the acquired technology in future products. The Company charged to expense at the date of the acquisition $2,900 relating to the portion of the purchase price allocated to those in-process research and development projects where technological feasibility had not yet been established and where there are no alternative future uses. This amount is included as non-recurring expense in the accompanying consolidated statements of operations. The purchase price for the technology was allocated as follows: Tangible net assets $ 685 In-process research and development expense 2,900 Goodwill 315 Supply agreement 1,200 Workforce in place 100 ------ $5,200 ======
The Company is amortizing goodwill on a straight-line basis over 15 years The value assigned to an existing supply agreement assumed by the Company is being amortized on a straight-line basis over the life of the patent underlying the key technology involved in the supply agreement. The workforce in place costs are being amortized on a straight-line basis over 5 years. The Company has not recorded $300 of the $5,500 purchase price as of December 31, 1998, as management does not believe such amount will ultimately be paid. Should such amounts require payment in 1999, they will be classified as additional goodwill. F-23 EX-10.4.(D) 2 SERVICES EXTENSION AGREEMENT WITH JACK W. SCHULER 1 EXHIBIT 10.4(d) [VENTANA MEDICAL SYSTEMS, INC. LETTERHEAD] February 26, 1998 Mr. Jack W. Schuler C/O Crabtree Partners 1419 Lake Cook Road Suite 410 Deerfield, IL 60015 Dear Jack: This letter is to confirm the extension for an additional two years of the arrangement (the "Arrangement") under which you have agreed to devote a significant portion of your professional working time to the business and affairs of Ventana Medical Systems, Inc., ("Ventana" or the "Company"). Under the extension of the Arrangement, you would receive a grant of a nonstatutory option to purchase 150,000 shares of Common Stock of the Company at an exercise price of $12.625 per share, the fair market value of the Company's Common Stock on the date that the extension of the Arrangement, as well as the grant of these additional options, was approved by the Company's Board of Directors. These options would vest on a cumulative monthly basis over 24 months commencing February 26, 1998; provided that during such 24 month vesting period you devote, on a cumulative average basis, at least 50% of your professional working time to matters related to the Company. Please acknowledge your agreement with the foregoing by signing the enclosed counterpart of this letter. Very truly yours, /s/ HANK PIETRASZEK - ------------------- Hank Pietraszek President & CFO Acknowledged and agreed as of this 23rd day of April, 1998. /s/ JACK W. SCHULER ------------------------- Jack W. Schuler EX-10.5.(C) 3 SERVICES EXTENTION AGREEMENT WITH JOHN PATIENCE 1 EXHIBIT 10.5(c) [VENTANA MEDICAL SYSTEMS, INC. LETTERHEAD] February 26, 1998 Mr. John Patience C/O Crabtree Partners 1419 Lake Cook Road Suite 410 Deerfield, IL 60015 Dear John: This letter is to confirm the extension for an additional two years of the arrangement (the "Arrangement") under which you have agreed to devote a significant portion of your professional working time to the business and affairs of Ventana Medical Systems, Inc., ("Ventana" or the "Company"). Under the extension of the Arrangement, you would receive a grant of a nonstatutory option to purchase 150,000 shares of Common Stock of the Company at an exercise price of $12.625 per share, the fair market value of the Company's Common Stock on the date that the extension of the Arrangement, as well as the grant of these additional options, was approved by the Company's Board of Directors. These options would vest on a cumulative monthly basis over 24 months commencing February 26, 1998; provided that during such 24 month vesting period you devote, on a cumulative average basis, at least 50% of your professional working time to matters related to the Company. Please acknowledge your agreement with the foregoing by signing the enclosed counterpart of this letter. Very truly yours, /s/ HANK PIETRASZEK - ------------------- Hank Pietraszek President & CFO Acknowledged and agreed as of this 26th day of February, 1998. /s/ JOHN PATIENCE ------------------------- John Patience EX-10.20.(A) 4 BANK OF AMERICA BUSINESS LOAN AGREEMENT 1 EXHIBIT 10.20(a) [BAND OF AMERICA LOGO] BUSINESS LOAN AGREEMENT - -------------------------------------------------------------------------------- This Agreement dated as of June 9, 1998 is between Bank of America National Trust and Savings Association (the "Bank") and Ventana Medical Systems, Inc. (the "Borrower"). 1. LINE OF CREDIT AMOUNT AND TERMS 1.1 LINE OF CREDIT AMOUNT. (a) During the availability period described below, the Bank will provide a line of credit to the Borrower. The amount of the line of credit (the "Commitment") is Five Million and No/100 Dollars ($5,000,000.00). (b) This is a revolving line of credit with a within line facility for letters of credit. During the availability period, the Borrower may repay principal amounts and reborrow them. (c) The Borrower agrees not to permit the outstanding principal balance of the line of credit plus the outstanding amounts of any letters of credit, including amounts drawn on letters of credit and not yet reimbursed, to exceed the Commitment. 1.2 AVAILABILITY PERIOD. The line of credit is available between the date of this Agreement and May 31, 1999 (the "Expiration Date") unless the Borrower is in default. 1.3 INTEREST RATE. (a) Unless the Borrower elects an Optional interest rate as described below, the interest rate is the Reference Rate. (b) The Reference Rate is the rate of interest publicly announced from time to time by the Bank in San Francisco, California, as its Reference Rate. The Reference Rate is set by the Bank based on various factors, including the Bank's costs and desired return, general economic conditions and other factors, and is used as a reference point for pricing some loans. The Bank may price loans to its customers at, above or below the Reference Rate. Any change in the Reference Rate shall take effect at the opening of business on the day specified in the public announcement of a change in the Bank's Reference Rate. 1.4 REPAYMENT TERMS. (a) The Borrower will pay interest on June 1, 1998 and on the first day of each month thereafter until payment in full of any principal outstanding under this line of credit. (b) The Borrower will repay in full all principal and any unpaid interest or other charges outstanding under this line of credit no later than the Expiration Date. (c) The Borrower may prepay the loan in full or in part at any time. The prepayment will be applied to the most remote installment of principal due under this Agreement. 1.5 OPTIONAL INTEREST RATES. Instead of the interest rate based on the Reference Rate, the Borrower may elect to have all portions of the line of credit (during the availability period) bear interest at the rate(s) described below during an interest period agreed to by the Bank and the Borrower. Each interest rate is a rate per year. Interest will be paid on the last day of each interest period, and on the first day of each month during the interest period. At the end of any interest period, the interest rate will revert to the rate based on the Reference Rate, unless the Borrower has designated another optional interest rate for the portion. 1 2 1.6 FIXED RATE. The Borrower may elect to have all or portions of the principal balance of the line of credit bear interest at the Fixed Rate, subject to the following requirements: (a) The "Fixed Rate" means the fixed interest rate the Bank and the Borrower agree will apply to the portion during the applicable interest period. (b) The interest period during which the Fixed Rate will be in effect will be no shorter than 14 days and no longer than one year. (c) Each Fixed Rate portion will be for an amount not less than Five Hundred Thousand Dollars ($500,000). 1.7 LIBOR RATE. The Borrower may elect to have all or portions of the principal balance of the line of credit bear interest at the LIBOR Rate plus 1.75 percentage points. Designation of a LIBOR Rate portion is subject to the following requirements: (a) The interest period during which the LIBOR Rate will be in effect will be one, two, three, four, five, six, seven, eight, nine, ten, eleven, or twelve months. The last day of the interest period and the actual number of days during the interest period will be determined by the Bank using the practices of the London inter-bank market. (b) Each LIBOR Rate portion will be for an amount not less than Five Hundred Thousand Dollars ($500,000). (c) THE "LIBOR Rate" means the interest rate determined by the following formula, rounded upward to the nearest 1/100 of one percent. (All amounts in the calculation will be determined by the Bank as of the first day of the interest period.) LIBOR = London Inter-Bank Offered Rate ------------------------------ (1.00 - Reserve Percentage) Where, (i) "London Inter-Bank Offered Rate" means the interest rate at which the Bank's London Branch, London, Great Britain, would offer U.S. dollar deposits for the applicable interest period to other major banks in the London inter-bank market at approximately 11:00 a.m. London time two (2) London Banking Days before the commencement of the interest period. A "London Banking Day" is a day on which the Bank's London Branch is open for business and dealing in offshore dollars. (ii) "Reserve Percentage" means the total of the maximum reserve percentages for determining the reserves to be maintained by member banks of the Federal Reserve System for Eurocurrency Liabilities, as defined in the Federal Reserve Board Regulation D, rounded upward to the nearest 1/100 of one percent. The percentage will be expressed as a decimal, and will include, but not be limited to, marginal, emergency, supplemental, special, and other reserve percentages. (d) The Borrower shall irrevocably request a LIBOR Rate portion no later than 9:00 a.m. Phoenix time three (3) banking days before the commencement of the interest period. (e) The Borrower may not elect a LIBOR Rate with respect to any portion of the principal balance of the line of credit which is scheduled to be repaid before the last day of the applicable interest period. (f) Any portion of the principal balance of the line of credit already bearing interest at the LIBOR Rate will not be converted to a different rate during its interest period. (g) Each prepayment of a LIBOR Rate portion, whether voluntary, by reason of acceleration or otherwise, will be accompanied by the amount of accrued interest on the amount prepaid and a prepayment fee as described below. A "prepayment", for the purposes of this paragraph, is a payment of an amount on a date earlier than the scheduled payment date for such amount as required by this Agreement. The prepayment fee shall be equal to the amount (if any) by which: 3 (i) the additional interest which would have been payable during the interest period on the amount prepaid had it not been prepaid, exceeds (ii) the interest which would have been recoverable by the Bank by placing the amount prepaid on deposit in the domestic certificate of deposit market, the eurodollar deposit market, or other appropriate money market selected by the Bank, for a period starting on the date on which it was prepaid and ending on the last day of the interest period for such portion (or the scheduled payment date for the amount prepaid, if earlier). (h) The Bank will have no obligation to accept an election for a LIBOR Rate portion if any of the following described events has occurred and is continuing: (i) Dollar deposits in the principal amount, and for periods equal to the interest period, of a LIBOR Rate portion are not available in the London inter-bank market; or (ii) the LIBOR Rate does not accurately reflect the cost of a LIBOR Rate portion. 1.8 OFFSHORE RATE. The Borrower may elect to have all or portions of the principal balance of the line of credit bear interest at the Offshore Rate, subject to the following requirements: (a) The "Offshore Rate" means the interest rate the Bank and the Borrower agree will apply to the portion during the applicable interest period. (b) The interest period during which the Offshore Rate will be in effect will be no shorter than 30 days and no longer than one year. The last day of the interest period will be determined by the Bank using the practices of the offshore dollar inter-bank market. (c) Each Offshore Rate portion will be for an amount not less than Five Hundred Thousand Dollars ($500,000). (d) The Borrower may not elect an Offshore Rate with respect to any portion of the principal balance of the line of credit which is scheduled to be repaid before the last day of the applicable interest period. (e) Any portion of the principal balance of the line of credit already bearing interest at the Offshore Rate will not be converted to a different rate during its interest period. (f) Each prepayment of an Offshore Rate portion, whether voluntary, by reason of acceleration or otherwise, will be accompanied by the amount of accrued interest on the amount prepaid, and a prepayment fee equal to the amount (if any) by which; (i) the additional interest which would have been payable on the amount prepaid had it not been paid until the last day of the interest period, exceeds (ii) the interest which would have been recoverable by the Bank by placing the amount prepaid on deposit in the offshore dollar market for a period starting on the date on which it was prepaid and ending on the last day of the interest period for such portion. (g) The Bank will have no obligation to accept an election for an Offshore Rate portion if any of the following described events has occurred and is continuing: (i) Dollar deposits in the principal amount, and for periods equal to the interest period, of an Offshore Rate portion are not available in the offshore Dollar inter-bank markets; or (ii) The Offshore Rate does not accurately reflect the cost of an Offshore Rate portion. 3 4 1.9 LETTERS OF CREDIT. This line of credit may be used for financing: (a) Standby letters of credit with a maximum maturity of 365 days, (b) The amount of letters of credit outstanding at any one time (including amounts drawn on letters of credit and not yet reimbursed) may not exceed Two Million and No/100 Dollars ($2,000,000.00) for standby letters of credit. THE BORROWER AGREES: (a) Any sum drawn under a letter of credit may, at the option of the Bank, be added to the principal amount outstanding under this Agreement. The amount will bear interest and be due as described elsewhere in this Agreement. (b) If there is a default under this Agreement, to immediately prepay and make the Bank whole for any outstanding letters of credit. (c) The issuance of any letter of credit and any amendment to a letter of credit is subject to the Bank's written approval and must be in form and content satisfactory to the Bank and in favor of a beneficiary acceptable to the Bank. (d) To sign the Bank's form Application and Agreement for Commercial Letter of Credit or Application and Agreement for Standby Letter of Credit. (e) To pay any issuance and/or other fees that the Bank notifies the Borrower will be charged for issuing and processing letters of credit for the Borrower. (f) To allow the Bank to automatically charge its checking account for applicable fees, discounts, and other changes. 2. FEES AND EXPENSES 2.1 FEES. (a) Unused Commitment Fee. The Borrower agrees to pay a fee on any difference between the Commitment and the amount of credit it actually uses, determined by the weighted average loan balance maintained during the specified period. The fee will be calculated at 1/4% per year. This fee is due on July 1, 1998 and on the 1st day of each following quarter, until the expiration of the availability period. 2.2 EXPENSES. The Borrower agrees to immediately repay the Bank for expenses that include, but are not limited to, filing, recording and search fees, appraisal fees, title report fees, and documentation fees. 2.3 REIMBURSEMENT COSTS. (a) The Borrower agrees to reimburse the Bank for any expenses it incurs in the preparation of this Agreement and any agreement or instrument required by this Agreement. Expenses include, but are not limited to, reasonable attorneys' fees, including any allocated costs of the Bank's in-house counsel. (b) The Borrower agrees to reimburse the Bank for the cost of periodic audits and appraisals of the personal property collateral securing this Agreement, at such intervals as the Bank may reasonably require. The audits and appraisals may be performed by employees of 3. COLLATERAL 3.1 PERSONAL PROPERTY. The Borrower's obligations to the Bank under this Agreement will be secured by personal property the Borrower now owns or will own in the future as listed below. The collateral is further defined in security agreement(s) executed by the Borrower. 4 5 In addition, all personal property collateral securing this Agreement shall also secure all other present and future obligations of the Borrower to the Bank (excluding any consumer credit covered by the federal Truth in Lending law, unless the Borrower has otherwise agreed in writing). All personal collateral securing any other present or future obligations of the Borrower to the Bank shall also secure this Agreement. (a) Machinery and equipment. (b) Inventory. (c) Receivables. (d) Patents, trademarks and other general intangibles. 4. DISBURSEMENTS, PAYMENTS AND COSTS 4.1 REQUESTS FOR CREDIT. Each request for an extension of credit will be made in writing in a manner acceptable to the Bank, or by another means acceptable to the Bank. 4.2 DISBURSEMENTS AND PAYMENTS. Each disbursement by the Bank and each payment by the Borrower will be: (a) made at the Bank's branch (or other location) elected by the Bank from time to time; (b) made for the account of the Bank's branch selected by the Bank from time to time; (c) made in immediately available funds, or such other type of funds selected by the Bank; (d) evidenced by records kept by the Bank. In addition, the Bank may, at its discretion, require the Borrower to sign one or more promissory notes. 4.3 TELEPHONE AND TELEFAX AUTHORIZATION (a) The Bank may honor telephone or telefax instructions for advances or repayments or for the designation of optional interest rates or the issuance of letters of credit given by any one of the individual signer(s) of this Agreement or a person or persons authorized in writing by any one of the signer(s) of this Agreement. (b) Advances will be deposited in, and repayments will be withdrawn from, the Borrower's account number 252352864, or such other of the Borrower's accounts with the Bank as designated in writing by the Borrower. (c) The Borrower indemnifies and excuses the Bank (including its officers, employees, and agents) from all liability, loss, and costs in connection with any act resulting from telephone or telefax instructions it reasonably believes are made by any individual authorized by the Borrower to give such instructions. This indemnity and excuse will survive this Agreement's termination. 4.4 DIRECT DEBIT (PRE-BILLING) (a) The Borrower agrees that the Bank will debit the Borrower's account number 252352864, or such other of the Borrower's account with the Bank as designated in writing by the Borrower (the "Designated Account") on the date each payment of interest and any fees from the Borrower becomes due (the "Due Date"). If the Due Date is not a banking day, the Designated Account will be debited on the next banking day. (b) Approximately 10 days prior to each Due Date, the Bank will mail to the Borrower a statement of the amounts that will be due on that Due Date (the "Billed Amount"). The calculation will be made on the assumption that no new extensions of credit or payments will be made between the date of the billing statement and the Due Date, and that there will be no changes in the applicable interest rate. (c) The Bank will debit the Designated Account for the Billed Amount, regardless of the actual amount due on that date (the "Accrued Amount"). If the Billed Amount debited to the Designated Account differs from the Accrued 5 6 Amount, the discrepancy will be treated as follows: (i) If the Billed Amount is less than the Accrued Amount, the Billed Amount for the following Due Date will be increased by the amount of the discrepancy. The Borrower will not be in default by reason of any such discrepancy. (ii) If the Billed Amount is more than the Accrued Amount, the Billed Amount for the following Due Date will be decreased by the amount of the discrepancy. Regardless of any such discrepancy, interest will continue to accrue based on the actual amount of principal outstanding without compounding. The Bank will not pay the Borrower interest on any overpayment. (d) The Borrower will maintain sufficient funds in the Designated Account to cover each debit. If there are insufficient funds in the Designated Account on the date the Bank enters any debit authorized by this Agreement, the debit will be reversed. (e) The Borrower may terminate this direct debit arrangement at any time by sending written notice to the Bank at the address specified at the end of this Agreement. 4.5 BANKING DAYS. Unless otherwise provided in this Agreement, a banking day is a day other than a Saturday or a Sunday on which the Bank is open for business in Arizona. For amounts bearing interest at an offshore rate (if any), a banking day is a day other than a Saturday or a Sunday on which the Bank is open for business in California and is dealing in offshore dollars. All payments and disbursements which would be due on a day which is not a banking day will be due on the next banking day. All payments received on a day which is not a banking day will be applied to the credit on the next banking day. 4.6 TAXES. The Borrower will not deduct any taxes from any payments it makes to the Bank. If any government authority imposes any taxes on any payments made by the Borrower, the Borrower will pay the taxes and will also pay to the Bank, at the time interest is paid, any additional amount which the Bank specifies as necessary to preserve the after-tax yield the Bank would have received if such taxes had not been imposed. Upon request by the Bank, the Borrower will confirm that it has paid the taxes by giving the Bank official tax receipts (or notarized copies) within 30 days after the due date. However, the Borrower will not pay the Bank's net income taxes. 4.7 ADDITIONAL COSTS. The Borrower will pay the Bank, on demand, for the Bank's costs or losses arising from any statute or regulation, or any request or requirement of a regulatory agency. The costs and losses will be allocated to the loan in a manner determined by the Bank, using any reasonable method. The costs include the following: (a) Any reserve or deposit requirements; and (b) Any capital requirements relating to the Bank's assets and commitments for credit. 4.8 INTEREST CALCULATION. Except as otherwise stated in this Agreement, all interest and fees, if any, will be computed on the basis of a 360-day year and the actual number of days elapsed. This results in more interest or a higher fee than if a 365-day year is used. 4.9 INTEREST ON LATE PAYMENTS. At the Bank's sole option in each instance, any amount not paid when due under this Agreement (including interest) shall bear interest from the due date at the Reference Rate plus 2.00 percentage points. This may result in compounding of interest. 4.10 DEFAULT RATE. Upon the occurrence and during the continuation of any default under this Agreement, advances under this Agreement will at the option of the Bank bear interest at a rate per annum which is 3.00 percentage point(s) higher than the rate of interest otherwise provided under this Agreement. This will not constitute a waiver of any default. 5. CONDITIONS. The Bank must receive the following items, in form and content acceptable to the Bank, before it is required to extend any credit to the Borrower under this Agreement: 6 7 5.1 AUTHORIZATIONS. Evidence that the execution, delivery and performance by the Borrower of this Agreement and any instrument or agreement required under this Agreement have been duly authorized. 5.2 GOVERNING DOCUMENTS. A copy of the Borrower's articles of incorporation. 5.3 SECURITY AGREEMENTS. Signed original security agreements, assignments, and financing statements (together with Collateral in which the bank requires a possessory security interest), which the Bank requires. 5.4 EVIDENCE OF PRIORITY. Evidence that security interests and liens in favor of the Bank are valid, enforceable, and prior to all others' rights and interests, except those the Bank consents to in writing. 5.5 INSURANCE. Evidence of insurance coverage, as required in the "Covenants" section of this Agreement. 5.6 ENVIRONMENTAL QUESTIONNAIRE. A completed Bank form Environmental Questionnaire and Disclosure Statement, together with an environmental site assessment concerning any potential toxic or hazardous condition. 5.7 OTHER ITEMS. Any other items that the Bank reasonably requires. 6. REPRESENTATIONS AND WARRANTIES. When the Borrower signs this Agreement, and until the Bank is repaid in full, the Borrower makes the following representations and warranties. Each request for an extension of credit constitutes a renewed representation. 6.1 ORGANIZATION OF BORROWER. The Borrower is a corporation duly formed and existing under the laws of the state where organized. 6.2 AUTHORIZATION. This Agreement, and any instrument or agreement required hereunder, are within the Borrower's powers, have been duly authorized, and do not conflict with any of its organizational papers. 6.3 ENFORCEABLE AGREEMENT. This Agreement, and each other agreement or document executed and delivered to the Bank in connection with this Agreement, is a legal, valid and binding agreement of the Borrower, enforceable against the Borrower in accordance with its terms, and any instrument or agreement required hereunder, when executed and delivered, will be similarly legal, valid, binding and enforceable. 6.4 GOOD STANDING. In each state in which the Borrower does business, it is properly licensed, in good standing, and, where required, in compliance with fictitious name statutes. 6.5 NO CONFLICTS. This Agrement does not conflict with any law, agreement, or obligation by which the Borrower is bound. 6.6 FINANCIAL INFORMATION. All financial and other information that has been, or will be, supplied to the Bank is: (a) Sufficiently complete to give the Bank accurate knowledge of the Borrower's financial condition. (b) In form and content required by the Bank. (c) In compliance with all government regulations that apply. 6.7 LAWSUITS. There is no lawsuit, tax claim or other dispute pending or threatened against the Borrower, which, if lost, would impair the Borrower's financial condition or ability to repay the loan, except as have been disclosed in writing to the Bank prior to the date of this Agreement. 6.8 COLLATERAL. All collateral required in this Agreement is owned by the grantor of the security interest free of any title defects or any liens or interests of others. 6.9 PERMITS, FRANCHISES. The Borrower possesses all permits, memberships, franchises, contracts and licenses 7 8 required and all trademark rights, trade name rights, patent rights and fictitious name rights necessary to enable it to conduct the business in which it is now engaged. 6.10 OTHER OBLIGATIONS. The Borrower is not in default on any obligation for borrowed money, any purchase money obligation or any other material lease, commitment, contract, instrument or obligation. 6.11 INCOME TAX RETURNS. The Borrower has no knowledge of any pending assessments or adjustments of its income tax for any year. 6.12 NO EVENT OF DEFAULT. There is no event which is, or with notice or lapse of time or both would be, a default under this Agreement. 6.13 LOCATION OF BORROWER. The Borrower's place of business (or, if the Borrower has more than one place of business, its chief executive office) is located at the address listed under the Borrower's signature on this Agreement. 6.14 REPRESENTATIONS CONCERNING THE YEAR 2000. The Borrower acknowledges that it has received a copy of the brochure prepared by the Bank entitled "On Turning 00" and that it has reviewed this material and is aware of the possible impact of the year 2000 problem (that is, the risk that computer applications may not be able to properly perform date-sensitive functions after December 31, 1999) upon its computer applications and ongoing business. The Borrower represents that any corrective action necessary will be taken and that the Borrower does not believe the year 2000 problem will result in a material adverse change in the Borrower's business condition (financial or otherwise), operations, properties or prospects, or ability to repay the credit. 7. COVENANTS The Borrower agrees, so long as credit is available under this Agreement and until the Bank is repaid in full: 7.1 USE OF PROCEEDS. To use the proceeds of the credit only for working capital needs. 7.2 FINANCIAL INFORMATION. To provide the following financial information and statements and such additional information as requested by the Bank from time to time: (a) Within 90 days of the Borrower's fiscal year end, the Borrower's annual financial statements. These financial statements must be audited (with an unqualified opinion) by a Certified Public Accountant ("CPA") acceptable to the Bank. The statements shall be prepared on a consolidated basis. (b) Within 45 days of quarter end, copies of the Borrower's Form 10-Q Quarterly Report. (c) By February 15th of each year, the Borrower's annual projections. (d) Within 45 days of each quarter end, the Borrower shall provide to the Bank copies of statements from depository institutions or brokerage firms, or other evidence acceptable to the Bank of the Borrower's liquid assets. (e) Within 90 days of Borrower's fiscal year end, the Borrower shall provide to the Bank a Compliance Certificate. (f) Within 45 days of quarter end, the Borrower shall provide to the Bank a Compliance Certificate. 7.3 QUICK RATIO. To maintain on a consolidated basis a ratio of quick assets to current liabilities of at least 3.00:1.0, measured quarterly. "Quick assets" means cash, short-term cash investments, net trade receivables and marketable securities not classified as long-term investments. 7.4 MINIMUM LIQUIDITY. To maintain at all times, a minimum of at least Five Million and No/100 Dollars ($5,000,000.00) in the form of Cash or Readily Marketable Securities, measured quarterly. 8 9 7.5 TANGIBLE NET WORTH. To maintain on a consolidated basis tangible net worth equal to at least Thirty One Million and No/100 Dollars ($31,000,000.00), measured quarterly. "Tangible net worth" means the gross book value of the borrower's assets (excluding goodwill, patents, trademarks, trade names, organization expense, treasury stock, unamortized debt discount and expense, deferred research and development costs, deferred marketing expenses, developed technology, customer lists and other like intangibles) less total liabilities, including but not limited to accrued and deferred income taxes, and any reserves against assets. 7.6 TOTAL LIABILITIES TO TANGIBLE NET WORTH RATIO. To maintain on a consolidated basis a ratio of Total Liabilities to Tangible Net Worth not exceeding 0.50:1.0, measured quarterly. "Total Liabilities" means the sum of current liabilities plus long term liabilities. 7.7 PROFITABILITY. The Borrower, on a consolidated basis, shall incur no single quarterly loss in excess of Five Hundred Thousand and No/100 Dollars ($500,000.00) and no two consecutive quarterly losses (excluding non-cash expenses associated with acquisitions and write-downs of in-process technology). The Borrower shall incur no fiscal year end loss in any amount (including non-cash expenses associated with acquisitions and write-downs of in-process technology). 7.8 OTHER DEBTS. Not to have outstanding or incur any direct or contingent debts (other than those to the Bank), or become liable for the debts of others without the Bank's written consent. This does not prohibit: (a) Acquiring goods, supplies, or merchandise on normal trade credit. (b) Endorsing negotiable instruments received in the usual course of business. (c) Obtaining surety bonds in the usual course of business. (d) Debts and lines of credit and leases in existence on the date of this Agreement disclosed in writing to the Bank. (e) Additional debts and lease obligations for business purposes which do not exceed a total principal amount of One Million and No/100 Dollars ($1,000,000.00) outstanding at any one time. 7.9 OTHER LIENS. Not to create, assume, or allow any security interest or lien (including judicial liens) on property the Borrower now or later owns, except: (a) Deeds of trust and security agreements in favor of the Bank. (b) Liens for taxes not yet due. (c) Liens outstanding on the date of this Agreement disclosed in writing to the Bank. (d) Additional purchase money security interests in personal or real property acquired after the date of this Agreement, if the total principal amount of debts secured by such liens does not exceed One Million and No/100 Dollars ($1,000,000.00) at any one time. 7.10 CAPITAL EXPENDITURES. Not to spend or incur obligations for more than Three Million and No/100 Dollars ($3,000,000.00) in any single fiscal year to acquire fixed or capital assets. 7.11 DIVIDENDS. Not to declare or pay any dividends on any of its shares except dividends payable in capital stock of the Borrower, and not to purchase, redeem or otherwise acquire for value any of its shares, or create any sinking fund in relation thereto. 7.12 OUT OF DEBT PERIOD. To repay any advances in full, and not to draw any additional advances on its revolving line of credit, for two periods of at least 30 consecutive days, one in each semi-annual period of the line-year. "Line-year" means the period between the date of this Agreement and May 31, 1999, and each subsequent one-year 9 10 period (if any). 7.13 NOTICES TO BANK. To promptly notify the Bank in writing of: (a) Any lawsuit over Five Hundred Thousand and No/100 Dollars ($500,000.00) against the Borrower. (b) Any substantial dispute between the Borrower and any government authority. (c) Any failure to comply with this Agreement. (d) Any material adverse change in the Borrower's financial condition or operations. (e) Any change in the Borrower's name, legal structure, place of business, or chief executive office if the Borrower has more than one place of business. 7.14 BOOKS AND RECORDS. To maintain adequate books and records. 7.15 AUDITS. To allow the Bank and its agents to inspect the Borrower's properties and examine, audit, and make copies of books and records at any reasonable time. If any of the Borrower's properties, books or records are in the possession of a third party, the Borrower authorizes that third party to permit the Bank or its agents to have access to perform inspections or audits and to respond to the Bank's requests for information concerning such properties, books and records. 7.16 COMPLIANCE WITH LAWS. To comply with the laws, (including any fictitious name statute), regulations, and orders of any government body with authority over the Borrower's business. 7.17 PRESERVATION OF RIGHTS. To maintain and preserve all rights, privileges, and franchises the Borrower now has. 7.18 MAINTENANCE OF PROPERTIES. To make any repairs, renewals, or replacements to keep the Borrower's properties in good working condition. 7.19 PERFECTION OF LIENS. To help the Bank perfect and protect its security interests and liens, and reimburse it for related costs it incurs to protect its security interests and liens. 7.20 COOPERATION. To take any action requested by the Bank to carry out the intent of this Agreement. 7.21 INSURANCE. (a) INSURANCE COVERING COLLATERAL. To maintain all risk property damage insurance policies covering the tangible property comprising the collateral. Each insurance policy must be in an amount acceptable to the Bank. The insurance must be issued by an insurance company acceptable to the Bank and must include a lender's loss payable endorsement in favor of the Bank in a form acceptable to the Bank. (b) GENERAL BUSINESS INSURANCE. To maintain insurance satisfactory to the Bank as to amount, nature and carrier covering property damage (including loss of use and occupancy) to any of the Borrower's properties, public liability insurance including coverage for contractual liability, product liability and workers' compensation, and any other insurance which is usual for the Borrower's business. (c) EVIDENCE OF INSURANCE. Upon the request of the Bank, to deliver to the Bank a copy of each insurance policy or, if permitted by the Bank, a certificate of insurance listing all insurance in force. 7.22 ADDITIONAL NEGATIVE COVENANTS. Not to, without the Bank's written consent: (a) Engage in any business activities substantially different from the Borrower's present business. (b) Liquidate or dissolve the Borrower's business. (c) Enter into any consolidation, merger, pool, joint venture, syndicate, or other combination and any requests for 10 11 Bank consent will include proforma financial statements demonstrating covenant compliance. Credit taker's stockholders shall own at least 60% of the outstanding voting securities of the surviving entity or its parent. (d) Lease, or dispose of all or a substantial part of the Borrower's business or the Borrower's assets. (e) Acquire or purchase a business or its assets, except for unfinanced acquisitions that do not exceed Five Million and No/100 Dollars ($5,000,000.00) in the aggregate in any calendar year, provided Borrower is in and will continue to be in compliance with all other terms and conditions of the Loan Agreement. (f) Sell or otherwise dispose of any assets for less than fair market value or enter into any sale and leaseback agreement covering any of its fixed or capital assets. (g) Voluntarily suspend its business. 7.23 ERISA PLANS. To give prompt written notice to the Bank of: (a) The occurrence of any reportable event under Section 4043(b) of ERISA for which the PBGC requires 30 day notice. (b) Any action by the Borrower to terminate or withdraw from a Plan or the filing of any notice of intent to terminate under Section 4041 of ERISA. (c) Any notice of noncompliance made with respect to a Plan under Section 4041(b) of ERISA. (d) The commencement of any proceeding with respect to a Plan under Section 4042 of ERISA. 8. HAZARDOUS WASTE. The Borrower will indemnify and hold harmless the Bank from any loss or liability directly or indirectly arising out of the use, generation, manufacture, production, storage, release, threatened release, discharge, disposal or presence of a hazardous substance. This indemnity will apply whether the hazardous substance is on, under or about the Borrower's property or operations or property leased to the Borrower. The indemnity includes but is not limited to attorneys' fees (including the reasonable estimate of the allocated cost of in-house counsel and staff). The indemnity extends to the Bank, its parent, subsidiaries and all of their directors, officers, employees, agents, successors, attorneys and assigns. For these purposes, the term "hazardous substances" means any substance which is or becomes designated as "hazardous" or "toxic" under any federal, state or local law. This indemnity will survive repayment of the Borrower's obligations to the Bank. 9. DEFAULT. If any of the following events occur, the Bank may do one or more of the following: declare the Borrower in default, stop making any additional credit available to the Borrower, and require the Borrower to repay its entire debt immediately and without prior notice. If an event of default occurs under the paragraph entitled "Bankruptcy" below with respect to the Borrower, the entire debt outstanding under this Agreement will automatically be due immediately. 9.1 FAILURE TO PAY. The Borrower fails to make a payment under this Agreement when due. 9.2 LIEN PRIORITY. The Bank fails to have an enforceable first lien (except for any prior liens to which the Bank has consented in writing) on or security interest in any property given as security for the extensions of credit under this Agreement. 9.3 FALSE INFORMATION. The Borrower has given the Bank false or misleading information or representations. 9.4 BANKRUPTCY. The Borrower files a bankruptcy petition, a bankruptcy petition is filed against the Borrower, or the Borrower makes a general assignment for the benefit of creditors. 9.5 RECEIVERS. A receiver or similar official is appointed for the Borrower's business, or the business is terminated. 11 12 9.6 JUDGMENTS. Any judgments or arbitration awards are entered against the Borrower, or the Borrower enters into any settlement agreements with respect to any litigation or arbitration, in an aggregate amount of One Million and No/100 Dollars ($1,000,000.00) or more in excess of any insurance coverage. 9.7 GOVERNMENT ACTION. Any government authority takes action that the Bank believes materially adversely affects the Borrower's financial condition or ability to repay. 9.8 MATERIAL ADVERSE CHANGE. A material adverse change occurs in the Borrower's financial condition, properties or prospects, or ability to repay the extensions of credit under this Agreement. 9.9 CROSS-DEFAULT. Any default occurs under any agreement in connection with any credit the Borrower has obtain from anyone else or which the Borrower has guaranteed. 9.10 DEFAULT UNDER RELATED DOCUMENTS. Any guaranty, subordination agreement, security agreement, deed of trust, or other document required by this Agreement is violated or no longer in effect. 9.11 OTHER BANK AGREEMENTS. The Borrower fails to meet the conditions of, or fails to perform any obligation under any other agreement the Borrower has with the Bank or any affiliate of the Bank. 9.12 ERISA PLANS. The occurrences of any one or more of the following events with respect to the Borrower, provided such event or events could reasonably be expected, in the judgment of the Bank, to subject the Borrower to any tax, penalty or liability (or any combination of the foregoing) which, in the aggregate, could have a material adverse effect on the financial condition of the Borrower with respect to a Plan: (a) A reportable event shall occur with respect to a Plan which is, in the reasonable judgment of the Bank, likely to result in the termination of such Plan for purposes of Title IV of ERISA. (b) Any Plan termination (or commencement of proceedings to terminate a Plan) or the Borrower's full or partial withdrawal from a Plan. 9.13 OTHER BREACH UNDER AGREEMENT. The Borrower fails to meet the conditions of, or fails to perform any obligation under, any term of this Agreement not specifically referred to in this Article. If, in the Bank's opinion, the breach is capable of being remedied, then the breach will not be considered an event of default under this Agreement for a period of ten (10) days after the date on which the Bank gives written notice of the breach to the Borrower; provided, however, that the Bank will not be obligated to extend any additional credit to the Borrower during that period. 10. ENFORCING THIS AGREEMENT; MISCELLANEOUS 10.1 GAAP. Except as otherwise stated in this Agreement, all financial information provided to the Bank and all financial covenants will be made under generally accepted accounting principles, consistently applied. 10.2 ARIZONA LAW. This Agreement is governed by Arizona law. 10.3 SUCCESSORS AND ASSIGNEES. This Agreement is binding on the Borrower's and the Bank's successors and assignees. The Borrower agrees that it may not assign this Agreement without the Bank's prior consent. The Bank may sell participations in or assign this loan, and may exchange financial information about the Borrower with actual or potential participants or assignees. If a participation is sold or the loan is assigned, the purchaser will have the right of set-off against the Borrower. 10.4 ARBITRATION (a) This paragraph concerns the resolution of any controversies or claims between the Borrower and the Bank including, but not limited to, those that arise from: (i) This Agreement (including any renewals, extensions or modifications of this Agreement); (ii) Any document, agreement or procedure related to, or delivered in connection with this Agreement; 12 13 (iii) Any violation of this Agreement; or (iv) Any claims for damages resulting from any business conducted between the Borrower and the Bank, including claims for injury to persons, property or business interest (torts). (b) At the request of the Borrower or the Bank, any such controversies or claims will be settled by arbitration in accordance with the United States Arbitration Act. The United States Arbitration Act will apply even though this Agreement provides that it is governed by Arizona law. (c) Arbitration proceedings will be administered by the American Arbitration Association and will be subject to its commercial rules of arbitration. (d) For purposes of the application of the statute of limitations, the filing of an arbitration pursuant to this paragraph is the equivalent of the filing of a lawsuit, and any claim or controversy which may be arbitrated under this paragraph is subject to any applicable statute of limitations. The arbitrators will have the authority to decide whether any such claim or controversy is barred by the statute of limitations and, if so, to dismiss the arbitration on that basis. (e) If there is a dispute as to whether an issue is arbitrable, the arbitrators will have the authority to resole any such dispute. (f) The decision that results from an arbitration proceeding may be submitted to any authorized court of law to be confirmed and enforced. (g) This provision does not limit the right of the Borrower or the Bank to: (i) Exercise self-help remedies such as setoff; (ii) Foreclose against or sell any real or personal property collateral; or (iii) Act in a court of law, before, during or after the arbitration proceeding to obtain: (A) an interim remedy; and/or (B) additional or supplementary remedies. (h) The pursuit of or a successful action for interim, additional or supplementary remedies, or the filing of a court action, does not constitute a waiver of the right of the Borrower or the Bank, including the suing party, to submit the controversy or claim to arbitration if the other party contests the lawsuit. (i) If the Bank forecloses against any real property securing this Agreement, the Bank has the option to exercise the power of sale under the deed of trust or mortgage, or to proceed by judicial foreclosure. 10.5 SEVERABILITY; WAIVERS. If any part of this Agreement is not enforceable, the rest of the Agreement may be enforced. The Bank retains all rights, even if it makes a loan after default. If the Bank waives a default, it may enforce a later default. Any consent or waiver under this Agreement must be in writing. 10.6 ADMINISTRATION COSTS. The Borrower shall pay the Bank for all reasonable costs incurred by the Bank in connection with administering this Agreement. 10.7 ATTORNEYS' FEES. The Borrower shall reimburse the Bank for any reasonable costs and attorneys' fees incurred by the Bank in connection with the enforcement or preservation of any rights or remedies under this Agreement and any other documents executed in connection with this Agreement, and including any amendment, waiver, "workout" or restructuring under this Agreement. In the event of a lawsuit or arbitration proceeding, the prevailing party is entitled to recover costs and reasonable attorneys' fees incurred in connection with the lawsuit or arbitration proceeding, as determined by the court or arbitrator. As used in this paragraph, "attorneys' fees" includes 13 14 the allocated costs of in-house counsel. 10.8 ONE AGREEMENT. This Agreement and any related security or other agreements required by this Agreement, collectively: (a) Represent the sum of the understandings and agreements between the Bank and the Borrower concerning this credit; and (b) Replace any prior oral or written agreements between the Bank and the Borrower concerning this credit; and (c) Are intended by the Bank and the Borrower as the final, complete and exclusive statement of the terms agreed to by them. In the event of any conflict between this Agreement and any other agreements required by this Agreement, this Agreement will prevail. 10.9 EXCHANGE OF INFORMATION. The Borrower agrees that the Bank may exchange financial information about the Borrower with BankAmerica Corporation affiliates and other related entities. 10.10 USURY LAWS. This paragraph covers the transactions described in this Agreement and any other agreements with the Bank or its affiliates executed in connection with this Agreement, to the extent they are subject to the Arizona usury laws (the "Transactions"). The Borrower understands and believes that the Transactions comply with the Arizona usury laws. However, if any interest or other charges paid or payable in connection with the Transactions are ever determined to exceed the maximum amount permitted by law, the Borrower agrees that: (a) The amount of interest or other charges payable by the Borrower pursuant to the Transactions shall be reduced to the maximum amount permitted by law; and (b) Any excess amount previously collected from the Borrower in connection with the Transactions which exceeded the maximum amount permitted by law will be credited against the then outstanding principal balance. If the outstanding principal balance has been repaid in full, the excess amount paid will be refunded to the Borrower. All fees, charges, goods, things in action or any other sums or things of value, other than interest at the interest rate described in this Agreement, paid or payable by the Borrower (collectively the "Additional Sums"), that may be deemed to be interest with respect to the Transactions, shall, for the purposes of any laws of the State of Arizona that may limit the maximum amount of interest to be charged with respect to the Transactions, be payable by Borrower as, and shall be deemed to be, additional interest. For such purposes only, the agreed upon and "contracted for rate of interest" of the Transactions shall be deemed to be increased by the rate of interest resulting from the Additional Sums. 10.11 NOTICES. All notices required under this Agreement shall be personally delivered or sent by first class mail, postage prepaid, to the addresses on the signature page of this Agreement, or to such other addresses as the Bank and the Borrower may specify from time to time in writing. 10.12 HEADINGS. Article and paragraph headings are for reference only and shall not affect the interpretation or meaning of any provisions of this Agreement. 14 15 This Agreement is executed as of the date stated at the top of the first page. BANK OF AMERICA NATIONAL TRUST AND SAVINGS VENTANA MEDICAL SYSTEMS, INC. ASSOCIATION /s/ SEAN DICKES /s/ PIERRE SICE - ---------------------------------- ------------------------------ By: Sean Dickes, Vice President By: Pierre Sice, Vice President, Chief Financial Officer Address where notices to the Bank Address where notices to the are to be sent Borrower are to be sent Tucson Commercial, #2322 3865 N. Business Center Drive 33 North Stone, 6th Floor Tucson, Arizona 85705 Tucson, Arizona 85701 15 EX-10.20.(B) 5 AMENDMENT TO BANK AMERICA BUSINESS LOAN AGREEMENT 1 EXHIBIT 10.20(b) [BANK OF AMERICA LOGO] AMENDMENT TO DOCUMENTS - -------------------------------------------------------------------------------- FIRST AMENDMENT TO BUSINESS LOAN AGREEMENT This First Amendment to Business Loan Agreement is entered into as of October 1, 1998, between Bank of America National Trust and Savings Association ("Bank") and Ventana Medical Systems, Inc. ("Borrower"). RECITALS A. WHEREAS, Bank and Borrower have entered into that certain Business Loan Agreement dated June 9, 1998, (the "Agreement"); and B. WHEREAS, Borrower and Bank desire to amend certain terms and provisions of said Agreement as more specifically hereinafter set forth. AGREED NOW, THEREFORE, in consideration of the foregoing recitals, Bank and Borrower mutually agree to amend said Agreement as follows: 1. Paragraph 7.11 (Dividends) of the Agreement, is amended in the entirety to read as follows: 7.11 DIVIDENDS. Not to declare or pay any dividends on any of its shares except dividends payable in capital stock of the Borrower. The Borrower not to purchase, redeem or otherwise acquire for value any of its shares of common stock currently held in the open market, or create any sinking fund in relation thereto, in an amount exceeding 750,000 shares of common stock. This amendment will become effective as of October 1, 1998, the ("Effective Date"), provided that each of the following conditions precedent have been satisfied: The Bank has received from the Borrower's duly executed original of this Amendment. Except as provided in this Amendment, all of the terms and provisions of the Agreement shall remain in full force and effect. This Amendment shall be effective between the parties as of the date hereof. The Agreement as amended hereby, shall hereinafter constitute the Agreement between the parties. 1 2 IN WITNESS WHEREOF, this Amendment has been executed by the parties hereto as of the date first written above. BANK OF AMERICA NATIONAL TRUST AND SAVINGS VENTANA MEDICAL SYSTEMS, INC. ASSOCIATION /s/ SEAN DICKES /s/ PIERRE SICE - ---------------------------------- ------------------------------ By: Sean Dickes, Vice President By: Pierre Sice, Vice President, Chief Financial Officer 2 EX-10.20.(C) 6 AMENDMENT TO BANK OF AMERICA BUSINESS LOAN AGMT 1 EXHIBIT 10.20(c) [LOGO] BANK OF AMERICA AMENDMENT TO DOCUMENTS ================================================================================ SECOND AMENDMENT TO BUSINESS LOAN AGREEMENT This Second Amendment to Business Loan Agreement is entered into as of March 17, 1999, between Bank of America National Trust and Savings Association ("Bank") and Ventana Medical Systems, Inc. ("Borrower"). RECITALS A. WHEREAS, Bank and Borrower have entered into that certain Business Loan Agreement dated June 9, 1998, and amended on October 1, 1998 (collectively the "Agreement"): and B. WHEREAS, Borrower and Bank desire to amend certain terms and provisions of said Agreement as more specifically hereinafter set forth. AGREED NOW, THEREFORE, in consideration of the foregoing recitals, Bank and Borrower mutually agree to amend said Agreement as follows: 1. In paragraph 1.1 (a) (Line of Credit Amount) of the Agreement, the amount "Ten Million and No/100 Dollars ($10,000,000.00)" is substituted for the amount "Five Million and No/100 Dollars ($5,000,000.00)". 2. In Paragraph 1.2 (Availability Period) of the Agreement, the date "March 31, 2000" is substituted for the date "May 31, 1999". 3. The second sentence in Paragraph 2.1 (a) (Unused Commitment Fee) of the Agreement is amended and restated in its entirety to read as follows: The fee will be calculated at 1/2% per year. 4. Paragraph 7.3 (Quick Ratio) of the Agreement is amended and restated in its entirety to read as follows: 7.3 QUICK RATIO. To maintain on a consolidated basis a ratio of quick assets to current liabilities of at least the amounts indicated for each period specified below to be measured quarterly: PERIOD RATIO ------ ----- From the date herein through March 31, 1999 1.60:1.0 April 1, 1999 and thereafter 1.75:1.0 "Quick assets" means cash, short-term cash investments, net trade receivables and marketable securities not classified as long-term investments. 2 5. Paragraph 7.4 (Minimum Liquidity) of the Agreement is amended and restated in its entirety to read as follows: 7.4 MINIMUM LIQUIDITY. To maintain a minimum of at least Two Million and No/100 Dollars ($2,000,000.00) in the form of Cash or Readily Marketable Securities, measured quarterly. 6. In Paragraph 7.10 (Capital Expenditures) of the Agreement, the amount "Three Million Five Hundred Thousand and No/100 Dollars ($3,500,000.00)" is substituted for the amount "Three Million and No/1000 Dollars ($3,000,000.00)". 7. In Paragraph 7.12 (Out of Debt Period) of the Agreement is amended and restated in its entirety to read as follows: 7.12 OUT OF DEBT PERIOD. To repay any advances in full, and not to draw any additional advances on its revolving line of credit, for a period of at least 30 consecutive days in each semi-annual period ending September 30th and March 31st of each year. For the purposes of this paragraph, "advances" does not include undrawn amounts of outstanding letters of credit. The Amendment will become effective on March 17, 1999 (the "Effective Date"), provided that each of the following conditions precedent have been satisfied: The Bank has received from the Borrower a duly executed original of this Amendment. The Bank has received from the Borrower a duly executed Corporate Resolution in the amount of "Ten Million and No/100 Dollars ($10,000,000.00)". Except as provided in this Amendment, all of the terms and provisions of the Agreement shall remain in full force and effect. This Amendment shall be effective between the parties as of the date hereof. The Agreement, as amended hereby, shall hereinafter constitute the Agreement between the parties. IN WITNESS WHEREOF, the Amendment has been executed by the parties hereto as of the date first written above. Bank of America National Trust and Savings Ventana Medical Systems, Inc. Association /s/ KEVIN GILLETTE /s/ PIERRE SICE - ------------------------------ ---------------------------- Kevin Gillette, Vice President Pierre Sice, Vice President, Chief Financial Officer EX-23.1 7 CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS 1 Exhibit 23.1 CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statement (Form S-8 No. 333-16707) pertaining to the registration of the 1996 Stock Option Plan, 1996 Director Option Plan, 1988 Stock Option Plan, and 1996 Employee Stock Purchase Plan of Ventana Medical Systems, Inc. of our report dated February 2, 1999, with respect to the financial statements of Ventana Medical Systems, Inc. included in this Annual Report (Form 10-K) for the year ended December 31, 1998. Our audits also included the financial statement schedule of Ventana Medical Systems, Inc. listed in Item 14(a). This schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ ERNST & YOUNG LLP Tucson, Arizona March 24, 1999 EX-27.1 8 FINANCIAL DATA SCHEDULE
5 1,000 YEAR DEC-31-1998 JAN-01-1998 DEC-31-1998 2,424 0 17,225 694 11,009 31,751 15,696 5,759 56,280 8,589 0 0 0 13 45,771 56,280 47,704 47,704 14,542 14,542 32,621 392 114 1,630 0 1,630 0 0 0 1,630 0.12 0.11 For purposes of this exhibit, primary means basic.
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