ITEM 1. Business.
CAUTIONARY STATEMENTS ABOUT FORWARD-LOOKING INFORMATION
This Annual Report on Form 10-K includes "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, or the Exchange Act. Statements included or incorporated herein which are not historical facts are forward looking statements. When used in this Annual Report, the words estimates, expects, anticipates, projects, plans, intends, believes, forecasts and variations of such words or similar expressions are intended to identify forward-looking statements, but these terms are not the exclusive means of identifying forward looking statements.
Forward looking statements reflect management's current views with respect to future events and performance and are based on currently available information and management's assumptions regarding future events. While management believes that its assumptions are reasonable, forward-looking statements are subject to various known and unknown risks and uncertainties and actual results may differ materially from those expressed or implied herein. In connection with the "safe harbor provisions" of the Private Securities Litigation Reform Act of 1995, we note that certain factors, among others, which could cause future results to differ materially from the forward-looking statements, expectations and assumptions expressed or implied herein are discussed in greater detail under Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Item 1A
ITEM 1A. Risk Factors.
Risks Related To Our Business
We have a history of operating losses and may not achieve or sustain profitability.
Until fiscal 2009, we incurred losses in each year since our inception, and may incur additional losses over the next several years. As of December 31, 2014, we had an accumulated deficit of $203.5 million. These losses resulted principally from costs incurred in our research and development programs and from our general and administrative expenses. These losses, among other things, have had and will continue to have an adverse effect on our stockholders' equity, total assets and working capital.
We expect to continue to incur significant operating expenses in the foreseeable future as we seek to:
• Complete our confirmatory Phase III quality random clinical trial with Grafix for complex diabetic foot wounds with exposed tendon or bone;
• continue other studies and initiate and pursue additional studies and possible clinical trials for our Biosurgery products, including Grafix for venus leg ulcers, which we have begun, and possibly other potential indications;
• manage regulatory issues and requirements related to the marketing and distribution of our products and product candidates, including issues related to FDA approval and third party payor reimbursement;
• maintain, expand and protect our intellectual property; and
• continue to add sales, operational, financial, accounting, facilities engineering and information systems personnel, consistent with expanding our operations.
The extent of our future operating losses or profits is highly uncertain, and we may not achieve or sustain profitability. If we are unable to achieve and then maintain profitability, the market value of our common stock will decline and you could lose part or all of your investment.
The current credit and financial market conditions may exacerbate certain risk affecting our business.
We rely upon third parties for certain aspects of our business, including collaboration partners, wholesale distributors, contract clinical trial providers, contract manufacturers and third-party suppliers. Because of the tightened global credit and continuing volatility in the financial markets, there may be a delay or disruption in the performance or satisfaction of commitments to us by these third parties, which could adversely affect our business.
We depend on key personnel.
Our future success depends to a significant extent on the skills, experience and efforts of our scientific, management, and sales personnel. These include Lode Debrabandere Ph.D., Alla Danilkovitch, Ph.D., Philip R. Jacoby, Jr., and Frank Czworka. We also rely upon the guidance and experience of Peter Friedli, the Chairman of our Board of Directors. The loss of any or all of these individuals could harm our business and might significantly delay or prevent the achievement of research, development or business objectives. We are party to an employment agreement with Dr. Debrabandere. The existence of an employment agreement does not, however, guarantee retention of any officer or employee, and we may not be able to retain any of these individuals, whether or not we have an employment agreement with them. Except for Dr. Debrabandere, none of our employees is employed for a specified term. Competition for personnel is intense. We may be unable to retain our current personnel or attract or integrate other qualified management and scientific personnel in the future.
The potential of our Biosurgery products and products under development to treat conditions may not be realized.
We are continually evaluating the potential of our Biosurgery products and products under development. Our products are susceptible to various risks, including undesirable and unintended side effects, unintended immune system responses, inadequate efficacy or other characteristics that may prevent or limit their commercial use, or if required, marketing approval. If the treatment potential of our products is not realized, the value of our technology, our development programs and our products could be significantly reduced. Because our Biosurgery products are comprised of human tissue, any negative developments regarding the therapeutic potential or side effects of human tissue products could have a material adverse effect on our business, financial condition and results of operations.
Our product development programs are based on novel technologies and are inherently risky.
We are subject to the risks of failure inherent in the development of products based on new technologies. The novel nature of our products and product candidates creates significant challenges in regards to product development and optimization, processing and manufacturing, government regulation, third-party reimbursement and market acceptance. For example, questions persist with regard to the necessity of FDA approval for some cell-based products, and therefore, the pathway to commercialization of our Biosurgery products may be more complex and lengthy. Additionally, cell-based products are subject to donor-to-donor variability, which can make standardization more difficult. As a result, the development and commercialization pathway for our products may be subject to increased uncertainty, as compared to the pathway for conventional products.
Our Biosurgery products represent new classes of therapy that the marketplace may not understand or accept.
The market may not understand or accept our products. We are developing products that represent novel treatments or therapies and which will compete with a number of more conventional products and therapies manufactured and marketed by others, including major pharmaceutical companies. The novel nature of our Biosurgery products creates significant challenges in regards to product development and optimization, manufacturing, government regulation, and third-party reimbursement. As a result, the development pathway for our Biosurgery products may be subject to increased scrutiny, as compared to the pathway for more conventional products.
The degree of market acceptance of any of our developed or potential products will depend on a number of factors, including:
• the clinical safety and effectiveness of our products and their perceived advantage over alternative treatment methods;
• our ability to convince health care providers that the use of our products in a particular procedure is more beneficial than the standard of care or other available methods;
• our ability to explain clearly and educate others on the use of human placental tissue, to avoid potential confusion with and differentiate ourselves from the ethical controversies associated with human fetal tissue;
• ethical controversies that may arise regarding the use of human tissue of any kind, including tissues derived from deceased donor, and distribution for profit of our deceased donor products;
• adverse reactions involving our biosurgery products or the products or product candidates of others that are human tissue based;
• our ability to supply a sufficient amount of our product to meet regular and repeated demand in order to develop a core group of medical professionals familiar with and committed to the use of our products; and
• the cost of our products and the reimbursement policies of government and third-party payors.
If the health care community does not accept our potential products for any of the foregoing reasons, or for any other reason, it could affect our sales, having a material adverse effect on our business, financial condition and results of operations.
The successful commercialization and distribution of our Biosurgery products will depend on obtaining reimbursement from third-party payors.
We distribute our Biosurgery products in the United States. We may expand our distribution to other countries in the future. In the United States and elsewhere, the market for any pharmaceutical or therapeutic product is affected by the availability of reimbursement from third-party payors, such as government health administration authorities, private health insurers, health maintenance organizations and pharmacy benefit management companies. Biosurgery products like Grafix, Cartiform and BIO4 may have higher costs or fees associated with them compared with more traditional products, due to the higher cost and complexity associated with their research, development and production, and the complexity associated with their distribution-which requires special handling, storage and shipment procedures and protocols. This, in turn, may make it more difficult for us to obtain adequate reimbursement from third-party payors, particularly if we cannot demonstrate a favorable cost-benefit relationship. Third-party payors may also deny coverage or offer inadequate levels of reimbursement for our products if they determine that the product has not received appropriate clearances from the FDA or other government regulators or is experimental, unnecessary or inappropriate.
In the countries of Europe and in some other countries, the pricing of prescription and therapeutic products and services, and reimbursement, are subject to increased governmental control. In addition, many other countries require pre-marketing approval for human tissue based products, or otherwise more extensively regulate human tissue based products than does the United States.
Regardless of whether we are required to conduct a successful clinical trial in order to market a product in the United States or a foreign country, we may nevertheless be required to conduct one or more clinical trials, and to publish one or more peer reviewed journal articles supporting the product, before we are able to obtain third party reimbursement. We may also be required to conduct additional clinical trials that compare the cost effectiveness of our products to other available therapies before third party payors will provide reimbursement. Conducting clinical trials is expensive and will result in delays in wide scale commercialization and reimbursement. Publishing of peer reviewed journal articles may also be costly and result in delays. In addition, even if our products otherwise meet the requirements for reimbursement, pricing negotiations with third party payors may take months and result in significant delay in obtaining approval for reimbursement.
Reimbursement policies also sometimes differ depending upon the setting in which the product is to be used. The use of our Biosurgery products in a hospital setting as part of a surgical or other more extensive procedure may have a reimbursement pathway that differs from a use in an outpatient setting for a more narrowly defined procedure. Thus, for example, the reimbursement pathway for Grafix-which we expect to be used more often in an outpatient setting-may differ from that for BIO4-which we expect to be used more often in an in-patient hospital setting as part of a surgical procedure.
These differences may limit or make reimbursement more difficult for some products as compared to others, and influence our product development and marketing efforts in ways that may ultimately prove to be detrimental to us or our business.
Managing and reducing health care costs has been a general concern of federal and state governments in the United States and of foreign governments. Although we do not believe that any recently enacted or presently proposed U.S. legislation should impact our business specifically and negatively as compared to other health care product businesses generally, we might nevertheless be subject to future regulations or other cost-control initiatives that materially restrict the price we receive for our products. In addition, third-party payors are increasingly challenging the price and cost-effectiveness of medical products and services, and many limit reimbursement for newly approved health care products. In particular, third-party payors may limit the indications for which they will reimburse patients who use any products that we may develop. Cost control initiatives could decrease the price for products that we may develop, which would result in lower product revenues to us.
Our dependence upon human tissue necessary to produce our Biosurgery products may impact our ability to produce these products on a large scale.
Our Biosurgery products consist of human tissue. This tissue is obtained by us from not-for-profit donor procurement agencies. Grafix is processed from human placental tissue. BIO4 is processed from deceased donor bone. Cartiform is processed from deceased donor cartilage. While we are not aware of significant supply issues, and placental tissue and deceased donor bone and cartilage is generally available to us, the supplier agencies may not be able to provide us with sufficient amounts of tissue to meet the demand. In addition, the use of human tissue as a treatment for human disease and medical conditions has increased over recent years and continues to increase, creating greater and continually increasing competition and demand for donated human tissue. Even if we are successful in our efforts to expand our compliment of Biosurgery products, we may not be able to secure quantities of human tissue sufficient to meet the demand.
Our Biosurgery products are derived from human tissue and therefore have the potential for disease transmission.
The utilization of human tissue creates the potential for transmission of communicable disease, including but not limited to human immunodeficiency virus (HIV) viral hepatitis, syphilis, Creutzfeldt-Jakob disease, or the human form of "mad cow" disease, and other viral, fungal or bacterial pathogens. Although we are required to comply with federal and state regulations intended to prevent communicable disease transmission, and our suppliers of adult human bone, cartilage and placental tissue are also required to comply with such regulations in connection with their collection, storage and supply to us:
• we or our suppliers may fail to comply with such regulations;
• even with compliance, our products might nevertheless be viewed by the public as being associated with transmission of disease; and
• a patient that contracts an infectious disease might assert that the use of our products resulted in disease transmission, even if the patient became infected through another source.
Any actual or alleged transmission of communicable disease could result in patient claims, litigation, distraction of management's attention and potentially increased expenses. Further, any failure in screening, whether by us or other manufacturers of similar products, could adversely affect our reputation, the support we receive from the medical community and overall demand for our products. As a result, such actions or claims, whether or not directed at us, could have a material adverse effect on our reputation with our customers and our ability to distribute our products, which could have a material adverse effect on our business, financial condition and results of operations.
We may not be able to process our Biosurgery products in sufficient quantities to expand our market for the products.
We may encounter difficulties in the production of our Biosurgery products due to our limited manufacturing capabilities. This difficulty could reduce redistribution efforts of our products, increase our distribution costs or cause production delays, any of which could damage our reputation and effect our operations. Even if we have access to quantities of human tissue sufficient to allow us otherwise to expand our manufacturing capabilities, we may not be able to produce sufficient quantities of the product at an acceptable cost, or at all.
We use or may use third-party collaborators to help us develop and commercialize our products, and our ability to commercialize such products may be impaired or delayed if collaborations are unsuccessful.
We have arrangements in place with third-party collaborators as a means to help us with research and development efforts or marketing and distribution. We are subject to a number of risks associated with our dependence upon our collaborative relationships, including:
• our collaborators may not cooperate with us or perform their obligations under our agreements with them;
• we cannot control the quality, amount and timing of our collaborators' resources that will be devoted to performing their responsibilities under our agreements with them, and our collaborators may choose to pursue alternative technologies in preference to those being developed or commercialized in collaboration with us;
• refusal to or failure of our collaborators to perform their responsibilities in a timely manner, including breach;
• the right of the collaborator to terminate its collaboration agreement with us for reasons outside our control, and in some cases on limited notice;
• business combinations and changes in a collaborator's business strategy may adversely affect the party's willingness or ability to complete its obligations;
• loss of significant rights to our collaborative parties if we fail to meet our obligations;
• disagreements as to ownership of clinical trial results or regulatory approvals;
• the ability of a collaborator to successfully market and promote our products;
• withdrawal of support by a collaborator following development or acquisition by the collaborator of competing products; and
• disagreements with a collaborator regarding the collaboration agreement or ownership of intellectual property or other proprietary rights.
Due to these factors and other possible events, we could suffer delays in the research, development or commercialization of our products or we may become involved in litigation or arbitration, which would be time consuming and expensive.
Our most significant collaborative arrangement is with a subsidiary of Stryker Corporation, and our success may depend upon performance on the part of Stryker and the success of this collaboration. We are also dependent upon our exclusive partnership with Arthrex, Inc. for the commercial distribution of Cartiform, and may enter into and become dependent upon additional collaborations in the future.
We are party to an Exclusive Service Agreement with Howmedica Osteonics Corp., also referred to as Stryker Orthopaedics, a subsidiary of Stryker Corporation ("Stryker"), for the commercialization of our viable bone matrix allograft under the name BIO4. Pursuant to the agreement, Stryker is the exclusive worldwide marketer and promoter of allograft services for BIO4 for use in surgical applications, including spine, trauma, extremity, cranial, and foot and ankle surgery. This collaboration is subject to all of the risks and uncertainties applicable to collaborative arrangements generally, including those described above. In addition, this collaboration is subject to a number of risks and uncertainties specific to the transaction and the parties.
The agreement with Stryker provides for an initial four year exclusive term, commencing on the date of Stryker's initial commercial sale. The term may be extended by Stryker for an additional exclusive period of four years or an additional non-exclusive period of two years. If Stryker extends the term on an exclusive basis, it has the option to further extend the term on an exclusive basis for two years. Osiris is entitled to receive an initial exclusivity fee of $5,000,000 and additional fees upon any exercise by Stryker of its right to extend the initial term, whether on an exclusive or non-exclusive basis. These additional fees are reduced on a sliding scale if Stryker meets certain revenue thresholds during the initial term, or if revenue goals are not met as a result of Osiris not fulfilling its supply obligations. Stryker is entitled to a certain percentage of sales of allograft services for BIO4 and has limited early termination rights. The success of this collaboration for us will in part be dependent upon Stryker, including its success in marketing and promoting BIO4.
Stryker has significantly greater resources that we do, and this collaboration is not as core to its business as it is to ours. We are dependent upon Stryker's continued performance under this collaboration, and any determination by Stryker not to proceed or perform, or any material adverse event that affects Stryker's ability or desire to perform may have a material adverse effect on our business.
We are also dependent upon our exclusive commercial and development partnership with Arthrex, Inc., to which we have granted exclusive commercial distribution rights for Cartiform, and any determination by Stryker not to proceed or perform, or any material adverse event that affects Stryker's ability or desire to perform may have a material adverse effect on our business.
We may also enter into additional collaborations in the future. We are dependent upon our current collaborators, and will be dependent upon any future collaborators, in performing their responsibilities in connection with the relevant collaboration. If we fail to maintain our existing or any future collaborative relationships for any reason, we would need to undertake on our own and at our own expense, or find other collaborators, to perform the activities we currently anticipate will be performed by our collaborators. This may substantially increase our cash requirements. We may not have the capability or financial capacity to undertake these activities on our own, or we may not be able to find other collaborators on acceptable terms, or at all. This may limit the programs we are able to pursue and result in significant delays in the development, sale and manufacture of our products, and may have a material adverse effect on our business.
We distribute products through distribution arrangements that sometimes involve the consignment of inventory to third parties, which results in additional risk and uncertainty as to the viability of consigned inventory and as to inventory accounting.
We have historically distributed our Biosurgery products either ourselves or through third party distributors who sometimes take possession of our inventory on a consignment basis, or through a
combination of both methods. In some situations, we store consigned inventory on site in freezers at hospital or clinic facilities. We commercialize Grafix through the efforts of our own focused direct distribution and marketing staff, as well as through a network of specialty distributors for certain target markets. Like Ovation and OvationOS, Bio4 will sometimes be commercialized through a consignment arrangement, and our agreement with Stryker includes consignment terms, as does our agreement with Arthrex for Cartiform. Because our consigned inventory must be stored at -80 C, it is at risk of thawing, resulting in the loss of that inventory. That risk of loss of is borne by us, although we believe that we maintain adequate insurance to cover the risk. Inventory management is complicated by a consignment arrangement, as is revenue recognition and inventory and receivables accounting. Thus, for example, no revenue is recognized upon the placement of inventory into consignment, as we retain title and maintain the inventory on our balance sheet. For these products, revenue is recognized when we receive appropriate notification that the product has been used in a surgical procedure. This may not occur in a timely manner, meaning that our financial statements may not always reflect our actual inventory and receivables balances as of the end of a fiscal period. We monitor and verify the condition and status of all consigned inventory on at least a quarterly basis, at additional expense to us. In addition, FDA, AATB and other accrediting agency rules, regulations or standards require that we monitor our consigned inventory, and require tracking of human tissue and inventory as it moves through the supply chain. Moreover, as is the case with all of our inventory, should the FDA or any other regulatory authority determine that we are unable for any reason to continue to distribute consigned inventory, either on account of the viability of that inventory or because of the withdraw of necessary approvals or other qualifications allowing for the distribution and sale of that inventory, the value of that inventory may have to be written off and our balance sheet adjusted accordingly. The complexity of our inventory management, or the application of rules, regulations and standards to our product inventory, or the occurrence of any of these negative events, could have an adverse effect on our business, financial condition and results of operations.
We are currently dependent upon third-parties for services and raw materials needed for the processing of our Biosurgery products, and for distribution.
In order to produce our Biosurgery products we require biological media, reagents and other highly specialized materials. This is in addition to the human tissue donations used to manufacture our biosurgery products. These items must be manufactured and supplied to us in sufficient quantities and in compliance with cGMP. To meet these requirements, we have entered into supply agreements with firms that manufacture these components to cGMP standards.
We expect to continue to rely on third parties to sell or redistribute our biosurgery products. Proper shipping and distribution requires compliance with specific storage and shipment procedures. Failure to comply with these procedures or the occurrence of inadvertent damage to the shipping container will necessitate return and replacement, potentially resulting in additional cost and causing us to fail to meet supply requirements. If any of these third parties fail or are unable to perform in a timely manner, our ability to manufacture and deliver could be compromised, and our business would be harmed.
Our dependence on third parties may increase the risk that we will not have adequate quantities of our biosurgery products.
Our Biosurgery product supply chain and processing infrastructure depends on the performance of a number of complex contracts between us on the one hand and our suppliers and redistributors on the other. If any of our suppliers, distributors or other business partners cannot or do not perform their contractual obligations, then our production efforts may suffer. If we cannot or do not perform our contractual obligations, then we may be subject to arbitration, mediation or litigation that could have a material adverse effect on us.
Reliance on third-parties entails risks to which we would not be subject if we manufactured such components ourselves, including:
• reliance on the third party for regulatory compliance and quality assurance;
• the possible breach of the manufacturing agreement by the third party; and
• the possible termination or nonrenewal of the agreement by the third party, based on its own business priorities, at a time that is costly or inconvenient for us.
Our suppliers, distributors and other third parties with which we contract are subject to many or all of the risks and uncertainties that we are subject to. Similar to us, they are subject to ongoing, periodic, unannounced inspection by the FDA and corresponding state and foreign agencies or their designees to ensure strict compliance with cGMP regulations and other governmental regulations and corresponding foreign standards. However, we do not control compliance with these regulations and standards by our suppliers, distributors and other third parties with which we contract. They might not be able to comply with these regulatory requirements. If they fail to comply with applicable regulations, the FDA or other regulatory authorities could impose sanctions on us, including fines, injunctions, civil penalties, denial of any required marketing approval, delays, suspension or withdrawal of approvals, license revocation, product seizures or recalls, operating restrictions and criminal prosecutions. Any of these actions could significantly and adversely affect the supply of our products and could have a material adverse effect on our business, financial condition and results of operations.
If our processing and storage facility is damaged or destroyed, our business and prospects would be negatively affected.
If our processing and storage facility or the equipment in the facility were to be significantly damaged or destroyed, we could suffer a loss of some or all of the stored product, raw and other materials, and work in process.
We lease approximately 61,203 square feet of space in Columbia, Maryland that houses essentially all of our corporate operations. Currently, we maintain insurance coverage totaling $22.8 million against damage to our property and equipment, an additional $5.0 million to cover business interruption and extra expenses, and $7.3 million to cover R&D restoration expenses. If we have underestimated our insurance needs, we will not have sufficient insurance to cover losses above and beyond the limits on our policies.
Ethical, legal and other concerns surrounding the use of human tissue may negatively affect public perception of us or our products, or may result in increased scrutiny of our products and product candidates from a regulatory approval perspective, thereby reducing demand for our products, restricting our ability to market our products, or adversely affecting the market price for our common stock.
The commercial success of our Biosurgery products depends in part on general public acceptance of the use of human tissue for the treatment of human diseases and other conditions. While not as controversial as the use of embryonic stem cells and fetal tissue, the use of placental tissue and adult tissue has been the subject of substantial debate regarding related ethical, legal and social issues. We do not use embryonic stem cells or fetal tissue, but the public may not be able to, or may fail to, differentiate our use of placental or adult tissue from the use by others of embryonic stem cells or fetal tissue. Ethical concerns have been raised by some about the use of donated human tissue in a for-profit setting. This could result in a negative perception of our company or our products.
Future adverse events in the field of cellular based therapy or changes in public policy could also result in greater governmental regulation of our products and potential regulatory uncertainty or delay relating to any required testing or approval.
Many of our competitors have greater resources or capabilities than we have, or may succeed in developing better products or in developing products more quickly than we do.
In the marketplace, we compete with other companies and organizations that are marketing or developing products competitive with Grafix and our other Biosurgery products and products under development. In many cases, the competing product or candidate is based on traditional pharmaceutical, medical device or other therapies and technologies. Competitors competing with our Biosurgery products include, but are not limited to: Organogenesis, the manufacturer of Apligraf and Dermagraft and MiMedx, the manufacturer of EpiFix which competes with Grafix. BIO4 competes with bone tissue products such as Osteocel® and Trinity®, while Cartiform competes with cartilage allografts. In addition to those listed above, we have other existing and potential competitors developing a variety of treatments and therapies for the same conditions for which we market our products.
We also face competition in the cellular regenerative field from academic institutions and governmental agencies. Many of our current and potential competitors have greater financial and human resources than we have, including more experience in research and development and more established marketing and distribution capabilities.
We anticipate that competition in our industry will increase. In addition, the health care industry is characterized by rapid technological change, resulting in new product introductions and other technological advancements. Our competitors may develop and market products that render products now or in the future under development by us, or any products manufactured or marketed by us, non-competitive or otherwise obsolete.
The use of our Biosurgery products in human subjects may expose us to product liability claims, and we may not be able to obtain adequate insurance.
We face an inherent risk of product liability claims. None of our products have been widely used over an extended period of time, and therefore our safety data is limited. We derive the raw materials for our products from human donor sources, the production process is complex, and the handling requirements are specific, all of which increase the likelihood of quality failures and subsequent product liability claims. We may not be able to obtain or maintain product liability insurance on acceptable terms with adequate coverage or at all. If we are unable to obtain insurance, or if claims against us substantially exceed our coverage, then our business could be adversely impacted. Whether or not we are ultimately successful in any product liability litigation, such litigation could consume substantial amounts of our financial and managerial resources and could result in, among other things:
• significant awards against us;
• substantial litigation costs;
• recall of the product;
• injury to our reputation;
• withdrawal of clinical trial participants; or
• adverse regulatory action.
Any of these results could have a material adverse effect on our business, financial condition and results of operations.
In addition to costs incurred in product development and management of the regulatory approval and reimbursement processes, we will incur additional operating expenses in connection with the expansion of our Biosurgery business.
We expect to continue to incur significant operating expenses in connection with our planned expansion of our biosurgery business, as we seek to:
• continue to develop, expand and support our distribution network of third party distributors and independent sales professionals for the distribution of Grafix, BIO4 and other Biosurgery products;
• continue to expand and support our internal sales force and marketing capabilities, through the hiring of sales and marketing professionals and building an internal sales and marketing organization;
• hire additional manufacturing, quality control, and quality assurance, and management personnel as necessary to expand our processing operations;
• expand our processing capacity for our Biosurgery products, which will require that we maintain a portion of our space as an FDA compliant and validated product manufacturing facility; and
• expand and protect our intellectual property portfolio for our Biosurgery products.
Our redistribution fees from our Biosurgery products have been limited to date. Our ability to scale up our production capabilities for larger quantities of these products remains to be proven. Our costs in marketing and distributing these products will also increase as production increases.
Risks Related to Regulatory Approval and Other Government Regulations
Should the FDA determine that any of our products do not meet regulatory requirements that permit qualifying human cells, tissues and cellular and tissue-based products to be processed, stored, labeled and distributed without pre-marketing approval, we may be required to stop processing and distributing such products, or to narrow the indications for which those products are marketed.
The FDA has developed a tiered, risk-based regulatory framework, which includes criteria for facility management, quality assurance, donor selection, and processing of human cells, tissues, and cellular and tissue based products. We believe that commercial sale of Grafix as a wound allograft for the treatment of acute and chronic wounds, including diabetic foot ulcers, does not require pre-market approval by the FDA because we believe that this product meets the regulatory definition of human cells, tissue, and cellular and tissue-based products, or so-called Part 361 HCT/Ps (meaning that they comply with section 361 of the Public Health Service At (PHSA) and 21 CFR 1271). We received an "untitled letter" dated September 26, 2013 from the FDA stating, among other things, that both Grafix and Ovation do not meet these regulatory requirements because they are dependent upon the metabolic activity of living cells for their primary function and are not intended for autologous use or allergenic use in a first or second degree relative; and that Ovation does not meet the minimal manipulation criterion. After discussions with, and providing additional information to, the FDA, we reached an agreement with the FDA confirming the regulatory status of Grafix and allowing the product to remain on the market as an HCT/P and without FDA pre-marketing approval, as a wound allograft for the treatment of acute and chronic wounds. We further committed to the FDA that, before marketing Grafix for certain expanded indications, we would submit a Biologics License Application (BLA) to the FDA and seek pre-marketing approval for any such additional indication. We also agreed to continue to transition our Ovation product line over to OvationOS (now branded as BIO4) by no later than the second half of 2014, which we did. In August 2014, we stopped distributing promotional materials for Ovation and ceased manufacturing the product. In October 2014, we stopped shipping Ovation from our Columbia, MD facilities. At December 31, 2014, we owned some units of Ovation
located in the field for use in procedures by the end users. We believe that commercial distribution of BIO4, a viable bone matrix for bone growth, and Cartiform, a viable chondral allograft, does not require pre-market approval by the FDA because we believe that these products meet the regulatory definition of HCT/Ps.
We engage in ongoing discussion and communication with FDA representatives regarding the applicable regulatory requirements and pathways for our products and product candidates. The analysis and determination of compliance of a product with these regulatory requirements and pathways is complex and dependent upon numerous factors, and is readily subject to varying interpretations and conclusions. The FDA may not agree with our views on these matters. Should the FDA decide that Grafix, BIO4 or any of our other Biosurgery products do not meet the regulatory definition of HCT/Ps, we will not be able to produce and redistribute these products unless and until we submit a BLA and obtain pre-marketing approval from the FDA, which would require clinical trials and could take years to obtain, at significant expense. This or any other determination by the FDA that adversely affects our ability to produce or to market any of our products or product candidates would have a material adverse effect on our business, financial condition and results of operations.
Our ability to expand the marketing claims for Grafix and BIO4 is limited by Federal regulations, and will likely require the submission to the FDA of a biologics license application, or BLA, and the receipt of pre-marketing approval from the FDA, for the particular indication.
We cannot process, market or distribute our Biosurgery products without compliance with the United States Food Drug and Cosmetics Act, and comparable laws in foreign countries. Part 361 HCT/Ps may be processed, stored and distributed in the United States without FDA approval, provided that the product complies with the requirements of Part 361 of the PHSA and 21 CFR 1271. Absent such compliance, a BLA is required as a condition to marketing and sale of the product. In order to obtain a BLA we would be required to conduct extensive preclinical studies and clinical trials to demonstrate that the product is safe and effective and obtain required regulatory approvals. This process is costly and the product may fail to perform as we expect. Moreover, a product may ultimately fail to show the desired safety and efficacy traits despite having progressed successfully through preclinical or initial clinical testing. We would need to devote significant additional research and development, financial resources and personnel to obtain the necessary regulatory approvals, if required.
We have initiated efforts to obtain a BLA for Grafix. For the current label indications, for Grafix and BIO4,we rely upon the exception to the BLA limits requirement afforded Part 361 HCT/Ps. However, compliance with these requirements our activities in respect of these products. For example, we will not be able to enhance tissue based products in a manner which would result in the product being more than "minimally manipulated" within the meaning of 21 CFR 1271. These and other limitations applicable to HCT/Ps limit the indications for which these products may be marketed. Moreover, the FDA continues to review and inspect marketed products, manufacturers and manufacturing facilities, and even if a BLA is not required initially, the FDA or its foreign equivalents may create additional regulatory burdens in the future or may reevaluate or modify current regulatory frameworks in a manner adverse to us. Later discovery of previously unknown problems with a product, manufacturer or facility-including those of or associated with a competitor or competing product-may result in the imposition of additional restrictions on us or our products, including a withdrawal of the product from the market. This would have a material adverse effect on our business, financial condition and results of operations.
If we are not able to conduct clinical trials properly and on schedule, or if any such clinical trials prove to be unsuccessful, we would be unable to secure sought after, or any required, regulatory approvals.
We are currently pursuing and in the future may pursue additional clinical trials for our Biosurgery products to enhance our ability to successfully market these products, or to obtain pre-marketing approval if required by the FDA for us to market certain products, or to market our products for expanded indications. Clinical trials are costly and time consuming. The completion of clinical trials may be delayed or terminated, or the costs may be increased, for many reasons, including, but not limited to, if:
• the FDA does not grant permission to proceed and places the trial on clinical hold;
• subjects do not enroll in our trials at the rate we expect;
• subjects experience an unacceptable rate or severity of adverse side effects;
• third-party clinical investigators do not perform our clinical trials on our anticipated schedule or consistent with the clinical trial protocol, Good Clinical Practice and regulatory requirements, or other third parties do not perform data collection and analysis in a timely or accurate manner;
• inspections of clinical trial sites by the FDA or Institutional Review Boards (IRBs) of research institutions participating in our clinical trials find regulatory violations that require us to undertake corrective action, suspend or terminate one or more sites, or prohibit us from using some or all of the data in support of our marketing applications; or
• one or more IRBs suspends or terminates the trial at an investigational site, precludes enrollment of additional subjects, or withdraws its approval of the trial.
If we are unable to conduct clinical trials properly and on schedule, any potential marketing benefit may be lost, the reputation of the product could be damaged, and any required marketing approval may be delayed or denied by the FDA.
Tissue based products are generally subjected to greater regulatory scrutiny in many other countries as compared to the United States. These requirements may be costly and result in delay or otherwise preclude the distribution of our Biosurgery products in some foreign countries, any of which would adversely affect our ability to generate operating revenues.
Tissue based products are regulated differently in different countries. We believe that commercial distribution of Grafix as a wound allograft for the treatment of acute and chronic wounds, including diabetic foot ulcers, and the commercial distribution of BIO4, a viable bone matrix for bone growth, do not require pre-market approval by the FDA in the United States because we believe that these products meet the regulatory definition of human cells, tissue, and cellular and tissue-based products, and qualify as Part 361 HCT/Ps. Many foreign jurisdictions have a different and more difficult regulatory pathway for human tissue based products, which may prohibit the distribution of these products until the applicable regulatory agencies grant marketing approval, or licensure. The process of obtaining regulatory approval is lengthy, expensive and uncertain, and we may never seek such approvals, or if we do, we may never gain those approvals. Any sought after or required approvals in Europe will likely require that we conduct clinical trials, which are themselves are costly and time consuming, and subject to risk and uncertainty, and may prove to be unsuccessful. Any adverse events in our clinical trials for one of our products could negatively impact our other products.
If we seek regulatory approval in the United States or elsewhere for our Biosurgery products, whether to enhance our ability to successfully market these products, or if we are required to do so by the FDA or equivalent foreign regulatory agencies, we may not be successful.
Should we decide to seek regulatory approval in the United States or elsewhere for our Biosurgery products, or should we be required to obtain such approvals before we can market a product generally or for a specific indication, any of the following factors may cause marketing approval to be delayed, limited or denied:
• our products will require significant pre-clinical and clinical development before applications for marketing approval can be filed with the FDA;
• data obtained from preclinical and nonclinical animal testing and clinical trials can be interpreted in different ways, and the FDA or its foreign counterpart may not agree with our interpretations;
• it may take many years to complete the testing of our products, and failure can occur at any stage of the process;
• negative or inconclusive results or adverse side effects during a clinical trial could cause us to delay or terminate development efforts for product;
• approval may be delayed if the FDA or its foreign counterpart requires us to expand the size and scope of the clinical trials; or
• negative results from clinical trials or failure to obtain pre-marketing approval of a HCP/T product not otherwise requiring such approval may result in a negative public perception of the product and loss of market share and revenue.
If we seek marketing approval-whether or not then necessary to market a particular product-and that approval marketing approval is delayed, limited or denied, our ability to market products, and our ability to generate product sales, would be adversely affected.
We and our business are subject to rules and regulations regarding organ donation and transplantation.
Compliance with the issued operating standards established by The American Association of Tissue Banks ("AATB") is a requirement in order to become a licensed tissue bank. In addition, some states have their own tissue banking regulations. We are licensed to have permits as a tissue bank in Maryland, California, New York and Florida.
In addition, procurement of certain human organs and tissue for transplantation is subject to the restrictions of the National Organ Transplant Act ("NOTA"), which prohibits the transfer of certain human organs, including skin and related tissue, for valuable consideration, but permits the reasonable payment associated with the removal, transportation, implantation, processing, preservation, quality control and storage of human tissue and skin. We reimburse tissue banks for their expenses associated with the recovery, storage and transportation of donated human tissue that they provide to us for processing. We include in our pricing structure amounts paid to tissue banks to reimburse them for their expenses associated with the recovery and transportation of the tissue, in addition to certain costs associated with processing, preservation, quality control and storage of the tissue, marketing and medical education expenses, and costs associated with the development of tissue processing technologies. NOTA payment allowances may be interpreted to limit the amount of costs and expenses that we can recover in our pricing for our products, thereby reducing our future revenue and profitability. If we were to be found to have violated NOTA's prohibition on the sale or transfer of human tissue for valuable consideration, we would potentially be subject to criminal enforcement sanctions, which could materially and adversely affect our results of operations.
In Europe, regulations, if applicable, differ from one county to the next. Because of the absence of a harmonized regulatory framework and proposed regulation for advanced therapy medicinal products in Europe, as well as for other countries, the approval process for human derived cell or tissue based medical products could be extensive, lengthy, expensive, and unpredictable. Our Biosurgery products are subject to the country's regulations that govern the donation, procurement, testing, coding, traceability, processing, preservation, storage, and distribution of human tissues and cells and cellular or tissue-based products. These regulations include requirements for registration, listing, labeling, adverse-event reporting, and inspection and enforcement. Some countries have their own tissue banking regulations.
Our business involves the use of hazardous materials that could expose us to environmental and other liability.
We have facilities in Maryland that are subject to various local, state and federal laws and regulations relating to safe working conditions, laboratory and manufacturing practices, the experimental use of animals and the use and disposal of hazardous or potentially hazardous substances, including chemicals, micro-organisms and various radioactive compounds used in connection with our research and development activities. In the United States, these laws include the Occupational Safety and Health Act, the Toxic Test Substances Control Act and the Resource Conservation and Recovery Act. We cannot assure you that accidental contamination or injury to our employees and third parties from hazardous materials will not occur. We do not have insurance to cover claims arising from our use and disposal of these hazardous substances other than limited clean-up expense coverage for environmental contamination due to an otherwise insured peril, such as fire.
Risks Related to Intellectual Property
Given our patent position in regard to our Biosurgery products, if we are unable to protect the confidentiality of our proprietary information and know-how related to these products, our competitive position would be impaired and our business, financial condition and results of operations could be adversely affected.
A significant amount of our technology, including our teaching regarding the processing of our Biosurgery products, is unpatented and is maintained by us as trade secrets or confidential know-how. In an effort to protect this proprietary information, we require our employees, consultants, collaborators and advisors to execute confidentiality agreements upon the commencement of their relationships with us. These agreements require that all confidential information developed by the individual or made known to the individual by us during the course of the individual's relationship with us be kept confidential and not disclosed to third parties. These agreements, however, may not provide us with adequate protection against improper use or disclosure of trade secrets or confidential information, and these agreements may be breached. For example, a portion of the processing methodology and know-how for Grafix is protected by trade secret or through confidentiality arrangements. A breach of confidentiality could affect our competitive position. In addition, in some situations, these agreements may conflict with, or be subject to, the rights of third parties with whom our employees, consultants, collaborators or advisors have previous employment or consulting relationships.
Also, others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets or know-how.
Because FDA approval is generally not required for tissue based products which are not more than minimally manipulated, competitors might choose to enter this market and produce a substantially similar product, and we may not be able to prevent the marketing and distribution of any such similar products by others. Should others produce a substantially similar product, we will be subject to
increased competition and our potential revenues from redistribution of these Biosurgery products may be limited.
Moreover, if our Biosurgery products infringe or are alleged to infringe intellectual property rights of third parties, these third parties could bring claims against us that would cause us to incur substantial expenses and, if successful against us, could cause us to pay substantial damages. Further, if a patent infringement suit were brought against us, we could be forced to stop or delay research, development, manufacturing or redistribution of the product that is the subject of the suit.
Adequate remedies may not exist in the event of unauthorized use or disclosure of our confidential information. The disclosure of our trade secrets or know-how would impair our competitive position and could have a material adverse effect on our business, financial condition and results of operations.
If our patent position does not adequately protect our products, others could compete against us more directly, which would harm our business and have a material adverse effect on our financial condition and results of operations.
The patent position of biotechnology companies is generally highly uncertain, involves complex legal and factual questions and has been the subject of much litigation. Neither the U.S. Patent and Trademark Office nor the courts has a consistent policy regarding the breadth of claims allowed or the degree of protection afforded under many biotechnology patents.
The claims of our existing U.S. patents and those that may issue in the future, or those licensed to us, may not confer on us significant commercial protection against competing products. Even if we hold patents or have patent rights through licenses or otherwise with respect to a particular product, third parties may challenge, narrow, invalidate, design around, or circumvent any patents now or hereafter owned, assigned or licensed to us. Patents with broader claims tend to be more vulnerable to challenge by other parties than patents with extremely narrow claims. Also, our pending patent applications may not issue, may issue with substantially narrower claims than currently pending claims, or we may not receive any additional patents. Further, the laws of foreign countries may not protect our intellectual property rights to the same extent as do the laws of the United States. Our patents might not contain claims that are sufficiently broad to prevent others from utilizing our technologies. Consequently, our competitors may independently develop competing products that do not infringe our patents or other intellectual property.
Because of the extensive time required for development, testing and regulatory review of a potential product, it is possible that, before any of our products can be commercialized, any related patent may expire or remain in force for only a short period following commercialization, thereby reducing any advantages of the patent. A significant amount of our technology, including our teaching regarding the production processes for our Biosurgery products, is unpatented and is maintained by us as trade secrets. The lack of patent protection for our Biosurgery products reduces the barrier for entry by others and makes these products susceptible to increased competition, which could be harmful to our business.
If we are unable to protect the confidentiality of our proprietary information, trade secrets and know-how, our competitive position would be impaired and our business, financial condition and results of operations could be adversely affected.
Significant aspects of our Biosurgery product technology, especially the teaching regarding the manufacturing processes for these products, are unpatented and maintained by us as trade secrets or proprietary know-how. In an effort to protect these trade secrets and know-how, we require our employees, consultants, collaborators and advisors to execute confidential disclosure agreements before the commencement of their relationships with us. These agreements require that all confidential information developed by the individual or made known to the individual by us during the course of
the individual's relationship with us be kept confidential and not disclosed to third parties. These agreements, however, may not provide us with adequate protection against improper use or disclosure of confidential information, and these agreements may be breached. A breach of confidentiality could affect our competitive position. In addition, in some situations, these agreements may conflict with, or be subject to, the rights of third parties with whom our employees, consultants, collaborators or advisors have previous employment or consulting relationships. Also, others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets.
Adequate remedies may not exist in the event of unauthorized use or disclosure of our confidential information. The disclosure of our trade secrets or know-how would impair our competitive position and could have a material adverse effect on our business, financial condition and results of operations.
If we infringe or are alleged to infringe intellectual property rights of third parties, it will adversely affect our business, financial condition and results of operations.
Our research, development and commercialization activities, and the manufacture or distribution of our Biosurgery products, may infringe or be alleged to infringe patents owned by third parties and to which we do not hold licenses or other rights. There may be applications that have been filed but not published that, when issued, could be asserted against us. These third parties could bring claims against us that would cause us to incur substantial expenses and, if successful against us, could cause us to pay substantial damages. Further, if a patent infringement suit were brought against us, we could be enjoined from certain activities including a stop or delay in research, development, manufacturing or sales activities related to the product or biologic drug candidate that is the subject of the suit.
As a result of patent infringement claims, or in order to avoid potential claims, we may choose or be required to seek a license from the third party. These licenses may not be available on acceptable terms, or at all. Even if we are able to obtain a license, the license would likely obligate us to pay license fees or royalties or both, and the rights granted to us might be nonexclusive, which could result in our competitors gaining access to the same intellectual property. Ultimately, we could be prevented from commercializing a product, or be forced to cease some aspect of our business operations, if, as a result of actual or threatened patent infringement claims, we are unable to enter into licenses on acceptable terms.
There has been substantial litigation and other proceedings regarding patent and other intellectual property rights in the pharmaceutical and biotechnology industries. In addition to infringement claims against us, we may become a party to other patent litigation and other proceedings, including interference and reexamination proceedings declared by the United States Patent and Trademark Office and opposition proceedings before the patent offices for other countries (e.g. the European Patent Office) or similar adversarial proceedings, regarding intellectual property rights with respect to our products and technology. The cost to us of any patent litigation or other proceeding, even if resolved in our favor, could be substantial. Some of our competitors may be able to sustain the costs of such litigation or proceedings more effectively than we can because of their greater financial resources. Patent litigation and other proceedings may also absorb significant management time. Uncertainties resulting from the initiation and continuation of patent litigation or other proceedings could have a material adverse effect on our ability to compete in the marketplace and, as a result, on our business, financial condition and results of operations. To the extent that our employees, consultants or contractors use intellectual property owned by others, disputes may arise as to the rights related to or resulting from the use of such intellectual property.
We may become involved in lawsuits to protect or enforce our patents or the patents of our collaborators or licensors, which could be expensive and time consuming.
Litigation may be necessary to enforce patents issued or licensed to us, to protect trade secrets or know-how, or to determine the scope and validity of proprietary rights. Litigation, opposition or interference proceedings could result in substantial additional costs and diversion of management focus. If we are ultimately unable to protect our technology, trade secrets or know-how, we may be unable to operate profitably.
Competitors may infringe our patents or the patents of our collaborators or licensors. As a result, we may be required to file infringement claims to protect our proprietary rights. This can be expensive, particularly for a company of our size, and time-consuming. In addition, in an infringement proceeding, a court may decide that a patent of ours is invalid or is unenforceable, or may refuse to enjoin the other party from using the technology at issue. An adverse determination of any litigation or defense proceedings could put one or more of our patents at risk of being invalidated or interpreted narrowly. Interference proceedings brought by the U.S. Patent and Trademark Office may be necessary to determine the priority of inventions with respect to our patent applications or those of our collaborators or licensors. Litigation or interference proceedings may fail and, even if successful, may result in substantial costs and distraction to our management. We may not be able, alone or with our collaborators and licensors, to prevent misappropriation of our proprietary rights, particularly in countries where the laws may not protect such rights as fully as in the United States.
Furthermore, though we would seek protective orders where appropriate, because of the substantial amount of discovery required in connection with intellectual property litigation, there is a risk that some of our confidential information could be compromised by disclosure during this type of litigation. In addition, during the course of this kind of litigation, there could be public announcements of the results of hearings, motions or other interim proceedings or developments. If investors perceive these results to be negative, the market price for our common stock could be significantly harmed.
The biotechnology industry, including our fields of interest, is highly competitive and subject to significant and rapid technological change. Accordingly, our success will depend, in part, on our ability to respond quickly to such change through the development and introduction of new products. Our ability to compete successfully against currently existing and future alternatives to our products, and against competitors who compete directly with us, will depend, in part, on our ability to: attract and retain skilled scientific and research personnel; develop technologically superior products; develop competitively priced products; obtain patent or required regulatory approvals for our products; and be early entrants to the market; manufacture, market and sell our products, independently or through collaborations. If a third party were to commercialize a competitive product, there is no assurance that we would have a basis for initiating patent infringement proceedings or that, if initiated, we would prevail in such proceedings.
Risk Factors Regarding the Sale of our ceMSC Business
We may not receive all of the payments available to us under the terms of the Purchase Agreement, and accordingly, we may have less cash available to us to fund our operations.
The terms of our Purchase Agreement with Mesoblast for the sale of our ceMSC business provide for payment to us of $50 million in initial consideration, and up to an additional $50 million upon the achievement by Mesoblast of certain clinical and regulatory milestones. Additionally, we will be entitled to earn single to low double digit cash royalties on future sales by Mesoblast of Prochymal and other products utilizing the acquired ceMSC technology.
We have received all of the $50 million in initial consideration, consisting of $35 million in cash and $15 million in Mesoblast ordinary shares. Payment of the initial consideration made in Mesoblast
ordinary shares ($15 million) was subject to a one-year holding period that ended in December 2014. We continue to hold these shares and Mesoblast has agreed to purchase the shares for at least $15 million in cash prior to the middle of 2015. In the event that Mesoblast does not purchase these shares from us as agreed, the value of these shares will remain subject to market and foreign currency exchange risk, and we may be forced to liquidate these shares through other means and on terms materially less favorable to us. Our ability to receive the second $50 million is subject to satisfaction of a series of milestones, all of which are largely dependent upon the clinical and regulatory success of Mesoblast and other factors not in our control. These include many if not all of the risks and uncertainties that our ceMSC business was subject to prior to its sale to Mesoblast, including product development, efficacy and regulatory risks. We have received no such payments thus far, nor do we have any expectation of receiving any such payments in the foreseeable future. Our ability to earn royalty payments from Mesoblast is subject to these same risks and will require performance by Mesoblast that results in its meeting some or all of the milestones referred to above, and is thereafter also dependent upon the commercial success of Mesoblast's ceMSC business. Royalties, if any, are payable to us in cash. Any portion of the second $50 million that becomes payable to us will be payable, at the discretion of Mesoblast, in Mesoblast ordinary shares, based on a then current valuation of such shares.
Any portion of the second $50 million in consideration paid in Mesoblast ordinary shares will also be, is subject to a one year holding period, again with limited downside protection for a drop in the Mesoblast share price over the holding period. Therefore, any such payment, if made, will be are subject to investment risk, and because the Mesoblast ordinary shares are traded on the Australian Stock Exchange (ASX) and the per share price is denominated in Australian Dollars, will also be subject to foreign currency exchange risk.
Accordingly, not only do we have no assurances that any of the second $50.0 million in consideration will ever be paid to or received by us, but also we may be unable to liquidate on favorable terms any amounts paid to us in Mesoblast ordinary shares. As a result, we may have less cash available to fund our remaining operations and to support the continued development and pursuit of our Biosurgery business, and our financial condition or results of operations could be materially adversely affected.
The Purchase Agreement exposes us to contingent liabilities and other risks that could adversely affect our business or financial condition.
In the Purchase Agreement, we have made customary representations and warranties and the parties have agreed to indemnify each other for breaches of representations, warranties and covenants contained in the Purchase Agreement. Also pursuant to the Purchase Agreement, we have retained a royalty free license to all transferred intellectual property, insofar as necessary for us to continue in our other businesses, including our Biosurgery business, and we have agreed not to compete with Mesoblast in the ceMSC business for a period of eight years. The Purchase Agreement also subjects us to other risks typical in business transactions of this type, including payment and performance risks. Should disputes arise or should we incur liability for breach of any of these representations, warranties or obligations, or should any of these other risks materialize, our business, financial condition or results of operations could be materially adversely affected.
Our long term business prospects will depend on the success of our Biosurgery business.
As a result of the sale of our ceMSC business, including Prochymal, our Biosurgery business is our sole remaining business, and our overall business is less diverse. Our long term business prospects will, therefore, be dependent almost entirely on the success of our Biosurgery business. This business involves significant risks and challenges in regards to product development and optimization,
manufacturing, government regulation, intellectual property, third-party reimbursement and market acceptance, among other risks previously disclosed by us.
Payment of a portion of the purchase price for our Therapeutics business through the delivery of Mesoblast ordinary shares as permitted under the Purchase Agreement subjects us to significant additional risks.
Mesoblast ordinary shares delivered to us as payment under our Purchase Agreement with Mesoblast for the sale of our ceMSC business are subject to a one year holding period. Although we are afforded downside price protection for a drop over the holding period in the market price of Mesoblast ordinary shares delivered as payment, this downside protection is limited. To the extent the market price of the shares decreases over the holding period, Mesoblast has agreed to pay us for the decrease. This payment is to be made at least one half in cash and, at the option of Mesoblast, up to one half in additional shares of Mesoblast stock. Any additional Mesoblast stock will also have to be held for one year, for which period there will be no further downside price protection, and therefore the equity price risk will persist in respect of any additional Mesoblast shares issued to us. The Mesoblast ordinary shares are traded on the Australian Securities Exchange (ASX) and the share value is denominated there in Australian Dollars. Hence, there also exists an associated foreign currency exchange rate risk. There is no corresponding mitigation of the foreign currency exchange rate risk, and any devaluation of the Australian Dollar will directly impact the value of the Mesoblast shares to us.
Of the $50 million in initial consideration, $15 million has been paid to us in Mesoblast ordinary shares. Although we were initially subject to investment risk and foreign currency exchange risk in respect of our ownership of these shares, Mesoblast has agreed to purchase the shares for no less than $15 million during the first half of 2015.
Nevertheless, any portion of the second $50 million in consideration that may become payable to us under the Purchase Agreement (if and only if certain milestones are met by Mesoblast), is also payable to us, at the discretion of Mesoblast, in Mesoblast ordinary shares, based on a then current valuation of such shares. In the event of any negative events with respect to or otherwise affecting Mesoblast or the value of its ordinary shares, the value of any such additional Mesoblast ordinary shares acquired by us would be negatively affected and we could lose, in whole or in part, the value to us of that portion of the consideration paid to us by Mesoblast. If we are unable to liquidate on favorable terms any amounts paid to us in Mesoblast ordinary shares, we will have less cash available to fund our remaining operations and to support the continued development and pursuit of our biosurgery business, and our financial condition or results of operations could be materially adversely affected.
Risks Related to Our Common Stock
Although we have recently remediated a material weakness in our internal control over financial reporting, if we are unable to maintain the effectiveness of our internal controls, then a material misstatement could result in our financial statements.
We previously identified a material weakness in our internal control over financial reporting and, as a result of such weakness, our management, with the participation of our principal executive officer and principal financial officer, concluded that our disclosure controls and procedures and internal control over financial reporting were not effective as of December 31, 2013. The material weakness related to the maintenance of effective controls over the application and monitoring of our accounting for income taxes. With respect to our controls over the application and monitoring of our accounting for income taxes, we did not have controls designed and in place to ensure effective oversight of the work performed, and the accuracy of, financial information or professional conclusions provided by, third-party tax advisors. We have since remediated the material weakness through implementation of enhanced controls related to review and oversight of complex transactions and infrequent events. Additionally, we engaged a new third party tax advisor to oversee and prepare the Company's tax
provision and other related documents. As a result, our assessment of the effectiveness of our internal control over financial reporting as of December 31, 2014 no longer reports this material weakness or any other material weakness over financial reporting, and the audit report of our independent registered public accounting firm no longer expresses an adverse opinion on the effectiveness of our internal control over financial reporting as of December 31, 2014. Nevertheless, we may experience other material weaknesses in our internal control over financial reporting in the future, which could lead to or result in a material misstatement in our financial statements.
The trading price of the shares of our common stock is highly volatile, and purchasers of our common stock could incur substantial losses.
Our stock price is volatile. The stock market in general and the market for biotechnology companies in particular have experienced extreme volatility that has often been unrelated to the operating performance of particular companies. As a result of this volatility, investors may not be able to sell their common stock at or above the price they paid for it. The market price for our common stock may be influenced by many factors, including:
• results of clinical trials or those of our competitors;
• regulatory developments in the United States and foreign countries, both generally or specific to us and our products;
• variations in our financial results or those of companies that are perceived to be similar to us;
• changes in the structure of healthcare payment systems;
• announcements by us of significant acquisitions, strategic partnerships, joint ventures or capital commitments;
• market conditions in the pharmaceutical and biotechnology sectors and issuance of securities analysts' reports or recommendations;
• sales of substantial amounts of our stock by existing stockholders;
• sales of our stock by insiders and 5% stockholders;
• general economic, industry and market conditions;
• additions or departures of key personnel;
• intellectual property, product liability or other litigation against us;
• expiration or termination of our relationships with our collaborators; and
• the other factors described in this "Risk Factors" section.
In addition, in the past, stockholders have initiated class action lawsuits against biotechnology and pharmaceutical companies following periods of volatility in the market prices of these companies' stock. Such litigation, if instituted against us, could cause us to incur substantial costs and divert management's attention and resources, which could have a material adverse effect on our business, financial condition and results of operations.
Certain provisions of Maryland law and of our charter and bylaws contain provisions that could delay and discourage takeover attempts and any attempts to replace our current management by stockholders.
Certain provisions of Maryland General Corporation Law (MGCL) and of our Maryland charter and Maryland bylaws contain provisions that may make it more difficult for or prevent a third party
from acquiring control of us or changing our Board of Directors and management. These include, but are not limited to, the following:
• classification of the board of directors with staggered terms of three years, which prevents a majority of the incumbent directors from being replaced at a single annual stockholders' meeting;
• authorization of the board of directors to issue shares of preferred stock generally without stockholder approval;
• requirements that special meetings of stockholders may only be called by the chairman of the board of directors, upon request of stockholders holding at least 20% of the capital stock issued and outstanding, or upon a resolution adopted by, or an affirmative vote of, a majority of the board of directors; and
• requirements that our stockholders comply with advance notice procedures in order to nominate candidates for election to our Board of Directors or to place stockholders' proposals on the agenda for consideration at meetings of stockholders.
Maryland law also prohibits "business combinations" between us and an interested stockholder or an affiliate of an interested stockholder for five years after the most recent date on which the interested stockholder becomes an interested stockholder. These business combinations include a merger, consolidation, share exchange or, in certain circumstances specified in the statute, an asset transfer or issuance or reclassification of equity securities. Maryland law defines an interested stockholder as any person who beneficially owns 10% or more of the voting power of the corporation's stock, or an affiliate or associate of the corporation who, at any time within the two-year period prior to the date in question, was the beneficial owner of 10% or more of the voting power of the corporation's then-outstanding voting stock. A person is not an interested stockholder if the board of directors of the corporation approved in advance the transaction by which the person otherwise would have become an interested stockholder. However, such approval may be conditional.
After the five-year prohibition, any business combination between the corporation and an interested stockholder or an affiliate of an interested stockholder generally must be recommended by the board of directors and approved by the affirmative vote of at least 80% of the votes entitled to be cast by holders of the then-outstanding shares of voting stock, and two-thirds of the votes entitled to be cast by holders of the voting stock other than stock held by the interested stockholder with whom or with whose affiliate the business combination is to be effected or stock held by an affiliate or associate of the interested stockholder. These super-majority vote requirements do not apply if the holders of the common stock receive a minimum price, as defined under Maryland law, for their stock in the form of cash or other consideration in the same form as previously paid by the interested stockholder for its stock.
The statute permits various exemptions from its provisions, including business combinations that are approved or exempted by the board of directors before the time that the interested stockholder becomes an interested stockholder. Our Board of Directors has not exempted us from the business combination statute. Consequently, unless the Board of Directors adopts an exemption from this statute in the future, the statute will be applicable and may affect business combinations between us and other persons. The statute may discourage others from trying to acquire control of us or increase the difficulty of consummating any such acquisition.
Our bylaws also contain a provision exempting us from the "control share acquisition" provisions of the MGCL (Sections 3-701 through 3-709). We can provide no assurance that such provision of our bylaws will not be amended or eliminated in the future. Should this happen, the control share acquisition provisions would become effective and may discourage others from trying to acquire control of us and increase the difficulty of consummating any offer.
Subtitle 8 of Title 3 of the MGCL ("Subtitle 8") permits a Maryland corporation with a class of equity securities registered under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and with at least three independent directors to elect to be subject to any or all of five provisions:
• a classified board;
• a two-thirds vote requirement to remove a director;
• a requirement that the number of directors be fixed only by the vote of the directors;
• a requirement that a vacancy on the board be filled only by the remaining directors and for the remainder of the full term of the directorship in which the vacancy occurred rather than until the next annual meeting of stockholders as would otherwise be the case; and
• a majority requirement for the calling of a special meeting of stockholders.
An eligible Maryland corporation like us can elect into this statute by provision in its charter or bylaws or by a resolution of its board of directors, without stockholder approval. Furthermore, we can elect to be subject to the above provisions regardless of any contrary provisions in the charter or bylaws. Pursuant to Subtitle 8, we have elected to provide that vacancies on our Board of Directors may be filled only by the remaining directors and for the remainder of the full term of the class of directors in which the vacancy occurred. Through provisions in our charter and bylaws unrelated to Subtitle 8, we have a classified board, and the number of our directors may be fixed only by the vote of the directors.
Concentration of ownership of our common stock among our existing executive officers, directors and principal stockholders may prevent others from influencing significant corporate decisions, and provisions in our charter allowing for a stockholder vote by consent in lieu of a meeting may make it easier for stockholders holding a majority of our common stock to take action.
Our executive officers, directors and beneficial owners of 5% or more of our common stock and their affiliates, in aggregate, beneficially own approximately 54% of our outstanding common stock as of March 1, 2015. Included among this 54%, Peter Friedli, the Chairman of the Board of Directors, and certain entities with which he is affiliated, beneficially own approximately 43% of our outstanding common stock as of March 1, 2015. These persons, acting together, will be able to significantly influence all matters requiring stockholder approval, including the election and removal of directors and any merger or other significant corporate transactions. The interests of this group of stockholders may not coincide with our interests or the interests of other stockholders.
Moreover, as permitted by the MGCL, our charter provides that the holders of common stock entitled to vote generally in the election of directors may take action or consent to any action by delivering a consent in writing or by electronic transmission of the stockholders entitled to cast not less than the minimum number of votes (which is generally either a majority of votes cast or a majority of votes entitled to be cast) that would be necessary to authorize or take the action at a stockholders meeting if the corporation gives notice of the action not later than ten (10) days after the effective date of the action to each holder of the class of common stock and to each stockholder who, if the action had been taken at a meeting, would have been entitled to notice of the meeting.
Accordingly, these persons acting together, and Mr. Friedli specifically, currently has, and will continue to have, a significant influence over the outcome of all corporate actions requiring stockholder approval, including any actions that may be taken by stockholder consent in lieu of a meeting.
ITEM 1B.
ITEM 1B. Unresolved Staff Comments.
Not Applicable.
ITEM 2.
ITEM 2. Properties.
Our corporate headquarters are located in Columbia, Maryland, where we lease approximately 61,000 square feet, currently at a rent of approximately $1.5 million per annum. Our lease expires October 2023, and includes options to extend the term for two additional five year periods
ITEM 3.
ITEM 3. Legal Proceedings.
From time to time in the ordinary course of business, we are subject to claims, asserted or unasserted, or named as a party to lawsuits, arbitrations, or investigations. Litigation, in general, and intellectual property and securities litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of legal proceedings cannot be predicted with any certainty and in the case of more complex legal proceedings, such as intellectual property and securities litigation, the results are difficult to predict at all. We are not aware of any asserted or unasserted legal proceedings or claims that we believe would have a material adverse effect on our financial condition or results of our operations.
ITEM 4.
ITEM 4. Mine Safety Disclosures.
Not Applicable.
PART II
ITEM 5.
ITEM 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Our common stock trades on the NASDAQ Global Market under the symbol "OSIR." The following table lists the high and low sale prices per share for our common stock based on the prices as reported on the NASDAQ Global Market for the periods indicated.
Stockholders
As of February 23, 2015, there were approximately 127 stockholders of record of our common stock and, according to our estimates, approximately 5,678 beneficial owners of our common stock.
Dividends
We have not paid dividends to our stockholders since our inception. It is possible that we may pay cash dividends to our stockholders in the future if we feel our cash resources comfortably exceeds our projected needs for growth and unforeseen contingencies.
Unregistered Sales of Securities and Use of Proceeds
There were no issuances of unregistered securities during fiscal 2014.
Issuer Purchase of Equity Securities
There were no repurchases by us of our securities during fiscal 2014 or 2013.
Stock Performance Graph
The following graph shows the cumulative total return, assuming the investment of $100 on January 1, 2009 on an investment in each of our common stock, the NASDAQ Composite Index (U.S. and Foreign) and the NASDAQ Biotechnology Index. The comparisons in the table are required by the SEC and are not intended to forecast or be indicative of possible future performance of our common stock.
Securities Authorized for Issuance under Equity Compensation Plans
The information required by Item 201(d) of Regulation S-K, pursuant to paragraph (a) of this Item 5, is incorporated herein by reference to the information contained in the Company's Proxy Statement for the 2015 Annual Meeting of Stockholders, which is anticipated to be filed pursuant to Regulation 14A no later than one hundred twenty (120) days following the end of the fiscal year reported on.
ITEM 6.
ITEM 6. Selected Financial Data.
We derived the selected financial data presented below for the periods or dates indicated from our financial statements. Our financial statements for these periods were audited by an independent registered public accounting firm. You should read the data below in conjunction with our financial statements, related notes and other financial information appearing in "Item 7.
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
When reviewing the discussion below, you should keep in mind the substantial risks and uncertainties that characterize our business. In particular, we encourage you to review the risks and uncertainties described under "Risk Factors" included as Item 1A in this Annual Report on Form 10-K. These risks and uncertainties could cause actual results to differ materially from those forecasted in forward-looking statements or implied by past results and trends. Forward-looking statements are statements that attempt to project or anticipate future developments in our business; we encourage you to review the examples of forward-looking statements included in this Annual Report on Form 10-K under Item 1 at the beginning of this report. These statements, like all statements in this report, speak only as of the date of this report (unless another date is indicated), and we undertake no obligation to update or revise the statements in light of future developments.
The following is a discussion and analysis of our financial condition, results of operations, liquidity and capital resources for each of the three fiscal years ended December 31, 2014, 2013 and 2012 and significant factors that could affect our prospective financial condition and results of operations. You should read this discussion together with our financial statements and notes included in "Item 8. Financial Statements and Supplementary Data."
In October 2013, we sold our Therapeutics segment for up to $100.0 million in initial and contingent consideration and we are now focused on developing and commercializing our Biosurgery business. As a result of this sale, we eliminated our Therapeutics segment from our continuing operations and we have presented the assets, liabilities and results of this segment's operations as discontinued operations for all periods. The following discussion of our financial condition and results of operations excludes the results of our discontinued operations unless otherwise noted. See Note 2, "Discontinued Operations" in the accompanying consolidated financial statements for further discussion of these discontinued operations.
Business Overview
Osiris Therapeutics, Inc., based in Columbia, Maryland, is a world leader in researching, developing and marketing cellular regenerative medicine products that improve the health and lives of patients, and lower overall healthcare costs. We continue to advance our research and development in biotechnology by focusing on innovation in regenerative medicine-including bioengineering, stem cell research and viable tissue based products. We have achieved commercial success with products in orthopedics, sports medicine and wound care, including Ovation®, OvationOS® (now the subject of exclusive distribution rights held by Stryker under the brand BIO4 ™), Cartiform® and Grafix®.
We began operations on December 23, 1992 and were a Delaware corporation until, with approval of our stockholders, we reincorporated as a Maryland corporation on May 31, 2010.
From 2010 to October 2013, we operated as two business segments, Therapeutics and Biosurgery. Our Therapeutics business focused on developing biologic stem cell drug candidates from a readily available and non-controversial source-adult bone marrow. Our Biosurgery business, created in 2009, works to harness the ability of cells and novel constructs to promote the body's natural healing with the goals of improving surgical outcomes and offering better treatment options for patients and physicians.
In October 2013, we sold our Therapeutics business, including Prochymal and related assets, to a wholly-owned subsidiary of Mesoblast Limited (ASX: MSB; USOTC: MBLYT) in a transaction that is worth up to $100 million plus royalties. The agreement with Mesoblast provides for the receipt by us of $50 million in initial consideration for closing and delivery of the assets, and for up to an additional $50 million in payments, but only upon Mesoblast achieving certain clinical and regulatory milestones. In addition, we are entitled to earn single to low double-digit cash royalties on future sales by Mesoblast of Prochymal and other products utilizing the acquired technology. Mesoblast has assumed
all future development costs and efforts. As of December 31, 2013, of the $50 million in initial consideration, we had received $35 million, comprised of $20 million in cash and $15 million of Mesoblast stock, which was restricted from resale until December 2014. We received the remainder of the initial consideration, in the amount of $15 million, in cash, on April 10, 2014. Mesoblast has agreed to purchase the Mesoblast stock for not less than $15 million in April 2015. During fiscal 2014, we completed all of our responsibilities under a separate transition services agreement with Mesoblast and can now focus our full attention on our Biosurgery business.
During December 2014, the company signed a strategic commercial partnership for the orthopedics unit with Stryker Corporation, to distribute BIO4™. The Company signed a second strategic commercial partnership with Arthrex, Inc. for the Sports Medicine Unit, to distribute Cartiform®.
Over the past five fiscal quarters, we have experienced significant growth in revenues from our Biosurgery products. We have also made a significant investment in increasing our sales force, and expect to incur additional research and development expenses associated with efforts to obtain pre-marketing approval from the FDA for expanded indications for Grafix. As we continue with this transition, and the transition of Ovation to Ovation OS and BIO4, we face all of the risks and uncertainties to which our business is generally subject. Thus, while we have demonstrated some limited success thus far in the pursuit of our new Biosurgery strategy, we recognize that we operate in a competitive and challenging business environment and that our continued execution on this strategy will face a number of challenges. As a result, we may experience variability in our overall results, and in our quarter to quarter revenues.
We are a fully integrated company, having developed capabilities in research, development, manufacturing, marketing and distribution of stem cell products.
Financial Operations Overview
Revenue
We manufacture human tissue based products in our Columbia, Maryland facility and distribute these products through a network of independent distributors as well as through the efforts of employee sales personnel. We presently manufacture and distribute Grafix for the treatment of chronic wounds, and Cartiform, a viable cartilage mesh for cartilage repair. We also produce our viable bone matrix tissue form, OvationOS, now the subject of an exclusive worldwide arrangement with a subsidiary of Stryker Corporation, which will distribute the product under the brand BIO4, beginning in 2015. All of these products are cryo-preserved and stored in special freezers at -80 degrees Celsius. Customers have the product shipped to them on dry ice. Legal title usually passes to the customer when the product leaves our shipping dock. We do have consignment inventory at certain hospital sites and in those situations, title instead passes to the customer when the product is used in a surgical procedure. Due to the nature of the products and the manufacturing process, we generally do not allow sales returns.
During the third quarter of fiscal 2010, we launched Grafix as the first product in our then newly established Biosurgery segment, for limited commercial distribution. We began distribution of a second product, Ovation, in early fiscal 2011. We transitioned our Ovation product to OvationOS during the second half of fiscal 2014. These products followed our first generation Biosurgery product, Osteocel, which we sold to Nuvasive, Inc. in 2008 for approximately $80 million in aggregate consideration. We have continued to increase our distribution volume for Grafix and our other current Biosurgery products throughout fiscal 2012, 2013, and 2014 through both in-house personnel as well as through our expanding distributor network. The increase in product revenue and gross profit since commercial launch is due to volume increases. We anticipate continuing to increase our organizational focus on the development and commercialization of Biosurgery products in the foreseeable future.
Research and Development Costs
Our research and development costs consist of expenses incurred in identifying, developing and testing biologic tissue based products. These expenses consist primarily of salaries and related expenses for personnel, fees paid to professional service providers for independent monitoring and analysis of our clinical trials, costs of contract research and manufacturing, costs of facilities, and the costs of manufacturing clinical trial materials and quality control supplies. Our historic research and development costs included these and other costs specific to our efforts focused on our biologic drug candidates, including costs of manufacture of clinical batches of our biologic drug candidates.
Consistent with our historic focus on the development of biologic drug candidates with potential uses in multiple indications, many of our historic costs are not attributable to a specifically identified product. We use our employee and infrastructure resources across several projects. Accordingly, we do not account for internal research and development costs on a project-by-project basis. From inception in December 1992 through December 31, 2014, we incurred aggregate research and development costs of approximately $443 million.
Biosurgery research and development expenses were $5.5 million in fiscal 2012, $5.0 million in fiscal 2013, and $6.9 million in fiscal 2014, which includes costs incurred for Protocol 302, which began during the second quarter of Fiscal 2012 and was designed to allow for the collection of data necessary to obtain the permanent HCPCS Q-codes for Grafix, which are required for Medicare and Medicaid reimbursement when treatment is performed in the outpatient setting.
We expect our research and development expenses to continue to be substantial in the future, as we continue our clinical trial activity for our existing Biosurgery products if and as they advance through the development cycle, and if and as we invest in additional product opportunities and research programs. Clinical trials and preclinical studies are time-consuming and expensive. Our expenditures on current and future preclinical and clinical development programs are subject to many uncertainties. We test our products in several preclinical studies, and we then conduct clinical trials for those candidates that we determine to be the most promising. As we obtain results from clinical trials, we may elect to discontinue or delay trials for some product candidates in order to focus our resources on more promising product candidates. Completion of clinical trials may take several years or more, but the length of time generally varies substantially according to the type, size of trial and intended use of a product candidate. The cost of clinical trials may vary significantly over the life of a project as a result of a variety of factors, including:
• the number of patients who participate in the trials;
• the number of sites included in the trials;
• the length of time required to enroll trial participants;
• the duration of patient treatment and follow-up;
• the costs of producing supplies of the product candidates needed for clinical trials and regulatory submissions;
• the efficacy and safety profile of the product candidate; and
• the costs and timing of, and the ability to secure, regulatory approvals.
As a result of these uncertainties, we are unable to determine with any significant degree of certainty the duration and completion costs of our research and development projects or when and to what extent we will generate revenues from the commercialization and sale of any of our product candidates.
General and Administrative Expenses
General and administrative expenses consist primarily of the costs associated with our general management, including salaries, allocations of facilities and related costs, and professional fees such as legal and accounting expenses. Generally, we have experienced a decrease in general and administrative costs as the result of our continued cost cutting efforts and the refinement of many of our general business processes, as well as a reduction in share-based compensation expense. Beginning in fiscal 2012, we incurred additional general and administrative expenses related to increased distribution efforts for our Biosurgery products. We expect future expense increases to continue as a result of hiring additional operational, financial, accounting, facilities engineering and information systems personnel as we continue to increase distribution of our Biosurgery products. We did not experience any significant reductions in our general and administrative expenses as the result of the sale of our Therapeutics business.
Other Income, Net
Other income consists of interest earned on our cash and investments available for sale and realized gains and losses incurred on the sale of these investments. Interest expense consists of interest incurred on capital leases. We do not expect to incur material interest expense in the future as we do not have a material amount of equipment under capital lease or any outstanding debt.
Income Taxes
The total tax provision for 2014 is a combination of $193,000 from continuing operations and $941,000 from the portion of the proceeds from the sale of discontinued operations received in 2014, which is reflected as a component of discontinued operations. The tax expense from continuing operations is due to federal alternative minimum taxes and state taxes.
Because realization of deferred tax assets is dependent upon future earnings, a full valuation allowance has been recorded on the net deferred tax assets as of December 31, 2013 and 2014, which relate primarily to net operating loss and various business tax credit carry-forwards. In the event that we become profitable, we have general business credits (before a 100% valuation allowance) of approximately $70.5 million that may be utilized to reduce our Federal tax but not below the alternative minimum tax threshold. In addition, windfall equity based compensation deductions in the amount of $5.4 million are tracked but not recorded to the balance sheet until they are reduce income taxes payable on a with-and-without basis.
The total tax provision for 2013 is a combination of the income tax benefit of $1.3 million from continuing operations and the gain from sale of discontinued operations, which is reflected net of income taxes of $1.7 million. The tax provision for 2013 reflects an effective tax rate benefit for continuing operations of 54.8% and was greater U.S. statutory tax rate of 35% due primarily to the tax benefit from disqualifying dispositions of incentive stock options (excluding windfall tax benefits). The Company was also subject to the alternative minimum tax of $388,000, which was included in the income taxes allocated to the gain from the sale of discontinued operations.
In October 2013, we entered into an agreement with a wholly owned subsidiary of Mesoblast Limited for the sale of our culture-expanded mesenchymal stem cell (ceMSC) business, including Prochymal, in a transaction valued up to $100 million. Of the $50 million in initial consideration, $20 million was paid in cash and $15 million was paid in shares of Mesoblast Limited stock, prior to the close of fiscal 2013. The remaining $15 million payment was received in April 2014. The $50 million in initial consideration was recognized for financial statement reporting purposes and reported as a $49.4 million gain from sale of discontinued operations. For income tax purposes, the $35 million received was recognized in fiscal 2013 and the balance of the initial consideration of $15 million was recognized in fiscal 2014 for income tax purposes. The tax effect of the $15 million
consideration received in fiscal 2014 was reported as a deferred tax liability in the amount of $6.1 million in 2013. This deferred payment also required that interest be accrued in the amount of $103,000 that increased the income taxes payable in 2013.
Amended income tax returns were filed for fiscal years 2010, 2011 and 2012 to reverse the calculation of the Orphan Drug Tax Credit taken in those years and increase the net operating loss carry-forwards which will be utilized to offset the gain generated from sale of discontinued operations. The amended 2010 federal income tax return will generate an income tax recoverable in the amount of $79,000. The inventory of deferred tax assets has been updated for these income tax amendments. Those refunds were received in 2014.
In fiscal 2012, we recognized an income tax benefit of $37,000 from continuing operations, in connection with truing up our tax asset accounts in connection with the filing of our 2011 income tax returns.
The total tax provision for 2013 is a combination of the income tax benefit of $1.3 million from continuing operations and the gain from sale of discontinued operations, which was reflected net of income taxes of $1.7 million. The tax provision for 2013 reflected an effective tax rate benefit for continuing operations of 54.8% compared to a U.S. statutory tax rate of 35%. This represented the benefit from continuing operations in 2013.
Critical Accounting Policies
General
Our discussion and analysis of our financial condition and results of operations are based on our financial statements, which we have prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, inventory valuation, derivative valuation, fair value accounting, deferred tax assets, share-based compensation, and contingencies. We base our estimates on historical experience and on various other assumptions that we believe are reasonable. These results form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We believe that the following critical accounting policies reflect our more significant judgments and estimates used in the preparation of our financial statements.
Revenue Recognition
In fiscal 2010 we began operations of our Biosurgery business as a separate business segment, focused on developing high-end biologic products for use in wound healing and surgical procedures. We commenced the manufacturing of our first Biosurgery segment product, Grafix, a regenerative wound care product, during the first quarter of 2010. During the first and second quarters of 2010, we distributed the product only for initial clinical evaluation. We launched the product for limited commercial distribution during the third quarter of 2010. We began distribution of another Biosurgery product, Ovation, in early fiscal 2011, and continued to increase our distribution volume of both products throughout fiscal 2011 and 2012. During fiscal 2013, we launched Cartiform, a viable cartilage mesh for cartilage repair and in 2014 we transitioned our Ovation product to OvationOS (now branded by Stryker as BIO4), a viable bone matrix. We recognized revenues of $59.9 million, $24.3 million, and $7.8 million on distribution of our Biosurgery products in fiscal 2014, 2013 and 2012, respectively.
We generally recognize revenue on the distribution of our Biosurgery products when we ship the frozen product to our customers. Legal title typically passes to the customers when the product leaves our shipping dock for most transactions. In some situations, we store consigned inventory on site in freezers at hospitals or clinic facilities. No revenue is recognized upon the placement of inventory into consignment as we retain title and maintain the inventory on our balance sheet. For these products, revenue is recognized when we receive appropriate notification that the product has been used in a surgical procedure. Due to the nature of the products and the manufacturing process, we generally do not allow sales returns or refunds.
Investments Available for Sale and Other Comprehensive Income
Investments available for sale consist primarily of marketable securities with maturities less than one year. Investments available for sale are valued at their fair value, with unrealized gains and losses reported as a separate component of stockholders' equity in accumulated other comprehensive income. All realized gains and losses on our investments available for sale are recognized in results of operations as investment income, a component of "Other income (expense), net".
Investments available for sale are evaluated periodically to determine whether a decline in their value is "other than temporary." Management reviews criteria such as the magnitude and duration of the decline, as well as the reasons for the decline, to predict whether the loss in value is other than temporary. If a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.
Accounts Receivable
Accounts receivable has grown as a result of our revenue increasing from $8.1 million in Q4 2013 to $19.3 million in Q4 2014. Accounts receivable are reported at their net realizable value. We charge off uncollectible receivables when the likelihood of collection is remote. We set credit terms with individual customers, and consider receivables outstanding longer than the time specified in the respective customer's contract, typically 75-days, to be past due. As of December 31, 2014 and 2013, accounts receivable in the accompanying balance sheets are reported net of a $1,256,000 and a $78,000 allowance for doubtful accounts, respectively. Accounts receivable balances are not collateralized. We have incurred bad debt expense of $1,178,000, $80,000, and $22,000 related to our Biosurgery operations during fiscal 2014, 2013 and 2012, respectively. We are experiencing some collection issues due to the termination of distributorships related to our new strategic partnerships with Arthrex and Stryker.
Inventory
We commenced limited distribution of our Biosurgery products during the third quarter of 2010, and began carrying inventory on our balance sheet thereafter. Inventory consists of raw materials, biologic products in process, and products available for distribution. We determine our inventory values using the first-in, first-out method. Inventory is valued at the lower of cost or market, and excludes units that we anticipate distributing for clinical evaluation.
Valuation of Long-lived Assets
We review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or group of assets may not be fully recoverable. These events or changes in circumstances may include a significant deterioration of operating results, changes in business plans, or changes in anticipated future cash flows. If an impairment indicator is present, we evaluate recoverability by a comparison of the carrying amount of the assets to future undiscounted net cash flows expected to be generated by the assets. Assets are grouped at the lowest level for which
there is identifiable cash flows that are largely independent of the cash flows generated by other asset groups. If the total of the expected undiscounted future cash flows is less than the carrying amount of the asset, an impairment loss is recognized for the difference between the fair value and carrying value of assets. Fair value is generally determined by estimates of discounted cash flows. The discount rate used in any estimate of discounted cash flows would be the rate required for a similar investment of like risk. There were no impairment losses recognized during the fiscal years 2014, 2013 or 2012.
Discontinued Operations
We report the results of our discontinued operations separately from the results of our continuing operations below the income (loss) from continuing operations on the Statements of Comprehensive (Loss) Income. Cash flows from discontinued operations are also reported separately in the operating activities section of the Statements of Cash Flows. The Balance Sheets include separate line items for current assets and liabilities associated with discontinued operations.
Derivative Accounting
We account for derivative financial instruments under ASC 815, Derivatives and Hedging. We do not trade derivative instruments as a part of our normal continuing operations. We held a derivative instrument for the price protection of the value of the Mesoblast stock held from falling below $15.0 million for a one year period, which was included in trading securities on the Balance Sheet as of December 31, 2013. The fair value of the price protection instrument was $1.7 million at December 31, 2013. The price protection ended in December 2014 and Mesoblast committed to us to purchase the Mesoblast ordinary shares held by us for no less than $15 million. Therefore, as of December 31, 2014, we no longer had a derivative instrument.
Fair Value Accounting
We report the value of our financial assets under ASC 825, Financial Instruments, at fair value in the accompanying financial statements. Fair value is defined as the price at which an asset could be exchanged or a liability transferred (an exit price) in an orderly transaction between knowledgeable, willing parties in the principal or most advantageous market for the asset or liability. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available, valuation models are applied.
Research and Development Costs
We expense internal and external research and development ("R&D") costs, including costs of funded R&D arrangements and the manufacture of clinical batches of our biologic drug candidates used in clinical trials, in the period incurred.
Biosurgery research and development expenses were $6.9 million, $5.0 million, and $5.5 million, in fiscal 2014, 2013 and 2012 respectively, which includes costs incurred for Protocol 302 designed to allow for the collection of data necessary to obtain the permanent HCPCS Q-codes that began during the second fiscal quarter of 2012.
Income Taxes
Deferred tax liabilities and assets are recognized for the estimated future tax consequences of temporary differences, income tax credits and net operating loss carry-forwards. Temporary differences are primarily the result of the differences between the tax bases of assets and liabilities and their financial reporting values. Deferred tax liabilities and assets are measured by applying the enacted statutory tax rates applicable to the future years in which deferred tax liabilities or assets are expected to be settled or realized. Valuation allowances are established when necessary to reduce deferred tax
assets to the amount expected to be realized. Income tax expense, if any, consists of the taxes payable for the current period and the change during the period in deferred tax assets and liabilities.
We recognize in our financial statements the impact of a tax position, if that position is more likely than not to be sustained upon an examination, based on the technical merits of the position. Interest and penalties related to income tax matters are recorded as income tax expense. At December 31, 2014 and 2013, we had no accruals for interest or penalties related to income tax matters.
Share-Based Compensation
We account for share-based payments using the fair value method.
We recognize all share-based payments to employees and non-employee directors in our financial statements based on their grant date fair values, calculated using the Black-Scholes option pricing model. Compensation expense related to share-based awards is recognized on a straight-line basis based on the value of share awards that are expected to vest during the requisite service period on the grant date, which is revised for forfeitures.
Income per Common Share
Basic income per common share is calculated by dividing net income by the weighted average number of common shares outstanding during the period. Diluted income per common share adjusts basic income per share for the potentially dilutive effects of common share equivalents, using the treasury stock method, and includes the incremental effect of shares that would be issued upon the assumed exercise of stock options and warrants.
Diluted loss from continuing operations for the year ended December 31, 2014 excluded all 1,608,557 shares issuable upon the exercise of options, as their impact on our loss from continuing operations is anti-dilutive. As a result, basic and diluted weighted average common shares outstanding are identical.
Diluted loss from continuing operations for the year ended December 31, 2013 excluded all 1,233,767 shares issuable upon the exercise of options, as their impact on our loss from continuing operations is anti-dilutive. As a result, basic and diluted weighted average common shares outstanding are identical.
Diluted loss per common share for the year ended December 31, 2012 excludes the 1,000,000 shares issuable upon the exercise of an outstanding "out-of the money" warrant, and all 1,826,114 of our outstanding options as of December 31, 2012, as their impact on our net loss is anti-dilutive. As a result, basic and diluted weighted average common shares outstanding are identical.
Derivative Instruments
Generally, we do not enter into hedging or derivative instrument arrangements. In connection with the sale of our Therapeutics business, we did receive $15 million of Mesoblast Limited ordinary shares which were restricted from sale for a period of twelve months. Mesoblast provided us with limited down-size protection in the event that the value of the shares when the restrictive period expired was lower than the price when the shares were issued. In the event the price was lower, Mesoblast agreed to pay us the difference in price, 50% of which would be in cash and the balance in either cash or additional Mesoblast shares, at the sole discretion of Mesoblast. In the event Mesoblast issued additional shares in this regard, the new shares would be subject to a new twelve month restriction period. We accounted for this as a derivative instrument. The price protection ended in December 2014 and Mesoblast has committed to us to purchase the Mesoblast ordinary shares held by us for no less than $15 million in the first half of fiscal 2015. Therefore, as of December 31, 2014, we no longer had a derivative instrument.
Results of Operations
Year ended December 31, 2014 compared to December 31, 2013
Product Revenues & Gross Profit
During fiscal 2014, our revenue from product distribution more than doubled to $59.9 million, as we continued to focus on the commercialization of our Biosurgery products. The increases in revenue were achieved through the expansion of our in-house sales and marketing team, as well as increased attributed to our product distributors. We experienced growth in sales in both Grafix and Ovation over this period. In addition, in 2013 we introduced Cartiform, a viable cartilage mesh for cartilage repair. During the latter half of fiscal 2014, we completed the transition of Ovation and introduced OvationOS (now branded as BIO4 by Stryker), a viable bone matrix for bone growth.
Our gross profit margin increased in fiscal 2014 to 78% compared to 73% in the prior year, primarily as the result of operational efficiencies as we more heavily utilize our production facilities. Throughout fiscal 2013 and 2014, we continued to operate our manufacturing facilities at our Columbia, Maryland location using one shift and have capacity to facilitate further growth without substantial increases in our clean room and manufacturing facilities.
Research and Development Expenses
Research and development expenses in fiscal 2014 were $6.9 million compared to $5.0 million in fiscal 2013. Just over half of our fiscal 2013 R&D spending was related to Protocol 302 to evaluate the efficacy of Grafix compared to the standard of care in the treatment of diabetic foot ulcers. The remaining 2013 R&D costs were spent on both new product development and product improvements. These efforts resulted in the introduction of OvationOS and Cartiform, and in novel packaging and application improvements to our Grafix product line. In 2014, we continued to increase investment in the development of innovative products. We continue to make substantial investments in research and development activities during fiscal 2015, as we further our research into using Grafix in the treatment of venous leg ulcers and other indications.
Selling, General and Administrative Expenses
Selling, general and administrative expenses rose to $37.4 million during fiscal 2014 compared to $15.3 million in fiscal 2013, driven in large part by the increase in sales people from 10 at the end of 2013 to approximately 100 at the end of 2014. The significant majority of these cost increases were incurred in sales and marketing efforts to increase our product distribution and to build up our infrastructure in the areas of reimbursement for public and private health care providers. During fiscal 2013, we hired our own in-house direct sales force, primarily for Grafix, and invested in training and more extensive product support capabilities. Selling, general and administrative costs were 62.5% of product revenue in fiscal 2014 compared to 62.9% during fiscal 2013. We will continue to heavily invest in our sales, marketing and reimbursement capabilities in fiscal 2015 and also incur additional costs to augment our human resources, finance and information technology capabilities to support our expanding sales force.
Other Income (expense), net
Other (expense) income, net in fiscal 2014 was $(1.8 million) compared to $414,000 in fiscal 2013. Other expense, net in fiscal 2014 consisted of the net realized investment income earned on our investments available for sale, together with unrealized loss on the market value decrease in the Mesoblast stock we received in connection with the sale of our Therapeutics business. We carry the Mesoblast stock as Trading Securities. Our fiscal 2013 Other income, net also included approximately
$50,000 from the market value decline of the derivative resulting from the limited downside protection afforded us on the market value of the Mesoblast stock.
Income Taxes
The total tax provision for 2014 is a combination of $193,000 from continuing operations and $941,000 from the portion of the proceeds from the sale of discontinued operations received in 2014, which is reflected as a component of discontinued operations. The tax expense from continuing operations is due to federal alternative minimum taxes and state taxes.
Because realization of deferred tax assets is dependent upon future earnings, a full valuation allowance has been recorded on the net deferred tax assets as of December 31, 2013 and 2014, which relate primarily to net operating loss and various business tax credit carry-forwards. In the event that we become profitable, we have general business credits (before a 100% valuation allowance) of approximately $70.5 million that may be utilized to reduce our Federal tax but not below the alternative minimum tax threshold. In addition, windfall equity based compensation deductions in the amount of $5.4 million are tracked but not recorded to the balance sheets until they are reduce income taxes payable on a with-and-without basis.
The total tax provision for 2013 is a combination of the income tax benefit of $1.3 million from continuing operations and the gain from sale of discontinued operations, which is reflected net of income taxes of $1.7 million. The tax provision for 2013 reflected an effective tax rate benefit for continuing operations of 54.8% and was greater than the U.S. statutory tax rate of 35%,due primarily to the tax benefit from disqualifying dispositions of incentive stock options (excluding windfall tax benefits). We were also subject to the alternative minimum tax of $388,000 in 2013, which was included in the income taxes allocated to the gain from the sale of discontinued operations.
In October 2013, we entered into an agreement with a wholly owned subsidiary of Mesoblast Limited for the sale of our culture-expanded mesenchymal stem cell (ceMSC) business, including Prochymal, in a transaction valued up to $100 million. Of the $50 million in initial consideration, $20 million was paid in cash and $15 million was paid in shares of Mesoblast Limited stock, prior to the close of fiscal 2013. The remaining $15 million payment was received in April 2014. The $50 million in initial consideration was recognized for financial statement reporting purposes and reported as a $49.4 million gain from sale of discontinued operations. For income tax purposes, the $35 million received was recognized in fiscal 2013 and the balance of the initial consideration of $15 million is recognized in fiscal 2014 for income tax purposes. The tax effect of the $15 million consideration received in fiscal 2014 was reported as a deferred tax liability in the amount of $6.1 million in 2013. This deferred payment also required that interest be accrued in the amount of $103,000 that increased the income taxes payable in 2013.
Amended income tax returns were filed for fiscal years 2010, 2011 and 2012 to reverse the calculation of the Orphan Drug Tax Credit taken in those years and increase the net operating loss carry-forwards which will be utilized to offset the gain generated from sale of discontinued operations. The amended 2010 federal income tax return will generate income tax recoverable in the amount of $79,000. We have recorded a full valuation allowance against our net deferred tax assets as of December 31, 2014 and 2013. The inventory of deferred tax assets has been updated for these income tax amendments. Such refunds were received in 2014.
In fiscal 2012, we recognized an income tax benefit of $37,000 from continuing operations, in connection with truing up our tax asset accounts in connection with the filing of our 2011 income tax returns.
Fees Paid to Related Parties, Including Share-Based Payments
In fiscal 2014 and 2013, we compensated non-employee members of our Board of Directors by grants of stock ranging from 2,500-10,000 shares annually, and we permit the directors to take their payments in either cash or stock or a combination thereof. During 2014, our non-employee Directors were awarded the value of 35,000 shares of our common stock which had a fair market value of $14.93 per share. This was paid with $119,400 of cash and 27,000 shares of stock valued at $403,100. During fiscal 2013, our non-employee Directors were awarded the value of 31,250 shares of our common stock which had a fair market value of $7.73 per share. This was paid with $62,000 of cash and 23,250 shares of stock valued at $180,000.
Year ended December 31, 2013 compared to December 31, 2012
Product Revenues & Gross Profit
During fiscal 2013, our revenue from product distribution more than tripled compared to the prior year to $24.3 million, as we continued to focus on the commercialization of our Biosurgery products. The increases in revenue were achieved through the expansion of our in-house sales and marketing team, as well as increases from our product distributors. We experienced growth in sales in both Grafix and Ovation and during the fiscal year introduced OvationOS, a viable bone matrix for bone growth, and Cartiform, a viable cartilage mesh for cartilage repair. Our gross profit increased in fiscal 2013 to 73% compared to 67% in the prior year, primarily as the result of operational efficiencies as we more heavily utilized our production facilities. Throughout fiscal 2013, we continued to operate our manufacturing facilities at our Columbia, Maryland location using one shift and had the capacity to facilitate further growth without substantial increases in our clean room and manufacturing facilities.
Research and Development Expenses
Research and development expenses in fiscal 2013 were $5.0 million compared to $5.5 million in fiscal 2012. A little over half of our fiscal 2013 R&D spending was related to Protocol 302 to evaluate the efficacy of Grafix compared to the standard of care in the treatment of diabetic foot ulcers. The remaining R&D costs were spent on both new product development and product improvements. These efforts resulted in the introduction of OvationOS and Cartiform, and in novel packaging and application improvements to our Grafix product line.
Selling, General and Administrative Expenses
Selling, general and administrative expenses rose to $15.3 million during fiscal 2013 compared to $5.5 million in fiscal 2012. The significant majority of these cost increases were incurred in sales and marketing efforts to increase our product distribution and to build up our infrastructure in the areas of reimbursement for public and private health care providers. During fiscal 2013, we hired our own in-house direct sales force, primarily for Grafix, and invested in training and more extensive product support capabilities. Selling, general and administrative costs were 62.9% of product revenue in fiscal 2013 compared to 69.8% during fiscal 2012.
Other Income, net
Other income, net in fiscal 2013 consisted of the net realized investment income earned on our investments available for sale, together with unrealized gain of approximately $400,000 on the market value increase of the Mesoblast stock we received in connection with the sale of our Therapeutics business. We carried the Mesoblast stock as Trading Securities. Our fiscal 2013 Other income, net also included approximately $50,000 from the market value decline of the derivative resulting from the limited downside protection afforded us on the market value of the Mesoblast stock. Other income, net
in fiscal 2013 was $414,000, compared to $49,000 in fiscal 2012. Fiscal 2012 Other income, net was comprised solely of the net investment gains on our investments available for sale.
Income Taxes
In fiscal 2013, we sold our Therapeutics business for initial consideration of $50 million, all of which was recognized for financial reporting purposes. The resulting gain from the sale of discontinued operations was substantially greater than the $2.4 million loss before income taxes that we reported on our operations of continuing operations and the loss from the operations of discontinued operations of $6.7 million. For income tax purposes, $35 million of the initial consideration was taxable in fiscal 2013, and the additional $15 million was taxable in 2014 when we received the payment.
The total tax provision for 2013 is a combination of the income tax benefit of $1.3 million from continuing operations and the gain from sale of discontinued operations, which is reflected net of income taxes of $1.7 million. The tax provision for 2013 reflects an effective tax rate benefit for continuing operations of 54.8% and was greater than the U.S. statutory tax rate of 35% due primarily to the tax benefit from disqualifying dispositions of incentive stock options (excluding windfall tax benefits). We were also subject to the alternative minimum tax of $388,000, which was included in the income taxes allocated to the gain from the sale of discontinued operations.
In fiscal 2012, we recognized an income tax benefit of $37,000 from continuing operations, in connection with truing up our tax asset accounts in connection with the filing of our 2011 income tax returns.
We recorded a full valuation allowance against our net deferred tax assets as of December 31, 2013 and 2012.
Fees Paid to Related Parties, Including Share-Based Payments
In fiscal 2013 and 2012, we compensated non-employee members of our Board of Directors by grants of stock ranging from 2,500-10,000 shares annually, and we permit the directors to take their payments in either cash or stock or a combination thereof. During fiscal 2013, our non-employee Directors were awarded the value of 31,250 shares of our common stock which had a fair market value of $7.73 per share. This was paid with $62,000 of cash and 23,250 shares of stock valued at $180,000. During fiscal 2012, our non-employee Directors were awarded the value of 30,000 shares of our common stock which had a fair market value of $5.08 per share. This was paid with $25,000 in cash and 25,000 shares of stock valued at $127,000.
Liquidity and Capital Resources
Liquidity
At December 31, 2014, we had $2.2 million in cash and $37.3 million in investments available for sale. Other receivables at December 31, 2014 included the $5.0 million initial payment from Stryker and the $4.0 million difference between the market value at December 31, 2014 of the Mesoblast ordinary shares held by us and the $15 million agreed by Mesoblast required to be paid to us. As of December 31, 2014, the trading securities of $10.6 million include the fair value of the Mesoblast stock held by us. We have not had any outstanding debt at any time since fiscal 2008.
Cash Flow
The following table sets forth a summary of our cash flows for each of our three most recently completed fiscal years:
Net cash used in operating activities of continuing operations was $16.6 million for the year ended December 31, 2014, and primarily reflects our net loss of $0.2 million and net increases in our trade receivables and inventory, partially offset by non-cash charges and increase in accounts payable and accrued expenses.
Net cash used in operating activities of continuing operations during fiscal 2013 was $3.0 million, and primarily reflects our net loss of $1.1 million and net increases in our trade receivables and inventory, partially offset by non-cash charges.
Net cash used in operating activities of continuing operations during fiscal 2012 was $4.8 million, and reflects our net loss of $5.7 million, partially offset by $1.1 of non-cash charges and net unfavorable changes in working capital.
Net cash provided by investing activities was $1.1 million, $11.6 million, and $13.3 million, respectively, during fiscal years 2014, 2013, and 2012, and in each year primarily reflects proceeds from the sales of our investments to fund our operations, as well as the proceeds from the sale of our Therapeutics business.
Net cash provided by financing activities was $1.9 million and $2.2 million in fiscal 2014 and 2013, respectively, and was insignificant in the year ended December 31, 2012. The fiscal 2014 cash provided by financing activities is primarily the net proceeds from the exercise of stock options by our employees to purchase our common stock.
Capital Resources
Our future capital requirements will depend on many factors, including:
• the scope and results of our research and preclinical development programs;
• the scope and results of our clinical trials;
• the timing of and the costs involved in obtaining regulatory approvals for our biologic product candidates, which could be more lengthy or complex than obtaining approval for a new conventional drug, given the FDA's limited experience with late-stage clinical trials and marketing approval for stem cell biologics;
• the costs of maintaining, expanding and protecting our intellectual property portfolio, including possible litigation costs and liabilities; and
• the costs of enlarging our work force consistent with expanding our business and operations and distribution of our Biosurgery products.
We did not have any outstanding debt at any time during 2014.
Off-Balance Sheet Arrangements
We have no off-balance sheet financing arrangements and we have not entered into any transactions involving unconsolidated subsidiaries or special purpose entities.
Future Contractual Obligations
The following table sets forth our estimates as to the amounts and timing of contractual payments for our most significant contractual obligations at December 31, 2014. The information in the table reflects future unconditional payments and is based on the terms of the relevant agreements, appropriate classification of item under accounting principles generally accepted in the United States and certain assumptions. Future events could cause actual payments to differ from these amounts.
Contract Research Organizations. We contract with independent contract research organizations, or CROs, to perform many of the tasks required under our clinical trials, and we utilize their testing expertise to ensure the objectivity of the clinical results. Under the terms of these agreements, we design the protocol regarding the testing to be performed, and the CRO assists in the enrollment of the patients and testing sites, administers the trial, performs statistical analysis of the results, and compiles the final report.
We pay fees directly to the CROs for their professional services, which may be payable upon specified trial milestones or as they provide services, depending on the structure of the contract. We are also responsible for reimbursing the CROs for certain pass thru expenses they incur in administering the trial. The timing of our payments to the CROs is dependent upon the progress of the various trials, which is highly variable dependent upon the speed with which the CROs are able to enroll patients and testing sites. As such, we are unable to specifically predict the timing of future payments to CROs in connection with a specific clinical trial.
We have active contracts with a CRO related to on-going clinical trials. Although we cannot directly control the timing of the remaining payments, based on our estimates and assumptions as of February 27, 2015, we expect to pay approximately $10.7 million to the CRO between fiscal 2015 and fiscal 2017.
Leases. During 2006, we entered into a sublease agreement for approximately 61,000 square feet of laboratory, production, warehouse and office space in Columbia, Maryland. We have also entered into a direct lease with the owner of this facility that was effective as of June 1, 2009 upon the expiration of the sublease and originally expired in July 2016. According to the terms of the lease agreement, we were required to provide a letter of credit which was fully collateralized by restricted cash and as of December 31, 2013, the letter of credit of $224,000 remained outstanding. In September 2014, we entered into an amendment to the operating lease for our Columbia, Maryland facilities, extending the term of the lease through October 2023 and increasing the future minimum lease commitment by $9.0 million. The lease amendment includes an allowance for tenant improvements of approximately $1.5 million that we expect to utilize in 2015 to expand our manufacturing facilities and adjust our office space to accommodate our additional employees. Under the amended lease
agreement, we also replaced the $224,000 letter of credit with a $96,000 cash deposit and eliminated all restricted cash.
Effect of Inflation
Inflation and changing prices are not generally a material factor affecting our business. General operating expenses such as salaries, employee benefits and lease costs are, however, subject to normal inflationary pressures.
ITEM 7A.
ITEM 7A. Quantitative and Qualitative Disclosures about Market Risk.
Interest Rate Risk
Due to the short duration of our investment portfolio and the high quality of our investments, an immediate 10% change in interest rates would not have a material effect on the value of our portfolio. Therefore, we would not expect our operating results or cash flows to be affected to any material degree by the effect of a sudden change in market interest rates on our securities portfolio.
We believe that the interest rate risk related to our accounts receivable is not significant. We manage the risk associated with these accounts through periodic reviews of the carrying value for non-collectability and establishment of appropriate allowances in connection with our internal controls and policies.
Derivative Instruments
Generally, we do not enter into hedging or derivative instrument arrangements. In connection with the sale of our Therapeutics business, we did receive $15 million of Mesoblast Limited ordinary shares which were initially restricted from sale for a period of twelve months. Mesoblast provided us with limited down-size protection in the event that the value of the shares when the restrictive period expires is lower than the price when the shares were issued. In the event the price is lower, Mesoblast agreed to pay us the difference in price, 50% of which in cash and the balance in either cash or additional Mesoblast shares, at the sole discretion of Mesoblast. The agreement further provided that, in the event Mesoblast issued additional shares in this regard, the new shares would be subject to a new twelve month restriction period. We accounted for this as a derivative instrument. In December 2014, the price protection was removed and Mesoblast agreed to purchase the Mesoblast ordinary shares for no less than $15 million. Accordingly, we did not have a derivative instrument as of December 31, 2014.
Foreign Currency Exchange Rate Risk
We conduct clinical trial activities in areas that operate in a functional currency other than the United States dollar (USD). As a result, when the USD rises and falls against the functional currencies of these other nations, our costs will either increase or decrease by the relative change in the exchange rate. Foreign currency gains and losses were not material during the three years ended December 31, 2014, and at the present time, we have elected not to hedge our exposure to foreign currency fluctuations.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
OSIRIS THERAPEUTICS, INC.
FINANCIAL STATEMENTS
INDEX
*All other information and financial statement schedules are omitted because they are not applicable, or required, or because the required information is included in the consolidated financial statements or notes thereto.
REPORT OF MANAGEMENT
Management's Report on Financial Statements
Our management, under the supervision of the Company's Chief Executive and Chief Financial Officers, is responsible for the preparation, integrity and fair presentation of information in our financial statements, including estimates and judgments. The financial statements presented in this Annual Report on Form 10-K have been prepared in accordance with accounting principles generally accepted in the United States of America. Our management believes the financial statements and other financial information included in this Annual Report on Form 10-K fairly present, in all material respects, our financial condition, results of operations and cash flows as of and for the periods presented in this Annual Report on Form 10-K. The financial statements included herein have been audited by BDO USA, LLP, an independent registered public accounting firm, as stated in their report.
Management's Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.
Our internal control over financial reporting includes those policies and procedures that:
• pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect our transactions and dispositions of our assets;
• provide reasonable assurance that our transactions are recorded as necessary to permit preparation of our financial statements in accordance with accounting principles generally accepted in the United States of America, and that our receipts and expenditures are being made only in accordance with authorization of our management and our directors; and
• provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting can provide only reasonable assurance and may not prevent or detect misstatements. Also, projections of any evaluation of the effectiveness of such controls in future periods are subject to the risk that the controls may become inadequate because of changes in conditions or that the degree of compliance with the policies and procedures may deteriorate.
Our management, including our Chief Executive Officer and Chief Financial Officer, assessed the effectiveness of our internal control over financial reporting as of December 31, 2014. In making this assessment, our management used the criteria set forth in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on its assessment, including the remediation of the material weakness described below, our management concluded that, as of December 31, 2014, our internal control over financial reporting was effective based on those criteria.
The previously identified material weakness relating to the maintenance of effective controls over the application and monitoring of our accounting for income taxes was remediated during the year ended December 31, 2014. We enhanced our processes by engaging a new third party tax advisor and also enhanced our existing controls over financial reporting by including a formal review of the provision to ensure completeness and accuracy. Management has remediated the material weaknesses and will continue to review and make necessary changes to the overall design of its internal control
environment in 2015 and beyond, as well as to policies and procedures to improve the overall effectiveness of internal control over financial reporting.
BDO USA, LLP has issued an attestation report on our internal control over financial reporting. This report is referred to in the Report of Independent Registered Public Accounting Firm on the following page, and is included elsewhere herein.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders of
Osiris Therapeutics, Inc.
Columbia, Maryland
We have audited the accompanying balance sheets of Osiris Therapeutics, Inc. as of December 31, 2014 and 2013 and the related statements of comprehensive (loss) income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2014. In connection with our audits of the financial statements, we have also audited the financial statement schedule listed in the accompanying index. These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and schedule. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Osiris Therapeutics, Inc. at December 31, 2014 and 2013, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2014, in conformity with accounting principles generally accepted in the United States of America.
Also, in our opinion, the financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Osiris Therapeutics, Inc.'s internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 20, 2015 expressed an unqualified opinion thereon.
/s/ BDO USA, LLP
Bethesda, Maryland
March 20, 2015
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
Osiris Therapeutics, Inc.
Columbia, Maryland
We have audited Osiris Therapeutics, Inc.'s internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Osiris Therapeutics, Inc.'s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying "Item 9A, Management's Report on Internal Control Over Financial Reporting". Our responsibility is to express an opinion on the company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Osiris Therapeutics, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2014, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the balance sheets of Osiris Therapeutics, Inc. as of December 31, 2014 and 2013, and the related statements of comprehensive (loss) income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2014 and our report dated March 20, 2015 expressed an unqualified opinion thereon.
/s/ BDO USA, LLP
Bethesda, Maryland
March 20, 2015
OSIRIS THERAPEUTICS, INC.
BALANCE SHEETS
(amounts in thousands, except per share amounts)
The accompanying notes are an integral part of these financial statements.
OSIRIS THERAPEUTICS, INC.
STATEMENTS OF COMPREHENSIVE (LOSS) INCOME
(amounts in thousands, except per share data)
The accompanying notes are an integral part of these financial statements.
OSIRIS THERAPEUTICS, INC.
STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(amounts in thousands, except for share and per share data)
The accompanying notes are an integral part of these financial statements.
OSIRIS THERAPEUTICS, INC.
STATEMENTS OF CASH FLOWS
(amount in thousands)
The accompanying notes are an integral part of these financial statements.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
1. Description of Business and Significant Accounting Policies
Description of Business
Osiris Therapeutics, Inc. ("we," "us," "our," or the "Company") is a Maryland corporation headquartered in Columbia, Maryland. We began operations on December 23, 1992 and were a Delaware corporation until, with approval of our stockholders, we reincorporated as a Maryland corporation on May 31, 2010. We are a world leader in researching, developing and marketing cellular regenerative medicine products that improve the health and lives of patients and lower overall healthcare costs. We continue to advance research and development in biotechnology by focusing on innovation in regenerative medicine, including bioengineering, stem cell research and viable tissue based products. Osiris has achieved commercial success with products in orthopedics, sports medicine and wound care.
From 2010 to 2013, we operated our business in two segments, Biosurgery and Therapeutics. Our Biosurgery business focuses on products for wound healing, cartilage repair, and orthopedics to harness the ability of cells and novel constructs to promote the body's natural healing. Our Therapeutics business focused on developing biologic stem cell drug candidates from a readily available and non-controversial source-adult bone marrow-until it was sold, as described further below.
Our Biosurgery business has continued to grow since its inception, and we have increased our organizational focus on the development and commercialization of products in this segment. Consistent with this organizational focus, as discussed further in Note 2-Discontinued Operations below, on October 10, 2013, we entered into a Purchase Agreement to sell our Therapeutics segment, including all of our culture expanded mesenchymal stem cell business, including Prochymal and other related assets. We eliminated the Therapeutics segment from our continuing operations as a result of the disposal transaction, and have presented the assets, liabilities, and results of the segment's operations as a discontinued operation for all periods presented. Our continuing operations now represent the portion of our business previously referred to as our Biosurgery segment.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Due to the inherent uncertainty involved in making those assumptions, actual results could differ from those estimates. We believe that the most significant estimates that affect our financial statements are those that relate to deferred tax assets, inventory valuation, share-based compensation and the value of the derivative obtained in connection with the sale of our former Therapeutics business.
Cash and Cash Equivalents
Amounts listed as cash on our balance sheets are maintained in depository accounts at a commercial bank. Cash and cash equivalents, which include highly liquid investments with maturities of three months or less when purchased, held in our brokerage investment accounts are classified as investments available for sale, as the amounts represent investments that have matured and are anticipated to be reinvested in debt securities in the near future, and are disclosed at fair value, which approximates cost.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
1. Description of Business and Significant Accounting Policies (Continued)
Reclassifications
We have reclassified certain prior-year amounts for comparative purposes. These reclassifications did not affect our results of operations or financial positions for the years presented.
Investments Available for Sale
Investments available for sale consist primarily of marketable securities with maturities less than one year. Investments available for sale are valued at their fair value, with unrealized gains and losses reported as a separate component of stockholders' equity in accumulated other comprehensive income. All realized gains and losses on our investments available for sale are recognized in results of operations as other income.
Investments available for sale are evaluated periodically to determine whether a decline in their value is "other than temporary." The term "other than temporary" is not intended to indicate a permanent decline in value. Rather, it means that the prospects for near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the security. We review criteria such as the magnitude and duration of the decline, as well as the reasons for the decline, to predict whether the loss in value is other than temporary. If a decline in value is determined to be other than temporary, the carrying value of the security is reduced and a corresponding charge to earnings is recognized.
Restricted Cash
We periodically are required under the terms of various agreements to provide letters of credit which are collateralized by cash deposits. The majority of the restricted cash balance relates to a letter of credit that we caused to be issued in lieu of a security deposit under the operating lease for our Columbia, Maryland facility.
Trade Accounts Receivable
Trade accounts receivable are reported at their net realizable value. We charge off uncollectible receivables when the likelihood of collection is remote. We set credit terms with individual customers, and consider receivables outstanding longer than the time specified in the respective customer's contract, typically 45-days, to be past due. As of December 31, 2014 and 2013, accounts receivable in the accompanying balance sheets are reported net of a $1,256,000 and a $78,000 allowance for doubtful accounts, respectively. We believe the reported amounts are fully collectible. Trade accounts receivable balances are not collateralized. We have incurred bad debt expense of $1,178,000, $80,000 and $22,000 related to our Biosurgery operations during fiscal 2014, 2013 and 2012, respectively.
Inventory
We began carrying inventory of our Biosurgery products on our balance sheet following commercial launch of such products. Inventory consists of raw materials, biologic products in process, and products available for distribution. We determine our inventory values using the first-in, first-out method. Inventory is valued at the lower of cost or market, and excludes units that we anticipate distributing for clinical evaluation.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
1. Description of Business and Significant Accounting Policies (Continued)
Property and Equipment
Property and equipment, including improvements that extend useful lives, are valued at cost, while maintenance and repairs are charged to operations as incurred. Depreciation is calculated using the straight-line method based on estimated useful lives ranging from three to seven years for furniture, equipment and internal use software. Leasehold improvements and assets under capital leases are amortized over the shorter of the estimated useful life of the asset or the original term of the lease.
Valuation of Long-lived Assets
We review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or group of assets may not be fully recoverable. These events or changes in circumstances may include a significant deterioration of operating results, changes in business plans, or changes in anticipated future cash flows. If an impairment indicator is present, we evaluate recoverability by a comparison of the carrying amount of the assets to future undiscounted net cash flows expected to be generated by the assets. Assets are grouped at the lowest level for which there is identifiable cash flows that are largely independent of the cash flows generated by other asset groups. If the total of the expected undiscounted future cash flows is less than the carrying amount of the asset, an impairment loss is recognized for the difference between the fair value and carrying value of assets. Fair value is generally determined by estimates of discounted cash flows. The discount rate used in any estimate of discounted cash flows would be the rate required for a similar investment of like risk. There were no impairment losses recognized during fiscal years 2014, 2013 or 2012.
Derivative and Securities Received in Business Disposition
As discussed in Note 2-Discontinued Operations, we disposed of our Therapeutics segment in October 2013. A portion of the consideration for the sale of that business was stock of Mesoblast Limited ("Mesoblast"), the parent of the purchaser. We were required to hold that stock for one year from the date of receipt. We intended to dispose of the Mesoblast stock as soon as we were able to do so. Mesoblast is a public company and its stock is traded on the Australian stock exchange. As of December 31, 2014 and 2013, we reflect the investment as a current asset in Trading Securities. In December 2014, the price protection on these shares expired, but Mesoblast agreed to pay us $15 million in cash for the stock in the first half of fiscal 2015. Accordingly, as of December 31, 2014, this $15 million is shown as $10.6 million in Trading Securities and $4.4 million in Other Receivables on our Balance Sheets.
The Mesoblast stock was previously subject to limited price protection for the one year required holding period. To the extent the value of those shares decreased during the holding period, Mesoblast was required to pay us for the decrease in value. This payment was to be made at least one half in cash and at the option of Mesoblast, up to one half in additional shares of Mesoblast stock. Any additional Mesoblast stock would also have to be held for one year during which period there was no further price protection. In fiscal 2013, the price protection was accounted for as a derivative under ASC 815, Derivatives and Hedging, and, as such was recorded on the balance sheets at fair value, with changes recognized in net income. We elected to measure the Mesoblast stock at fair value with changes in fair value reflected in net income, as permitted under ASC 825-10, Financial Instruments-Fair Value Option. The price protection ended in December 2014 and we no longer have a derivative instrument.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
1. Description of Business and Significant Accounting Policies (Continued)
All derivative instruments within the scope of ASC 815, Derivatives and Hedging, are recorded on the balance sheet at fair value. As of December 31, 2013 our only derivative instrument was the price guarantee regarding the payment received in restricted Mesoblast shares described in Note 13-Derivative and Securities Received in Business Disposition below. We do not hold derivative financial instruments for trading purposes.
Biosurgery Revenue Recognition
We recognize revenue from product distribution when title passes to the customer. Title usually passes when the product is shipped to the customer and leaves our loading dock. In some situations, we store consigned inventory on site in freezers at hospital or clinic facilities. No revenue is recognized upon the placement of inventory into consignment as we retain title and maintain the inventory on our balance sheet. For these products, revenue is recognized when we receive appropriate notification that the product has been used in a surgical procedure. We verify the condition and status of all consigned inventory on at least a quarterly basis. Due to the nature of our products and the need to ensure they are maintained at the proper frozen temperature, we generally do not allow product returns.
In December 2014, we entered into exclusive distribution agreements with a subsidiary of Stryker Corporation for the marketing and distribution of BIO4, our viable bone matrix allograft. Pursuant to the agreement, Stryker has been granted worldwide distribution rights to the product and any improvements, for all surgical applications. We will be responsible for supply, manufacturing, inventory management, shipments to customers, continued research and product improvement activities. We will recognize as revenue the amounts charged to customers for the allografts and related services. Commissions and administrative fees paid to Stryker will be accounted for as selling expenses, as Stryker is acting as outside sales and marketing agent for Osiris. We are entitled to receive an initial exclusivity fee of $5.0 million and additional fees upon any exercise by Stryker of its right to extend the initial term, whether on an exclusive or non-exclusive basis. The exclusivity fee and any extension fees subsequently received are considered to be adjustments of the selling expenses. As such, we recognize the exclusively fee as a liability and will be amortized over the related exclusivity period in proportion to the expected fees to be paid to Stryker, as an offset to selling expenses. At December 31, 2014, Osiris recorded a $5.0 million receivable included in other receivables with the offset to short-term deferred commissions of $1.67 million and long-term deferred commissions $3.33 million included in other long term liabilities.
In October 2014, we entered into an exclusive commercial and development partnership for our cartilage product, Cartiform, with Arthrex, Inc. The agreement provides Arthrex with exclusive commercial distribution rights to Cartiform beginning in 2015. We will be responsible for manufacturing, continued research and product improvement activities. The responsibilities related to the design and conduct of future clinical development programs will be shared between both organizations. Pursuant to the agreement, Arthrex is entitled to a certain commission on Cartiform sales. We will recognize the full sales price as revenue and account for the payment to Arthrex as commission expense.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
1. Description of Business and Significant Accounting Policies (Continued)
Therapeutics Revenue Recognition
In our former Therapeutics business, we evaluated revenues from agreements that have multiple elements to determine whether the components of the arrangement represent separate units of accounting. To recognize a delivered item in a multiple element arrangement, the delivered items must have value on a standalone basis and the delivery or performance must be probable and within our control for any delivered items that have a right of return. The determination of whether multiple elements of a collaboration agreement meet the criteria for separate units of accounting requires us to exercise judgment. We account for the activities of our former Therapeutics business as discontinued operations.
Revenues from research licenses associated with our former Therapeutics business were recognized as earned upon either the incurring of reimbursable expenses directly related to the particular research plan or the completion of certain development milestones as defined within the terms of the agreement. Payments received in advance of research performance were designated as deferred revenue. Non-refundable upfront license fees and certain other related fees associated with our former Therapeutics business were recognized on a straight-line basis over the development periods of the contract deliverables. Fees associated with substantive at risk performance based milestones are recognized as revenue upon their completion, as defined in the respective agreements. Incidental assignment of technology rights were recognized as revenue when and if it was earned and received.
In October 2008, we entered into a Collaboration Agreement with Genzyme Corporation, then an independent and now a Sanofi company ("Genzyme"), for the development and commercialization of our biologic drug candidates, Prochymal and Chondrogen™. Under this agreement, Genzyme made non-contingent, non-refundable cash payments to us, totaling $130 million. The agreement provided Genzyme with certain rights to intellectual property developed by us, and required that we continue to perform certain development work related to the subject biologic drug candidates. In February 2012, Sanofi issued a press release which included an update on their R&D pipeline, stating that it had discontinued its project with Prochymal for GvHD. In September 2012, we reached agreement with Sanofi to conclude the Collaboration Agreement without either party having any continuing obligation to the other.
We evaluated the deliverables related to the upfront payments made to us under the Genzyme collaboration agreement, and concluded that the various deliverables represent a single unit of accounting. For this reason, we deferred the recognition of revenue related to the upfront payments, and amortized these amounts to revenue on a straight-line basis over the estimated delivery period of the required development services, which extended through January 2012.
Research and Development Costs
We expense internal and external research and development ("R&D") costs, including costs of funded R&D arrangements and the manufacture of clinical batches of Biosurgery products used in clinical trials, in the period incurred.
Internal resources are applied interchangeably across several product candidates due to the potential applicability of our biologic drug candidates for multiple indications.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
1. Description of Business and Significant Accounting Policies (Continued)
Income Taxes
Deferred tax liabilities and assets are recognized for the estimated future tax consequences of temporary differences, income tax credits and net operating loss carry-forwards. Temporary differences are primarily the result of the differences between the tax bases of assets and liabilities and their financial reporting values. Deferred tax liabilities and assets are measured by applying the enacted statutory tax rates applicable to the future years in which deferred tax liabilities or assets are expected to be settled or realized. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense, if any, consists of the taxes payable for the current period and the change during the period in deferred tax assets and liabilities.
We recognize in our financial statements the impact of a tax position, if that position is more likely than not to be sustained upon an examination, based on the technical merits of the position. Interest and penalties related to income tax matters are recorded as income tax expense. At December 31, 2014 and 2013, we had no accruals for interest or penalties related to income tax matters.
Income per Common Share
Basic income per common share is calculated by dividing net income by the weighted average number of common shares outstanding during the period. Diluted income per common share adjusts basic income per share for the potentially dilutive effects of common share equivalents, using the treasury stock method, and includes the incremental effect of shares that would be issued upon the assumed exercise of stock options and warrants.
Diluted loss from continuing operations for the year ended December 31, 2014 excluded all 1,608,557 shares issuable upon the exercise of options, as their impact on our loss from continuing operations is anti-dilutive. As a result, basic and diluted weighted average common shares outstanding are identical.
Diluted loss from continuing operations for the year ended December 31, 2013 excluded all 1,233,767 shares issuable upon the exercise of options, as their impact on our loss from continuing operations is anti-dilutive. As a result, basic and diluted weighted average common shares outstanding are identical.
Diluted loss per common share for the year ended December 31, 2012 excludes the 1,000,000 shares issuable upon the exercise of an outstanding "out-of the money" warrant, and all 1,826,114 of our outstanding options as of December 31, 2012, as their impact on our net loss is anti-dilutive. As a result, basic and diluted weighted average common shares outstanding are identical.
Share-Based Compensation
We account for share-based payments using the fair value method.
We recognize all share-based payments to employees and non-employee directors in our financial statements based on their grant date fair values, calculated using the Black-Scholes option pricing model. Compensation expense related to share-based awards is recognized on a straight-line basis for each vesting tranche based on the value of share awards that are expected to vest on the grant date, which is revised if actual forfeitures differ materially from original expectations.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
1. Description of Business and Significant Accounting Policies (Continued)
Comprehensive Income
Comprehensive income consists of net income and all changes in equity from non-stockholder sources, which consist of changes in unrealized gains and losses on investments.
Concentration of Risk
We maintain cash and short-term investment balances in accounts that exceed federally insured limits, although we have not experienced any losses on such accounts. We also invest excess cash in investment grade securities, generally with maturities of one year or less.
We have historically provided credit in the normal course of business to contract counterparties and to the distributors of our product. Trade accounts receivable in the accompanying balance sheets consist primarily of amounts due from distributors of our Biosurgery products within the United States. During fiscal 2014 and 2013 respectively, revenues from one of the distributors of our Biosurgery products, Stability Biologics, comprised approximately 10% and 50% of our total Biosurgery revenues. As of December 31, 2014 and 2013 respectively, receivables from this distributor comprised 13% and 6% of our total receivables. As discussed under "Trade Accounts Receivable" above, we have incurred bad debt expense of $1,178,000, $80,000 and $22,000 for the three years ended December 31, 2014, 2013 and 2012, respectively.
Recent Accounting Guidance Not Yet Adopted at December 31, 2014
In May 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers," which requires an entity to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. The new standard will replace most of the existing revenue recognition standards in U.S. GAAP when it becomes effective on January 1, 2017. Early adoption is not permitted. The new standard can be applied retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of the change recognized at the date of the initial application. We are currently assessing the impact the adoption of ASU 2014-09 will have on our financial statements.
In August 2014, the FASB issued ASU No. 2014-15, "Presentation of Financial Statements-Going Concern," which require management to evaluate, at each reporting period, whether there are conditions or events that raise substantial doubt about the entity's ability to continue as a going concern within one year after the date the financial statements are issued and provide related disclosures. ASU 2014-15 is effective for the annual period ending after December 15, 2016, and for annual periods and interim periods thereafter. We are currently assessing the impact the adoption of ASU 2014-15 will have on our financial statements.
2. Discontinued Operations
As reported on our Current Report on Form 8-K, dated October 10, 2013, we entered into a Purchase Agreement with Mesoblast, pursuant to the terms of which we sold our culture expanded mesenchymal stem cell (ceMSC) business, including Prochymal and other related assets. The Purchase Agreement provides for payment to us of $50 million in initial consideration, and payment of up to an additional $50 million upon the achievement by Mesoblast of certain clinical and regulatory milestones.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
2. Discontinued Operations (Continued)
Additionally, we will be entitled to earn low single to double digit cash royalties on future sales by Mesoblast of Prochymal and other products utilizing the acquired ceMSC technology.
The Purchase Agreement provides for the $50.0 million of initial payments and up to $50.0 million of contingent additional payments to us upon our achievement of milestone events, as follows:
Of the $50 million in total initial consideration, we received at December 31, 2013, payment of $20 million in cash, and $15 million in Mesoblast ordinary shares, which were delivered to us upon completed delivery of the ceMSC assets. The remaining $15 million of the initial consideration was paid in cash in April 2014. The Mesoblast shares received by us were subject to a one year holding period from the date of receipt, but had limited downside protection for a drop in the Mesoblast share price over the holding period. We evaluated this downside protection, and determined that it met the criteria of a derivative instrument. The fair value of the protection at the time of the disposition of our Therapeutics business was $1.7 million. We recognized the price protection derivative as an asset at December 31, 2013 at its then fair value of $1.7 million, which was reflected in the calculation of the gain on sale of the Therapeutics business. The price protection ended in December 2014 and Mesoblast agreed to pay us no less than $15 million in cash for the stock prior to the end of the first half of fiscal 2015. Accordingly, we no longer have a derivative instrument as of December 31, 2014.
Our ability to receive the second $50 million is subject to satisfaction of the milestones indicated above all of which are largely dependent upon the clinical and regulatory success of Mesoblast and other factors not in our control. These include many if not all of the risks and uncertainties that our ceMSC business was subject to prior to its sale to Mesoblast, including product development, efficacy and regulatory risks. We have received no such payments thus far, nor do we have any expectation of receiving any such payments in the foreseeable future. Our ability to earn royalties from Mesoblast is
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
2. Discontinued Operations (Continued)
subject to these same risks and will require performance by Mesoblast that results in its meeting some or all of the milestones referred to above, and is thereafter also dependent upon the commercial success of Mesoblast's ceMSC business. Royalties, if any, are payable to us in cash. Any portion of the second $50 million that becomes payable to us will be payable, at the discretion of Mesoblast, in Mesoblast ordinary shares, based on a then current valuation of such shares. Any such Mesoblast ordinary shares that we receive will also be subject to a one year holding period, with the same limited downside protection described above.
We eliminated the Therapeutics segment from our continuing operations as a result of the disposal transaction and have presented the assets, liabilities, and results of the segment's operations as a discontinued operation for all periods presented. We have no continuing involvement with the Therapeutics business, and the only continuing cash flows to us related to the Therapeutics business will be the contingent consideration and royalties provided for under the purchase agreement, as described above. We received no such contingent payments or royalties in 2014 or 2013.
We recognized a gain of approximately $49.4 million of the sale of discontinued operations during the year ended December 31, 2013, representing the $50.0 million in initial payments received under the Purchase Agreement and the $1.7 million fair value of the derivative instrument received, net of transaction costs of $0.6 million, including legal, accounting and advisory fees, and income tax expense of $1.7 million.
The net assets allocable to the Therapeutics business at December 31, 2014 and 2013 were as follows:
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
2. Discontinued Operations (Continued)
Summarized operating results of the Therapeutics segment are as follows:
Revenues for our Therapeutics segment historically consisted primarily of collaborative research agreements and royalties. Because of the disposition of our Therapeutics business in 2013, we no longer incur related research and development expenses related to these discontinued operations. Our Therapeutics segment also earned royalty revenues and cost reimbursement under our adult expanded access program. Royalties are earned on the sale of human mesenchymal stem cells sold for research purposes. We recognize this revenue as sales are made. Revenues from our former Therapeutics business include approximately $288,000 of royalty revenue in 2014, $215,000 of royalty revenue in 2013, and $305,000 of royalty revenue in 2012. Revenues from our former Therapeutics business also include approximately $0, $424 000, and $296,000 in cost reimbursement for Prochymal used in our adult expanded access program during 2014, 2013, and 2012, respectively.
3. Segment Reporting
Prior to the sale of our Therapeutics business in 2013, we managed our business in two operating segments: our Biosurgery segment and our Therapeutics segment.
Our Biosurgery segment is focused on the development, manufacture and distribution of biologic products for wound healing, cartilage repair, and orthopedics to harness the ability of cells and novel constructs to promote the body's natural healing. We launched Grafix for commercial distribution in 2010, began distribution of Ovation in early fiscal 2011, and began distribution of Cartiform during 2013. We transitioned Ovation to OvationOS (now branded as BIO4) during the second half of 2014. We have continued to increase our distribution volume of these products since their respective commercial launches and are developing additional products for future commercialization. We have developed a proprietary direct sales force in the field of wound care for the marketing and distribution of Grafix and have entered into exclusive distribution agreements with a subsidiary of Stryker Corporation for the marketing and distribution of BIO4, and with Arthrex, Inc. for the marketing and distribution of Cartiform.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
3. Segment Reporting (Continued)
Our Therapeutics segment focused on developing and marketing products to treat medical conditions in the inflammatory and cardiovascular disease areas. Its operations have focused on clinical trials and discovery efforts. As disclosed in Note 2-Discontinued Operations, we entered into a Purchase Agreement with Mesoblast, pursuant to the terms of which we sold our culture expanded mesenchymal stem cell business, including Prochymal and other related assets.
Given the sale of our former Therapeutics segment, we now have only one operating segment in the United States of America. As such, our financial statements present the assets, liabilities, and results of the former Therapeutics segment as discontinued operations for all periods presented, the rest of our balance sheets and statements of comprehensive (loss) income present information of the remaining Biosurgery segment.
4. Property and Equipment
Property and equipment at December 31, 2014 and 2013 are as follows:
Depreciation expense was $940,000, $587,000 and $552,000 for 2014, 2013 and 2012, respectively.
5. Inventory
We began carrying inventory of our Biosurgery products on our balance sheet following commercial launch of such products.
As of December 31, 2014 and 2013, inventory for our Biosurgery business consists of the following:
Prior to the transaction described in Note 2-Discontinued Operations, we did not carry any inventory for our Therapeutics products, as we had yet to launch Prochymal for commercial distribution.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
6. Capital Lease
In July 2012, we leased equipment under a capital lease at an effective interest rate of approximately 5%, with 60 monthly payments of $4,000 starting July 2012. The capital lease is recorded at the present value of the future minimum lease payments. Future minimum lease payments under the capital lease agreement at December 31, 2014 are as follows:
7. Share-Based Compensation
In April 2006, we adopted our 2006 Omnibus Plan. We amended and restated this plan in 2008 and 2010, and amended it further in 2012, in each case to, among other things, increase the number of shares available for grant. In addition, we had previously established our Amended and Restated 1994 Stock Incentive Plan. Both Plans authorize the issuance of various forms of stock-based awards, including incentive and non-qualified stock options, stock purchase rights, stock appreciation rights and restricted and unrestricted stock awards. A total of 2,250,000 shares of our common stock have been reserved for issuance under the Amended and Restated 2006 Omnibus Plan, and 736,378 shares were reserved under our Amended and Restated 1994 Stock Incentive Plan. We ceased all grants under the Amended and Restated 1994 Stock Incentive Plan concurrent with our initial public offering in August 2006. As a result, no shares are currently available for future awards under the Amended and Restated 1994 Stock Incentive Plan. At December 31, 2014, there were approximately 513,906 shares available for future awards under the Amended and Restated 2006 Omnibus Plan.
We generally issue stock option awards that vest over four years and have a ten-year contractual life. We estimate the fair value of stock options using the Black-Scholes option-pricing model. Estimates of fair value are not intended to predict actual future events or the value ultimately realized
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
7. Share-Based Compensation (Continued)
by persons who receive equity awards. The fair value of stock options granted during each of the periods was estimated using the following assumptions:
The expected life of stock options granted was based on the our historical option exercise experience and post vesting forfeiture experience using the historical expected term from the vesting date. The expected volatility of the options granted was determined using historical volatilities based on stock prices over a look-back period corresponding to the expected life. The risk-free interest rate was determined using the yield available for zero-coupon United States government issues with a remaining term approximating the expected life of the options. The forfeiture rate was determined based on historical pre-vesting forfeitures. We have never paid a dividend and have no intention to pay a dividend, and as such, the dividend yield is zero.
In connection with the stock options exercised during the year ended December 31, 2014, we received cash proceeds of $1.7 million. At December 31, 2014, there was $4.6 million of total unrecognized compensation costs related to non-vested stock options, which is expected to be recognized through fiscal 2018.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
7. Share-Based Compensation (Continued)
A summary of stock option activity for the years ended December 31, 2014, 2013, and 2012 is as follows:
A summary of stock options outstanding at December 31, 2014, by price range is as follows:
The weighted fair value of options granted during the years ended December 31, 2014, 2013, and 2012 were $7.62, $4.68 and $2.82, respectively.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
7. Share-Based Compensation (Continued)
The table below reflects the total share-based compensation expense, including share-based payments to our non-employee directors, but excluding the non cash expense related to the extension of the expiration date of an outstanding warrant as discussed in Note 9 below recognized in our statements of comprehensive (loss) income for the years ended December 31, 2014, 2013, and 2012.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
8. Investments Available for Sale
Investments available for sale consisted of the following as of December 31, 2014 and 2013:
The cash equivalents detailed above represent highly liquid investments with maturities of three months or less when purchased that are held in our brokerage investment accounts. They are classified as investments available for sale as the amounts represent investments that have matured and are anticipated to be reinvested in debt securities in the near future.
The following tables summarize the securities with unrealized losses, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, as of December 31, 2014 and 2013:
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
8. Investments Available for Sale (Continued)
The following table summarizes maturities of our investments available for sale as of December 31, 2014 and 2013:
Realized gains (losses) and investment income earned on investments available for sale were $(390,000), $(414,000), and $0, respectively, for the years ended December 31, 2014, 2013, and 2012, and have been included as a component of "Other income, net" in the accompanying financial statements.
9. Related Party Transactions and Warrant
Peter Friedli. Peter Friedli, the Chairman of our Board of Directors, or entities with which he is affiliated, have been responsible for procuring since 1993, an aggregate of approximately $270 million in debt and equity financing for us and our predecessor company. Mr. Friedli is the beneficial owner of approximately 43% of our common stock as of December 31, 2014. Of the shares beneficially owned by Mr. Friedli at December 31, 2014, 85,000 shares were received by him as Board compensation since 1996, 12,500 shares were granted in recognition of his fundraising efforts, as discussed below, 567,610 shares were received by him upon his net exercise of a warrant to purchase 1,000,000 shares of our common stock at $11.00 per share, as described below, and the remaining shares were acquired through investment or through purchase from third parties.
Of the 85,000 shares received by Mr. Friedli as board compensation since 1996, 10,000 shares, then valued at approximately $149,300, were issued to Mr. Friedli in 2014, 10,000 shares, then valued at approximately $77,000, were issued to Mr. Friedli in 2013, and 10,000 shares, then valued at approximately $51,000, were issued to Mr. Friedli in 2012.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
9. Related Party Transactions and Warrant (Continued)
In response to Mr. Friedli's successful efforts in procuring for us accommodations relative to financing transactions that had occurred prior to our initial public offering, we issued to Mr. Friedli in 2006, in connection with and just prior to our initial public offering, a warrant exercisable for up to 1,000,000 shares of our common stock at $11.00 per share, the price for which shares were sold in the initial public offering. This warrant was originally scheduled to expire in May 2011and was extended to expire in fiscal 2015 by a vote of our stockholders at the 2011 Annual Meeting of Stockholders.
Mr. Friedli exercised this warrant on August 14, 2013 using the Net Exercise Method, resulting in the net issuance of 567,610 shares of our common stock. As of December 31, 2013, we no longer have any outstanding warrants.
Prolexys Pharmaceuticals, Inc. During the third quarter of fiscal 2011 we entered into a contract research agreement with Prolexys Pharmaceuticals, Inc. under which we are conducting for Prolexys an early stage clinical trial investigating a novel compound as a product candidate for cancer therapeutics. This contract was filed as an exhibit to and discussed in a Current Report on Form 8-K filed by us with the SEC primarily because of the related nature of the management and ownership of Prolexys with us and our management and with certain of our significant stockholders, and not because our rights or obligations under the contract research agreement with Prolexys are otherwise material to us. We are not incurring any third party costs related to our work with Prolexys and are primarily contributing only the efforts of employees. All third party costs associated with the Prolexys study are paid directly by Prolexys. As of December 31, 2014, the amount of internal resources we have devoted to Prolexys is not material to our operations as a whole.
Prolexys is 35.7% owned by BIH SA, which owns 7.8% of our outstanding common stock; 24.3% owned by Peter Friedli who is the Chairman of our Board of Directors and direct owner of 29.3% of our common stock; and 13.8% owned by Venturetec, Inc., which holds 12.5% of our common stock. Peter Friedli is the President and an approximately 2% owner of Venturetec, Inc. Mr. Friedli has also recently reported the acquisition of a convertible bond that would entitle him, upon conversion, to acquire an additional approximately 19% interest in Venturetec, Inc. Lode Debrabandere, our Chief Executive Officer, serves on the Board of Directors of Prolexys, but has no other interest therein.
This arrangement is part of our ongoing efforts to expand our portfolio of product candidates, but we do not consider this arrangement to be material to us at this time.
Our Board of Directors and Audit Committee, including all of our independent directors, but with Mr. Friedli abstaining, unanimously approved this transaction.
10. Income Taxes
For income tax reporting purposes, we reported taxable income in fiscal 2014 and 2013, compared to a loss in fiscal 2012. The income in 2014 and 2013 was primarily attributable to the gain from sale of discontinued operations which are reflected in the statements of comprehensive (loss) income, net of income taxes. Continuing operations below reflect a tax expense in the amount of $193,000 and a benefit in the amount of $1.3 million generated during fiscal 2014 and 2013, respectively. Included in the 2013 amount is $79,000 of taxes recoverable from a prior period.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
10. Income Taxes (Continued)
Included as a component of discontinued operations was a tax expense of $0.9 million and $1.7 million for 2014 and 2013, respectively. The gain from sale of discontinued operations in 2013 included interest to be accrued in the amount of $70,000 which increased income taxes payable. In the future, the utilization of our tax attributes will be limited to the federal alternative minimum tax threshold.
The effective tax rate benefit (expense) varies from the U.S. Federal Statutory tax rate principally due to the following:
The components of our net deferred tax assets and liabilities at December 31 are as follows:
We presently have available for federal income tax purposes, approximately $70.5 million of general business credit carry-forwards, which expire beginning in 2025 through 2032. In addition, we
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
10. Income Taxes (Continued)
have approximately $1.67 million alternative minimum tax credit carry- forwards as of December 31, 2014, which do not expire. In addition, the windfall equity-based compensation deductions are tracked, but will not be recorded to the balance sheet until Management determines that such amounts will be utilized. During 2014, we had $5.4 million, of windfall stock compensation deductions. When realized, the tax benefit associated with these deductions will be credited to additional paid-in capital.
Our ability to realize its deferred tax assets depends primarily upon the generation of sufficient future taxable income to allow for the utilization of the Company's deductible temporary differences and upon tax planning strategies. Realization of net deferred tax assets is dependent on the Company's ability to generate future taxable income, which is uncertain. We have recorded a valuation allowance of $72.7 million and $72.6 million, against the Company's net deferred tax assets as of December 31, 2014 and December 31 2013, respectively, as Management believes it is more likely than not that the assets will not be realized.
Utilization of the credit carryforwards may be subject to an annual limitation due to the ownership change limitations provided by the Internal Revenue Code of 1986, as amended, and similar state provisions. The Company has not performed a detailed analysis to determine whether an ownership change under Section 382 of the Internal Revenue Code occurred. The effect of an ownership change would be the imposition of an annual limitation on the use of credits attributable to periods before the change and could result in a reduction in the total credits available.
We are subject to income taxes in the United States and several states. Tax regulations within each jurisdiction are subject to the interpretation of the related tax laws and regulations and require significant judgment to apply. The Company had tax net operating losses and credit carryforwards that are subject to examination for a number of years beyond the year in which they are generated for tax purposes. Since a portion of these carryforwards may be utilized in the future, many of these attribute carryforwards remain subject to examination.
Our policy is to recognize interest and penalties related to income tax matters in income tax expense. As of December 31, 2014 and December 31, 2013, we had no accruals for interest or penalties related to income tax matters.
11. Defined Contribution Plan
We have a 401(k) plan that is available to all employees. Employee contributions are voluntary and are determined on an individual basis up to the amount allowable under federal regulations. Employer contributions to the plan are at the discretion of the Board of Directors and vest over a seven year period beginning after the third year of eligibility. No employer contributions have been made to date.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
12. Commitments and Contingencies
Contract Research Organizations. We utilize independent contract research organizations ("CROs") to perform many of the tasks required under our clinical trials. We rely on CROs for their testing expertise and to ensure the objectivity of our clinical results. Under the terms of these agreements, we design the protocol regarding the testing to be performed, and the CRO assists in the enrollment of the patients and testing sites, administers the trial, performs statistical analysis of the results, and compiles the final report.
We pay fees directly to the CROs for their professional services, which may be payable upon specified trial milestones or as they provide services, depending on the structure of the contract. We are also responsible for reimbursing the CROs for certain pass thru expenses they incur in administering the trial. The timing of our payments to the CROs is dependent upon the progress of the various trials, which is highly variable dependent upon the speed with which the CROs are able to enroll patients and testing sites. As such, we are unable to specifically predict the timing of future payments to CROs. We may also utilize CROs for future clinical trials.
The total cost of these future obligations is estimated to be approximately $10.7 million which is expected to be paid through 2017.
Leases. During 2006, we entered into a sublease agreement for approximately 61,000 square feet of laboratory, production, warehouse, and office space in Columbia, Maryland. We have also entered into a direct lease with the owner of this facility that was effective as of June 1, 2009 upon the expiration of the sublease and originally expired in July 2016. According to the terms of the lease agreement, we were required to provide a letter of credit which was fully collateralized by restricted cash and as of December 31, 2013, the letter of credit of $243,000 remained outstanding. In September 2014, we entered into an amendment to the operating lease for our Columbia, Maryland facilities, extending the term of the lease through July 2023 and increasing the future minimum lease commitment by $9.0 million. The lease amendment includes an allowance for tenant improvements of approximately $1.5 million that we expect to utilize in 2015 to expand our manufacturing facilities and adjust our office space to accommodate our additional employees. Under the amended lease agreement, we also replaced the $243,000 letter of credit with a $95,000 cash deposit and eliminated all restricted cash.
The future minimum lease payments due under the operating lease for this facility are as follows:
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
12. Commitments and Contingencies (Continued)
Our expenses under this lease were $1.3 million, $1.3 million, and $1.3 million, during 2014, 2013, and 2012, respectively.
Historically, we also have entered into various financing arrangements to lease laboratory and other equipment. The terms of these facilities and equipment leases are considered capitalized leases.
As discussed in Note 6 Capital Lease, in July 2012, we leased an additional $228,000 of equipment under a capital lease, which was included in our balance sheets at December 31, 2014 along with $114,100 of accumulated depreciation.
Legal. We are subject to certain litigation, claims and assessments which occur in the normal course of business. Based on consultation with our legal counsel, management is of the opinion that there are no matters that are probable or reasonably possible that require accrual or disclosure.
13. Derivative and Securities Received in Business Disposition
The only derivative instrument to which the company was a party was the price protection related to the shares received from Mesoblast as part of the disposition of our Therapeutics business. As discussed in Note 2-Discontinued Operations, the $15 million milestone for completed delivery of the ceMSC assets was payable in either cash or stock, at Mesoblast's election. Because Mesoblast made that payment in stock, the Purchase Agreement provided that these shares were subject to a one year holding period, during which time we were afforded limited protection for any drop in the Mesoblast share price. In the event that the shares decreased in value during the holding period, we would be compensated for 100% of the decrease in value, with 50% of the decrease payable to us in cash, and the remaining 50% again payable in either cash or ordinary shares, at Mesoblast's election. Any additional shares issued would have been subject to an additional one year holding period, but would not be afforded price protection.
The price protection was recorded as a part of the initial consideration received under the Purchase Agreement at its fair value as of that date of $1.7 million. We evaluated this downside protection, and determined that it met the criteria of a derivative instrument under ASC 815. As such, the price protection derivative was re-measured at its fair value with change in fair value recorded in net income as a component of "Other income".
In December, the price protection for the Mesoblast ordinary shares expired, but Mesoblast agreed to pay us no less than $15 million in cash for the stock prior to the end of the first half of fiscal 2015. Accordingly, we no longer have a derivative instrument as of December 31, 2014. The fair value of the price protection derivative was $1.7 million as of December 31, 2013, which was included as a component of "Trading Securities." From the closing of the sale of the Therapeutics business through December 31, 2014 and 2013, respectively, we recorded a loss of $1.7 million and $52,000 on the price protection, which was included as a component of "Other income."
The shares of Mesoblast to which the price protection relates were received by the Company on December 18, 2013 and were required to be held for one year from the date of receipt. The fair value of the shares when they were received was $15 million. The Company elected to remeasure the Mesoblast shares at fair value, with changes in fair value being recorded as a component of "Other income". As such, the statement of comprehensive (loss) income impact of changes in the fair value of
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
13. Derivative and Securities Received in Business Disposition (Continued)
the Mesoblast shares and the statement of comprehensive (loss) income impact of changes in the fair value of the price protection derivative largely offset each other during the mandatory holding.
The fair value of the Mesoblast shares as of December 31, 2014 and 2013, determined by reference to the trading price of identical Mesoblast ordinary shares on the Australian Securities Exchange, was $10.6 million and $15.4 million, respectively. The gain during the period from December 18, 2013 through December 31, 2013 was $401,000. The loss during the year ended December 31, 2014 was $401,000. The difference of $4.4 million between the fair value of the Mesoblast shares, and the guaranteed payment of $15 million is included in "Other Receivables" on our Balance Sheets as of December 31, 2014.
14. Fair Value
Fair value is defined as the price at which an asset could be exchanged or a liability transferred (an exit price) in an orderly transaction between knowledgeable, willing parties in the principal or most advantageous market for the asset or liability. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available, valuation models are applied.
Financial assets recorded at fair value in the accompanying financial statements are categorized based upon the level of judgment associated with the inputs used to measure their fair value. The levels are directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities, and are as follows:
Level 1
Inputs are unadjusted, quoted prices in active markets for identical assets at the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis.
The fair valued assets we hold that are generally included in this category are money market securities and the Mesoblast shares received in the disposition of the Therapeutics business, where fair value is based on publicly quoted prices.
Level 2
Inputs are other than quoted prices included in Level 1, which are either directly or indirectly observable for the asset or liability through correlation with market data at the reporting date and for the duration of the instrument's anticipated life.
The fair valued assets we hold that are generally included in this category are investment grade short-term securities and our derivative instrument.
Level 3
Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities and which reflect management's best estimate of what market participants would use in pricing the asset or liability at the reporting date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.
The only asset we hold that is included in this category is the price protection derivative related to the Mesoblast shares received in the disposition of our Therapeutics business.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
14. Fair Value (Continued)
When quoted prices in active markets for identical assets are available, we use these quoted market prices to determine the fair value of financial assets and classify these assets as Level 1. In other cases where a quoted market price for identical assets in an active market is either not available or not observable, we obtain the fair value from a third party vendor that uses pricing models, such as matrix pricing, to determine fair value. These financial assets would then be classified as Level 2. In the event quoted market prices were not available, we would determine fair value using broker quotes or an internal analysis of each investment's financial statements and cash flow projections. In these instances, financial assets would be classified based upon the lowest level of input that is significant to the valuation. Thus, financial assets might be classified in Level 3 even though there could be some significant inputs that may be readily available. There have been no transfers between level 1 and 2.
The price protection derivative related to the Mesoblast shares was classified in Level 3. Its fair value was determined through use of the Black-Scholes valuation method, a standard industry methodology for valuing equity options, because the price protection is economically equivalent to a put option on the Mesoblast shares at a price of $15 million. Significant inputs to the model include the following:
Fair value of underlying Mesoblast stock: $15,000,000
Contractual life: 1.0 year
Volatility: 40%
Risk-free interest rate: 0.13%
Expected dividends: $0
The price protection related to Mesoblast shares ended in December 2014. There were no other transfers in and out of Level 3. The following table represents a rollforward of the fair value of Level 3 instruments, comprised solely of the limited price protection derivative related to the Mesoblast stock issued to us in connection with the sale of our former Therapeutics business:
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
14. Fair Value (Continued)
Assets and liabilities measured at fair value on a recurring basis are summarized below as of December 31, 2014 and 2013:
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
15. Quarterly Financial Data (Unaudited)
Following is a summary of our unaudited quarterly results for the years ended December 31, 2014 and 2013:
**(Loss) income per share is calculated on a quarterly basis and may not be additive to year-to-date amounts.
OSIRIS THERAPEUTICS, INC.
NOTES TO FINANCIAL STATEMENTS (Continued)
YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
16. Subsequent Events
We evaluated our December 31, 2014 financial statements for subsequent events through the date the financial statements were issued. Pursuant to the exclusive distribution agreement we entered into with a subsidiary of Stryker Corporation in December 2014, we received the initial exclusivity fee of $5 million from Stryker in February 2015. This fee was required to be paid by Stryker within five business days of receipt of documents outlined in the December 2014 agreement. We are not aware of any other subsequent events which would require recognition or disclosure in the financial statements.
OSIRIS THERAPEUTICS, INC.
SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
(in thousands)
ITEM 9.
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
ITEM 9A.
ITEM 9A. Controls and Procedures.
Evaluation of Disclosure Controls and Procedures. An evaluation of the effectiveness of the design and operation of our "disclosure controls and procedures" (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended), as of the end of the period covered by this Annual Report on Form 10-K was made under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer. Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (a) are effective to ensure that information required to be disclosed by us in reports filed or submitted under the Securities Exchange Act of 1934 is timely recorded, processed, summarized and reported and (b) include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in reports filed or submitted under the Securities Exchange Act of 1934 is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Previously Reported Material Weakness. During the year ended December 31, 2014, we developed and implemented new control procedures to address a previously identified material weakness in our internal control over financial reporting. As of December 31, 2013, our management determined that our processes, procedures and controls related to financial reporting were not effective to ensure effective oversight of the work performed by, and the accuracy of financial information or professional conclusions provided by, third-party tax advisors, regarding components of the income tax provision calculation (specifically the allocation between continuing and discontinuing operations), given a one-time significant transaction of disposing of a business segment. We have taken steps to remediate the material weakness, including adherence to existing control procedures and implementation of enhanced controls related to review and oversight of complex transactions and infrequent events. Additionally, we engaged a new third party tax advisor to oversee and prepare the Company's tax provision and other related documents. We believe that these remediation efforts have improved our internal control over tax accounting, as well as our disclosure controls and procedures, and that the material weakness has been remediated at December 31, 2014.
Management's Report on Internal Control over Financial Reporting. Management's report on internal control over financial reporting is included in "Item 8. Financial Statements and Supplementary Data."
Attestation Report of Registered Public Accounting Firm. BDO USA, LLP's attestation report on our internal control over financial reporting is included in "Item 8. Financial Statements and Supplementary Data."
Changes in Internal Control over Financial Reporting. With the exception of the remediation efforts described above, there has been no change in our internal control over financial reporting that occurred in the annual period covered by this report that materially affect our internal control over financial reporting.
ITEM 9B.
ITEM 9B. Other Information.
None.
PART III
Certain information required in Part III is omitted from this report, but is incorporated by reference from our definitive proxy statement for the 2014 Annual Meeting of Stockholders anticipated to be filed within 120 days after the end of our fiscal year ended December 31, 2014, pursuant to Regulation 14A with the Securities and Exchange Commission.
ITEM 10.
ITEM 10. Directors, Executive Officers and Corporate Governance.
The information required by this item and not set forth below is incorporated herein by reference to the information contained in the Proxy Statement.
We have adopted the Osiris Therapeutics, Inc. Code of Business Conduct & Ethics for Members of the Board of Directors and Executive Officers and the Osiris Therapeutics, Inc. Code of Conduct which applies to all our employees and members of the Board of Directors. These policies are publicly available on our website at http://www//investor.osiris.com/documents.cfm.
ITEM 11.
ITEM 11. Executive Compensation.
The information required by this item is incorporated herein by reference to the information contained in the Proxy Statement.
ITEM 12.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The information required by this item is incorporated herein by reference to the information contained in the Proxy Statement.
ITEM 13.
ITEM 13. Certain Relationships and Related Transactions, and Director Independence.
The information required by this item is incorporated herein by reference to the information contained in the Proxy Statement.
ITEM 14.
ITEM 14. Principal Accounting Fees and Services.
The information required by this item is incorporated herein by reference to the information contained in the Proxy Statement.
PART IV
ITEM 15.
ITEM 15. Exhibits, Financial Statement Schedules.
(a)The following documents are filed as part of this report:
1.The following financial statements are included in Item 8 of this Annual Report:
2.Exhibits:
Incorporated herein by reference to corresponding Exhibit to the Registrant's Registration Statement on Form S-1, which was declared effective by the SEC on August 3, 2006.
*Confidential portions omitted and filed separately with the United States Securities and Exchange Commission pursuant to Rule 24b-2 promulgated under the Securities Exchange Act of 1934, as amended.
Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
/s/ LODE DEBRABANDERE
Lode Debrabandere, Ph.D.
Director, President and Chief Executive Officer (principal executive officer)
March 20, 2015
/s/ PHILIP R. JACOBY, JR.
Philip R. Jacoby, Jr.
Chief Financial Officer (principal financial officer)
March 20, 2015
/s/ GREGORY I. LAW
Gregory I. Law
Vice President of Finance (principal accounting officer)
March 20, 2015
/s/ PETER FRIEDLI
Peter Friedli
Director
March 20, 2015
/s/ FELIX GUTZWILLER
Felix Gutzwiller M.D., Dr.P.H.
Director
March 20, 2015
/s/ HANS KLINGEMANN
Hans Klingemann, M.D., Ph.D.
Director
March 20, 2015
/s/ JAY M. MOYES
Jay M. Moyes
Director
March 20, 2015