Item 1. Business
Overview
We were established in 2000 to develop proprietary polymer materials and products based on these materials. We are currently developing products for two primary markets: bioscience and electro-optics. We design and synthesize polymer materials at the molecular level by using our expertise in nanotechnology, which is the development of products and production processes at a scale smaller than 100 nanometers (a nanometer is one-billionth of a meter). Our goal is to optimize the electrical, optical and surface properties of these materials. We use these materials to improve the design, performance and functionality of products for use in biochemical analysis and in optical communications networks and systems. We believe we have developed a proprietary intellectual property position based on a combination of patents, licenses and trade secrets relating to the design and characterization of polymer materials, methods of polymer synthesis and production of polymers in commercial quantities, as well as device design, characterization, fabrication, testing and packaging technology.
From our inception through December 31, 2003, we were considered to be in the development stage concentrating primarily on the development of our technology and potential products. Products for wireless networking and biochip applications became available for customer evaluation in early 2004; therefore, we were considered to have exited the development stage in 2004. To date, substantially all of our revenues have come from contracts to develop custom-made electro-optic materials and devices for government agencies. As we transition to a product-based company, we expect to record both revenue and expense from product sales, and to incur increased costs for sales and marketing and to increase general and administrative expense. Accordingly, the financial condition and results of operations reflected in our historical financial statements are not expected to be indicative of our future financial condition and results of operations.
In 2004, we also began the development of our label-free, high throughput detection system and related biochip products aimed primarily at the growing proteomics marketplace. We also continued the development of our polymer modulators, and pending demand for higher bandwidth and speeds from optical communications equipment suppliers, we have been developing other applications for our modulators such as millimeter wave detection and communication systems. We currently have products being evaluated by customers and potential customers in each of our product areas.
During March 2006, we changed the organizational structure of our business to focus on our two primary markets, creating two distinct business segments: bioscience and electro-optics.
Technology Background
Nanotechnology: Polymer Materials, Engineering and Process Development
Polymers are large carbon-based molecules that bond many small molecules together to form a long chain. Polymer materials can be engineered and optimized using nanotechnology to create a system in which unique electrical, chemical and electro-optic characteristics can be controlled. Nanotechnology refers to the development of products and production processes at a scale smaller than 100 nanometers (a nanometer is one-billionth of a meter).
Materials based on polymers are used in a multitude of industrial and consumer products, from automotive parts to home appliances and furniture, as well as scientific and medical equipment. We believe that polymer materials engineered at the molecular level can have a significant role in the future development of commercially relevant biotechnology and electro-optic related products. In addition, polymers, polymer-based devices and the processes used to create them are often patentable, which can provide the developers of such technology with a significant competitive advantage.
Markets and Product Opportunities
Bioscience Segment
The Market
Lumera’s Bioscience business segment is focused on delivering tools and applications to the life science and pharmaceutical industry, specifically those concerned with discovering and characterizing proteins. We are currently focused in two primary market segments: Antibodies and kinase inhibitors.
According to Frost and Sullivan, in 2005, the pharmaceutical industry spent $2.3 billion on instruments and consumables for compound screening. We have estimated that therapeutic antibody characterization accounted for approximately $200 million of that amount. While we do not yet have precise data on the kinase inhibitor screening segment, we believe that it is similar in size to the therapeutic antibody segment. According to Frost and Sullivan, nearly $15 billion of the $50 billion that is spent industry wide on pharmaceutical research and development is focused on kinase inhibitors.
Lumera Bioscience Product Opportunity
We are developing a high throughput Surface Plasmon Resonance (“SPR”) biosensor designed to enable discovery and characterization of proteins. In addition, the system is being designed to characterize possible drug candidates that target protein molecules and to facilitate biomarker discovery and protein pathway elucidation. Lumera’s competitive advantage is expected to be the ability to provide researchers kinetic information about protein interactions in a label free and high throughput format.
Our NanoCapture™ Arrays are a family of microarrays targeting specific applications. Our initial product is expected to be a NanoCapture™-Gold microarray on which users will print their own biological content. We envision that future generations of NanoCapture™ Arrays will have specific surface chemistry to enable, and in some cases, enhance the biological assay. Ultimately, we believe we will generate a significantly more valuable consumable by providing the customer with biological content on the microarray.
In early 2005, we acquired exclusive rights within our markets to Helix Biopharma’s Heterodimer Protein Technology (“HPT”) which was recently branded with the trade name ExpressTag™. We believe this technology gives us the necessary basis by which to provide biological content on the microarray, specifically because ExpressTag™ enables proteins to properly orient on a surface allowing them to maintain function.
The traditional commercial markets - e.g., large pharmaceutical companies and biotech companies - look to recognized research organizations and universities for development and validation of core research methodologies. Our commercialization strategy is to place a number of pre-commercial devices with our collaboration partners and research institutions to generate data useful for external validation, to speed application development efforts and to strengthen the functionality of our upcoming commercial release. Demonstrating the value of our products through these opinion leaders will, therefore, allow us to be in a stronger position when we enter these commercial markets.
In 2005 we entered into a collaboration agreement with the Institute for Systems Biology (ISB), an internationally renowned non-profit research institute dedicated to the study and application of systems biology. This agreement was extended in 2006 and is now focused on biomarker discovery, specifically with identifying biomarkers associated with drug induced liver injury. Early results suggest that Lumera’s ProteomicProcessor™ platform can be used to identify new biomarkers. Experiments are ongoing to further quantify and validate the results.
Our collaboration with the Harvard University Medical School (Harvard), which began informally in early 2005, is focused on integrating Harvard’s NAPPA (Nucleic Acid Programmable Protein Array) technology, which provides a simple and cost-effective way to generate a protein biochip, with the ProteomicProcessorÔ to read and analyze the biochip. In October 2006, we released an update on Dr. LaBaer’s work in connection with the ProteomicProcessor™. Successful integration of NAPPA on the ProteomicProcessorÔ was presented by Harvard researchers at the PepTalk conference in January 2007. Follow on research is focused on developing a new protein biochip containing kinase proteins for use in both kinase interaction studies as well as kinase inhibitor studies.
Currently our beta release devices are installed at the Institute for Systems Biology, Harvard, the Medical University of South Carolina and Baylor Institute for Immunology Research. Additional academic, as well as select commercial beta sites, have expressed an interest in the system.
Our life sciences product development and manufacturing team is focused on bringing all of the necessary features and functions to provide the market with a competitive product. We continue to work through a number of outstanding issues, which are demanding much of the team’s focus, including vendor qualification and building required quality control processes.
Electro-Optics Segment
The Market
We believe that the increasing demand for faster, higher bandwidth communications applications will ultimately stimulate demand for components that can operate at these faster parameters. Electro-optic devices such as modulators translate electric signals into optical signals used in communication systems to transfer data, either over fiber-optic networks or between chip-based circuits, acting like high speed switches.
Optical data transfer is significantly faster and more efficient than transfer technologies using only electric signals. Current technologies that translate electric signals into optical signals generally rely on inorganic electro-optic materials which have speed limitations and require higher operating voltages that in turn increase operating temperatures and systems costs. Polymer-based electro-optic modulators appear to provide advantages over current switching technologies based on inorganic materials by increasing switching speed, improving optical transmission properties and lowering operating voltages. Higher switching speeds will permit more cost-effective use of bandwidth for broadband Internet and voice services. Lower operating voltages may enable systems design to eliminate costs and importantly to reduce the heat these systems generate. Polymer modulators are also resistant to radiation, making them highly suitable for satellite communications.
We anticipate that an additional market for electro-optic devices may develop in connection with computer components. Some integrated circuit manufacturers are seeking to solve problems that exist with metal interconnects, which are used to move data directly from microprocessors to other computer components. Metal interconnects may become more problematic as processor speeds continue to increase. In particular, as speeds increase, it is likely that heat transfer will become a more serious issue to address. Unlike many metal interconnects, polymer-based interconnects can operate at higher circuit speeds by optically transmitting data between computer components and systems. Because the data is being transferred via light, the heat transfer issue is also resolved.
There is a growing need in wireless applications for high frequency signals in the millimeter wave range (70 GHz to 100+ GHz) that are generated coherently. Certain high frequencies in this range are attractive for wireless communications since this spectrum can be used to achieve transmission of ultra high data transfer (10 Gbps). Examples of high data transfer uses are transmission of uncompressed high-definition video content, high-speed communication between space or airborne platforms, communications between flight vehicles and ground operations, and temporary restoration of communications infrastructure in a disaster recovery scenario. Thus far, no solution has been developed to address the technical need to serve these applications in a commercially viable way.
By creating a millimeter wave signal in the optical domain, one can generate a coherent signal that is essential for high-data-rate (>10 Gbps) wireless transmission. Modulating the signal in the optical domain allows one to leverage industry standard optical modulation and filtering capabilities already widely deployed in the fiber optic communications infrastructure. This approach takes advantage of lower frequency and lower cost electronic components.
We believe our polymeric electro-optic materials show great advantages for these applications due to their ability of achieving large bandwidth with low driving voltages and processing capabilities in arrays of communications devices with low cross-talk. This market is still evolving but is believed capable of becoming quite large as the need for greater bandwidth continues to accelerate. Companies that are spread between multiple buildings either in a campus setting or within a metropolitan area and transmit backup files of customer data, billing data, etc. would be interested in the ability to service higher traffic loads. Similarly, universities, health care enterprises, and government agencies have high data capacity users. Moreover, in many undeveloped countries, where no fiber optic infrastructure exists, a wireless solution can become a very attractive broadband connectivity option as the wireless bridge offers high data rate transmission at low cost in an integrated solution, while avoiding the expense of digging and laying optical fiber.
Lumera Electro-Optic Product Opportunity
We are developing a new generation of electro-optic modulators and other devices for optical networks and systems based on our proprietary polymer materials. The applications for these advanced materials include electro-optic components such as modulators and ring oscillators, polymer electronics such as high performance diodes and transistors, and optical interconnects for high speed (greater than 20 billion cycles per second) inter and intra semiconductor chip communication. Our polymer-based modulators can operate at speeds up to five times faster than existing inorganic crystalline-based electro-optic modulators and are smaller, lighter and more energy efficient than electro-optic modulators using inorganic crystals. We have designed and manufactured polymer-based electro-optic modulators that operate at speeds up to 95 GHz. We are continuing development efforts to enhance the speed, efficiency and power requirements of electro-optic materials and devices to meet evolving customer requirements and applications.
We are also developing millimeter wave systems which could be used in wireless communication systems applications and in security related applications, offering high data-rate wireless transmission at low cost compared to current last mile wire-line infrastructure. During the fourth quarter of 2006, we completed testing of our prototype millimeter wave wireless bridge, successfully transmitting 10 Gbps at 94 GHz through the use of Gigabit Ethernet and other standard protocols. We also successfully tested a prototype of our multiband, high data-rate adaptive millimeter-wave communication system during the fourth quarter of 2006. Potential customers for these systems include various telecommunications and broadcasting companies as well as defense and security agencies.
In July 2006, the Defense Advanced Research Projects Agency (DARPA) awarded us an 18-month, $3.45 million contract which, based on the achievements of certain milestones, will be followed by a 12-month, $2.43 million contract for a total of $5.9 million over a period of 30 months, which could be shortened if milestone deliveries are accelerated. The objective of the project is to provide high performance polymer optical modulators that are critical in leading-edge defense applications, including terrestrial and satellite RF photonic links and phased array radar. The scope of the 30 month multi-phase project, which can be shortened with acceleration of deliverables, involves developing materials with unprecedented electro-optic coefficients, with qualified thermal and photo-stability and processing them into devices. The combination of reduced drive voltage and optical loss will enable defense applications that are impractical with currently available optical modulator technologies.
Government Research Applications
In addition to our polymer based electro-optic products in development for commercial markets, we develop customized products on a contract basis for U.S. government agencies and government subcontractors, including high performance electro-optic modulators currently unavailable in the commercial market. These development contracts provide us with revenues, help fund our research and development efforts, and provide access to certain technological resources of the government and government subcontractors.
We are currently working on contracts with government agencies to produce polymer-based modulators for use in defense communications and detection systems and phased array radar. In addition to the 30-month DARPA
contract discussed above, in March 2007, our longest running contract with a government agency, under which we have been paid a total of $6.9 million since 2001, was renewed for a total of $1.2 million for development work through March 2008. Backlog on our governmental contracts totaled $1,672,000 at December 31, 2006.
Summary of Applications and Product Development
The following table summarizes our target markets, our current and potential products and the initial applications for these products.
Markets
Products
Applications
Bioscience
NanoCapture™ Arrays
ProteomicProcessor™
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Protein characterization
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Drug development and screening
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Biomarker discovery
Electro-Optic Devices
Electro-Optic Modulators
High Speed Optical Interconnects
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Satellite communications
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Optical switching for telecom components
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High speed signal processing (computing)
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Terahertz imaging
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Defense/aerospace
Business Strategy
Our objective is to be a leading provider of products based on our proprietary technology and know-how in nanotechnology-based polymer materials. We are currently targeting the markets for bioscience and electro-optic devices and systems. We are also developing customized polymer-based applications for government agencies. Our business strategy has the following components:
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Use our nanotechnology-based polymer materials technology to establish an initial portfolio of successful products. We are presently developing polymer-enhanced commercial products and applications for bioscience and electro-optic markets to achieve a broad customer base and multiple revenue sources. We also intend to continue to develop and provide polymer-based products for government applications which help fund our research and development efforts and open up potentially large government markets for our products.
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Continue to develop proprietary intellectual property. We plan to advance our core competence in polymer materials technology by continuing to develop proprietary materials, processes, designs and devices. We also plan to protect our technology by filing patent applications where appropriate, obtaining exclusive technology rights where available and taking other appropriate steps to secure and protect intellectual property.
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Bring customer relevant products to market. We intend to continue to improve our product development process and to design, test and fabricate nanotechnology-based polymer materials and polymer-enabled devices in our facilities. We believe our efforts to vertically integrate our development process will allow us to develop products which satisfy customer demands and take advantage of emerging market opportunities.
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Pursue scientific and commercial collaborative relationships. Because we recognize that our products and technologies propose new, disruptive methods, we will continue to seek relationships and partnerships with world opinion leaders in their respective fields. Doing so, we believe, will allow our products and technologies to be validated by these respected leaders. We also believe these partnerships will provide valuable introductions to the commercial markets we seek to penetrate.
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Leverage government contracts for technology advantage. We plan to continue to pursue government contracts to stay at the forefront of polymer materials technology advances. We believe the expertise we
gain from government contract work will expand our proprietary knowledge, which we can use to develop products for commercial applications.
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Maintain and broaden our relationships with leading research facilities and personnel. Our relationships with academic institutions and their personnel have been critical to building our technology portfolio and our polymer materials expertise. We intend to continue these types of relationships to access novel technologies and achieve competitive advantages.
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Develop a multi-channel sales and marketing organization. We intend to build a sales and marketing organization dedicated to developing customers and multiple distribution channels for our products. We plan to aggressively pursue sales of our potential products through the use of industry-specific sales representation organizations, such as electro-optic and wireless component distributors. In addition, we plan to target market leaders as initial customers and to leverage relationships with these market leaders to obtain future contracts and sales references.
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Pursue opportunistic acquisitions. We intend to pursue acquisitions of complementary technologies and businesses to increase our intellectual property portfolio, expand our product offerings and enlarge and diversify our customer base.
Collaborative Relationships
External collaborations are an important aspect of our strategic plan for product and application development, validation and marketplace introductions. We have relationships with the following partners:
University of Washington. We collaborate actively with the University of Washington (the “UW”), a leading research institution, to conduct research and development in the field of optical materials technology. In October 2000, we entered into a sponsored research agreement (the “SRA”) with the UW to further the development of electro-optic materials and devices. The sponsored research covered improvements to polymer materials in several areas, including electro-optic activity, optical loss, long-term thermal stability and nanotechnology processibility. Although our formalized SRA has ended, we are continuing our collaboration directly with UW scientists and their departments. We paid the UW a total of $100,000 during 2006 under separate letter agreements.
We also entered into an exclusive licensing agreement with the UW in October 2000, pursuant to which we acquired rights to intellectual property relating to electro-optic polymers and related organic materials and processes in the following fields of use:
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Optical networks for voice, data and related telecommunications communications;
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Optical computing applications and holographic optical memory systems;
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Beam steering, control and scanning; and
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Commercial and defense radar, guidance and sensing systems
This UW research has resulted in 6 U.S. patent applications that are subject to our licensing agreement with the UW. The licensing agreement terminates upon the expiration of the last of the UW’s patents that relate to this technology and that are licensed to us under the agreement, unless earlier terminated by the UW or by us.
We paid the UW an aggregate of $5.75 million under the amended terms of the SRA. In exchange for our licensing rights to the UW technologies, we paid the UW a $200,000 license fee in March 2001 and issued shares of our common stock which were valued at an aggregate of approximately $3.0 million. We make ongoing minimum royalty payments of at least $75,000 per year and also pay certain costs related to filing and processing patents related to the licensing agreement.
Helix Biopharma/Sensium. We have a licensing agreement with Sensium Technologies, Inc., a subsidiary of Helix BioPharma Corporation, which gives us an exclusive worldwide royalty bearing license in our field of business to a number of patents and the related technology for use in our NanoCapture™ Arrays. Under the terms of the licensing agreement, we paid $250,000 in license fees, half of which we paid upon signing in January 2005 and half in February 2006. We also paid a $125,000 in technology transfer fees during the first half of 2005. The Sensium licensing agreement contains minimum royalty provisions totaling $50,000 for the first royalty year, $100,000 for the second royalty year, $150,000 for the third royalty year and $200,000 thereafter. We must also make a one-time payment to Sensium to reimburse patent legal costs of $200,000 upon the issuance of the latter of
two patents currently in the application stage. Our license exclusivity is based upon achieving certain minimum revenues by the fourth royalty year.
Institute for Systems Biology. We participate in a collaborative agreement with the Institute for Systems Biology to use the ProteomicProcessor™ as a novel biomarker platform for discovery of biomarkers associated with drug induced liver injury.
Harvard Medical School. We participate in a collaborative agreement with Harvard Medical School (HMS) and the Harvard Institute of Proteomics, a division of HMS to integrate HMS’s NAPPA™ methodology (nucleic acid programmable protein arrays) with our ProteomicProcessor™ biosensor. The resultant novel protein array will contain kinase proteins which are envisioned for use in drug interaction analysis as well as other fundamental biological studies.
Medical University of South Carolina. Researchers at Medical University of South Carolina (MUSC) are developing a new biomarker platform using the ProteomicProcessor™ specifically to monitor changes in mitochondrial proteins as a function of drug induced stress or toxicity.
Baylor Institute for Immunology Research. Researchers within the Baylor Institute for Immunology Research are using the ProteomicProcessor™ to identify cytokine and chemokine protein expression profiles to further therapeutic vaccine development.
Arizona Microsystems, L.L.C. We have a licensing agreement with Arizona Microsystems (AZM), a company specializing in the research and development of electro-optic polymeric materials and fabrication processes, which gives us exclusive rights to seven patents in the field of electro-optic polymers. In exchange for our licensing rights to the AZM technologies, we paid AZM a total of $400,000, half in 2003 and half in 2004, and issued a warrant to purchase 164,000 shares of our common stock in consideration for our exclusive license; upon our initial public offering in July 2004, the vested portion of the AZM warrant was converted into 38,935 shares in a cash-less exercise. From October 2002 through August 2005 we paid AZM $5,000 a month for technical consulting services under the terms of a consulting agreement. We pay AZM an ongoing minimum annual license fee of $10,000 in addition to reimbursing certain patent legal expenses.
We also have arrangements with various individual consultants who are experts in the field of polymers, including a professor at the University of Colorado at Boulder who specializes in novel polymer devices and optically controlled phased-array radar, a professor at the University of Southern California who specializes in material characterization, device processing, optical device design and device applications, a professor at the University of California, Los Angeles who specializes in device processing, optical device design, high-speed radio frequency design and system-level device applications and professors at Georgia Institute of Technology that specialize in the research and development of electro-optic polymeric materials and fabrication processes. The Georgia Tech professors are also principals of AZM. We sponsored approximately $36,000, and $194,000 during 2006, and 2005, respectively of research related to development of optical materials under the terms of a separate letter agreements.
Patents and Other Intellectual Property
We develop and exploit technologies relating to polymers and related materials. We have patents and patents pending covering technologies relating to:
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Polymer synthesis at the molecular level;
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Production of polymers in commercial quantities;
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Materials systems incorporating polymers;
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Materials characterization and testing methods; and
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Devices, designs and processes relating to polymers.
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Use of MEMS based optical systems for biodetection;
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Methods for anchoring proteins to a planar surface;
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Competitive assay for small molecule detection
As a small company seeking to market and sell novel products in new markets, we believe that a robust technology portfolio is an essential element of our business strategy. Accordingly, we believe that our success will depend in large part on our ability to:
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obtain patent and other proprietary protection for the materials, processes and device designs that we develop;
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enforce and defend patents and other rights in technology, once obtained;
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operate without infringing the patents and proprietary rights of third parties; and
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preserve our trade secrets.
Patent Portfolio. Our intellectual property consists principally of patentable inventions and trade secrets. We have developed some of this intellectual property internally and have also acquired intellectual property from our strategic partners and others. We and our strategic partners protect our intellectual property by filing domestic and foreign patent applications where appropriate and by maintaining an active program designed to preserve the confidentiality of our trade secrets. With respect to inventions and other intellectual property created under our development contracts with the U.S. government and government contractors, we typically have the right to retain title to any patents that issue to us in connection with the performance of these contracts, with the government retaining a non-exclusive license to use the patented technology for government purposes. The government typically also retains rights in any technical data that we develop using federal funding and deliver under a development contract. If we do not comply with government notice requirements with respect to inventions developed under these development contracts, the government could demand ownership of the inventions, in which case we would retain a license to use the inventions.
We have 19 issued United States patents and approximately 26 currently pending United States patent applications, 6 of which have received notices of allowance. Our patent and patent applications are directed to polymer and small molecule materials, methods of making materials, processing of materials, processing of devices, device designs and microarray analysis methods. We also have an exclusive sublicense in the field of electro-optic polymers to the rights to seven patents from Arizona Microsystems and have licensed 8 patent applications covering technology from the University of Washington. In connection with our transaction with Sensium, we licensed three U.S. patents and rights under patents granted under two additional U.S. patent applications, each of which patents has various corresponding international patents. Our patents will begin to expire in 2021.
Patent Valuation. While we believe our patent portfolio to be a valuable asset, the discoveries or technologies covered by the patents and patent applications we own or license may not have commercial value. Also, issued patents may not provide commercially meaningful protection against competitors. Other parties may be able to design around our issued patents or independently develop technology having effects similar or identical to our patented technology. In addition, the scope of our patents and patent applications is subject to uncertainty and competitors or other parties may obtain similar patents of uncertain scope. For example, other parties may discover uses for polymers or technology different from the uses covered in our patents or patent applications, and these other uses may be separately patentable. Also, other parties may have patents covering the composition of polymers for which we have patents or patent applications covering only methods of use of these polymers.
Third parties may infringe the patents that we own or license, or claim that our potential products or related technologies infringe their patents. Any patent infringement claims that might be brought by or against us may cause us to incur significant expenses, divert the attention of our management and key personnel from other business concerns and, if successfully asserted against us, require us to pay substantial damages. In addition, a patent infringement suit against us could force us to stop or delay developing, manufacturing or selling potential products that are claimed to infringe a patent covering a third party’s intellectual property.
Trade Secrets. In addition to our patented intellectual property, we also rely on unpatented technology, trade secrets and confidential information. We require each of our employees and consultants to execute a confidentiality agreement before beginning their employment or consulting relationship with us. These agreements generally provide that the individual must keep confidential and not disclose to other parties any confidential information developed or learned by the individual during the course of his or her relationship with us. Our agreements with employees provide that any intellectual property developed by the employee during the course of his or her employment is automatically assigned to us. Our agreements with consultants generally provide that we have the option to exclusively license all inventions conceived by the consultant in the course of rendering services to us.
These agreements with employees and consultants may not provide effective protection of our technology or confidential information or, in the event of unauthorized use or disclosure, may not provide adequate remedies.
Third Parties. As part of our business strategy we collaborate with third parties in our research and development activities. Accordingly, disputes may arise about inventorship and corresponding rights to know-how and inventions resulting from the joint creation or joint use of intellectual property. In addition, these third parties may circumvent any proprietary protection we do have. They may independently develop equivalent technologies or independently gain access to and disclose substantially equivalent information, and confidentiality agreements and material transfer agreements we have entered into with them may not provide us with effective protection.
Research and Development Process
For both our bioscience and electro-optic products, we have the ability to engineer, analyze, and test polymer materials and related devices as well as the ability to fabricate and test advanced products.
In March 2006, we changed the organizational structure of our business to focus on our primary markets, creating two distinct business units: bioscience and electro-optics. Each business unit has specific technical service groups supporting our research and product development efforts:
Materials and chemistry. Our materials and chemistry departments use existing synthesis methods as well as developing new methods to create novel polymer materials that meet electro-optic and bioscience customer specifications. Once a polymer material has passed all of the commercial test parameters these departments develop new methods to synthesize larger quantities.
Materials characterization and testing. Our materials characterization and testing department conducts a full battery of tests at the completion of the synthesis of each new polymer material. This department evaluates test data using a central database. The department also helps create strategies to optimize materials to meet customer specifications.
Process development and device fabrication. Our process development and device fabrication departments integrate data from the material characterization and testing department to fabricate electro-optic devices (i.e. the modulators, the biological chips. and the ProteomicProcessor™). This department analyzes testing results from electro-optic device and the ProteomicProcessor™ to refine and improve fabrication processes and methods. In addition, the department works closely with the other departments, providing technical proposals on how more efficient materials fabrication processes can help enable superior design.
Device design, testing and packaging. Our device design, testing and packaging departments takes customer specifications and creates an initial device design for electro-optics (modulators) and bioscience (ProteomicProcessor™) using simulation software. Following device fabrication, this department runs a series of optical and electronic tests and creates a report that provides our other departments with directions on enhancing performance in future generations of materials and processes. The department also has the capability to package devices in pilot production quantities.
Manufacturing
We currently manufacture prototype devices and chips in our research facilities. We expect that our in-house facilities will be capable of producing sufficient product quantities to meet initial commercial quantities. We may require additional capacity to meet anticipated further demand. We are investigating leasing additional production laboratory space that would accommodate larger bio-chip and polymer modulator volumes as well as enable polymer modulator production.
Sales and Marketing
As our product commercialization efforts progress we are applying resources to become a customer-focused organization. We are aggressively pursuing sales and marketing of our products, targeting opinion / market leaders and initial customers. We currently have prototypes installed in a number of high profile beta test sites in each of our current target markets, which will serve to validate the instrument and chips, as well as create awareness about our technology. We will leverage these expected initial sales with opinion and market leaders to obtain future contracts
and sales references. We are partnering with leading U.S. research institutions and opinion leaders such as the Institute of Systems Biology, the Harvard Institute of Proteomics and others.
We are targeting life science research centers and universities for protein pathway basic discovery and are in discussions with biotech companies and large pharmaceutical companies interested in the mechanisms of molecular biology, protein-protein interactions and networking, cell signaling, aging, disease and death. We plan to reach these potential customers through targeted direct selling, followed by non-exclusive co-marketing partnerships. In addition, we plan to advertise in trade journals, participate in targeted industry trade shows and organizations, engage in focused public relations campaigns, and make scientific presentations at technical conferences.
We have employees with experience in the marketing of polymer materials and related products. Our marketing professionals are focused on selling our bioscience biochips/instruments and electro-optic devices. As our products advance in development, we expect to increase our marketing and sales resources.
In addition to using our own sales and marketing organization, we may promote our potential products with marketing partners. We may also rely on relationships with companies with established distribution systems and direct sales forces to distribute and sell our products.
Competition
The markets that we are targeting for our polymer materials technologies are intensely competitive. In the biotechnology disposables market, we expect to compete with Tactical Fabs, Inc., Erie Scientific Company and Corning Incorporated. In the bioscience instrumentation and tools area we expect to compete with Biacore (GE Healthcare), Applera, Agilent and others. In the electro-optic modulators market, we expect to compete with Fujitsu Limited, Sumitomo Osaka Cement Company, Ltd., Avanex, Inc. and JDS Uniphase Corporation.
We believe the principal competitive factors affecting our markets are the:
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ability to develop and commercialize polymer-based products, including patent and proprietary rights protection;
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costs of these products; and
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ability to enable and improve performance.
Although we believe that we are well positioned to compete adequately with respect to these factors, our future success is currently difficult to predict because we are an early stage company and all of our products are in early stages of development.
Many of our existing and potential competitors have substantially greater research and product development capabilities and financial, scientific, marketing and human resources than we do. As a result, these competitors may:
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devote greater resources to developing, marketing or selling their products;
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succeed in developing superior products that achieve greater market acceptance than our potential products;
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respond more quickly to new or emerging technologies or scientific advances and changes in customer requirements, which could render our technologies or potential products obsolete;
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introduce products that make the continued development of our products uneconomical;
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obtain patents that block or otherwise inhibit our ability to develop and commercialize our products;
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withstand price competition more successfully than we can;
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establish cooperative relationships among themselves or with third parties that enhance their ability to address the needs of our prospective customers; and
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take advantage of acquisition or other opportunities more readily than we can.
Government Regulation
We are subject to federal, state and local laws and regulations relating to the generation, handling, treatment, storage and disposal of certain toxic or hazardous materials and waste products that we use or generate in our operations. We regularly assess our compliance with environmental laws and management of environmental matters.
We are also subject to federal procurement regulations associated with our U.S. government contracts. Violations of these regulations can result in civil, criminal or administrative proceedings involving fines, compensatory and punitive damages, restitution and forfeitures as well as suspensions or prohibitions from entering into government contracts. In addition, the reporting and appropriateness of costs and expenses under our government contracts are subject to extensive regulation and audit by the Defense Contract Audit Agency, an agency of the U.S. Department of Defense. The contracts and subcontracts to which we are a party are also subject to potential profit and cost limitations and standard provisions that allow the U.S. government to terminate such contracts at its convenience. We will be entitled to reimbursement of our allowable costs and to an allowance for earned profit if the contracts are terminated by the U.S. government for convenience.
Sales of our potential products and services internationally may be subject to the policies and approval of the U.S. Department of State and Department of Defense. Any international sales may also be subject to United States and foreign government regulations and procurement policies, including regulations relating to import-export control, investments, exchange controls and repatriation of earnings.
Employees
As of December 31, 2006, we employed 56 full-time and part-time employees. Our team of chemists, materials scientists, electrical engineers, and optical physicists includes 12 Ph.D.s. From time to time, we also use independent contractors. None of our employees is represented by collective bargaining arrangements. To date, we have experienced no work stoppages, and we believe that our relationship with our employees is good.
Item 1A.
Item 1A. Risk Factors
We have incurred substantial operating losses since our inception and will continue to incur substantial operating losses for the foreseeable future.
Since our inception, we have been engaged primarily in the research and development of our polymer materials technologies and potential products. As a result of these activities, we incurred net losses of $48.7 million from inception through December 31, 2005 and an additional net loss of $12.1 million for the twelve months ended December 31, 2006. We anticipate that we will continue to incur operating losses through at least 2007. As of December 31, 2006, we had an accumulated deficit of $60.8 million.
We may not be able to generate significant additional revenue either through development contracts from the U.S. government or government subcontractors or through customer contracts for our potential products or technologies. We expect to continue to make significant operating and capital expenditures for research and development and to improve and expand production, sales, marketing and administrative systems and processes. As a result, we will need to generate significant additional revenue to achieve profitability.
We are subject to the risks frequently experienced by early stage companies.
The likelihood of our success must be considered in light of the risks frequently encountered by early stage companies, especially those formed to develop and market new technologies. These risks include our potential inability to:
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establish product sales and marketing capabilities;
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establish and maintain markets for our potential products;
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identify, attract, retain and motivate qualified personnel;
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continue to develop and upgrade our technologies to keep pace with changes in technology and the growth of markets using polymer materials;
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develop expanded product production facilities and outside contractor relationships;
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maintain our reputation and build trust with customers;
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improve existing and implement new transaction-processing, operational and financial systems;
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scale up from small pilot or prototype quantities to large quantities of product on a consistent basis;
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contract for or develop the internal skills needed to master large volume production of our products; and
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fund the capital expenditures required to develop volume production due to the limits of our available financial resources.
We are entering new markets, and if we fail to accurately predict growth in these new markets, we may suffer substantial losses.
We are devoting significant resources to the development of products and the support of marketing and sales efforts in new markets, such as the disposable biochip and broader proteomics markets. We expect to continue to seek to identify and develop products for new markets. New markets change rapidly and we cannot assure you that they will grow or that we will be able to accurately forecast market demand, or lack thereof, in time to respond appropriately. Our investment of resources to develop products for these markets may either be insufficient to meet actual demand or result in expenses that are excessive in light of actual sales volumes. Failure to predict growth and demand accurately in new markets may cause us to suffer substantial losses. In addition, as we enter new markets, there is a significant risk that:
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the market may not accept the price and/or performance of our products;
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there may be issued patents we are not aware of that could block our entry into the market or result in excessive litigation; and
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the time required for us to achieve market acceptance of our products may exceed our capital resources, which would require additional investment.
The establishment and maintenance of original equipment manufacturer and other collaborative relationships is critical to the success of our business.
We expect to sell many of our products directly to research laboratories and commercial customers or through potential industry partners. For example, we expect to offer disposable bio-chips to research labs and customers who will use them in DNA analysis and protein discovery. Our ability to generate revenues depends significantly on the extent to which potential customers and other potential industry partners develop, promote and sell systems that incorporate our products. Any failure by potential customers and other potential industry partners to successfully develop and market systems that incorporate our products could adversely affect our sales. The extent to which potential customers and other industry partners develop, promote and sell systems incorporating our products is based on a number of factors that are largely beyond our ability to control.
Our future growth will suffer if we do not achieve sufficient market acceptance of our products.
We are developing nanotechnology-enhanced polymer-based products. We do not know when a market for these products will develop, if at all. Our success depends, in part, upon our ability to gain market acceptance of our products. To be accepted, our products must meet the technical and performance requirements of our potential customers. The biochip markets are evolving rapidly and involve many competitors and competing technologies, and the optical communications industry is currently fragmented with many competitors developing different technologies. We expect that only a few of these technologies will ultimately gain market acceptance. Products based on polymer materials may not be accepted by OEMs and systems integrators of optical communications networks. In addition, even if we achieve some degree of market acceptance for our potential products in one industry, we may not achieve market acceptance in other industries for which we are developing products. If the markets we are targeting fail to accept polymer-based products or determine that other products are superior, we may not be able to achieve market acceptance of our products.
All of our current products are either in the development stage or are being tested by potential customers. We cannot assure you that these customer tests will be successful or that they will result in actual material sales of our products.
Achieving market acceptance for our products will require marketing efforts and the expenditure of financial and other resources to create product awareness and demand by customers. We may be unable to offer products that compete effectively due to our limited resources and operating history. Also, certain large corporations may be predisposed against doing business with a company of our limited size and operating history. Failure to achieve broad acceptance of our products by customers and to compete effectively would harm our operating results.
Successful commercialization of our current and future products will require us to maintain a high level of technical expertise.
Technology in our target markets is undergoing rapid change. To succeed in our target markets, we will have to establish and maintain a leadership position in the technology supporting those markets. Accordingly, our success will depend on our ability to:
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accurately predict the needs of our target customers and develop, in a timely manner, the technology required to support those needs;
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provide products that are not only technologically sophisticated but are also available at a price acceptable to customers and competitive with comparable products;
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establish and effectively defend our intellectual property; and
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enter into relationships with other companies that have developed complementary technology into which our products may be integrated.
We cannot assure you that we will be able to achieve any of these objectives.
Many of our products will have long sales cycles, which may cause us to expend resources without an acceptable financial return and which makes it difficult to plan our expenses and forecast our revenues.
Many of our products will have long sales cycles that involve numerous steps, including initial customer contacts, specification writing, engineering design, prototype fabrication, pilot testing, regulatory approvals (if needed), sales and marketing and commercial manufacture. During this time, we may expend substantial financial resources and management time and effort without any assurance that product sales will result. The anticipated long sales cycle for some of our products makes it difficult to predict the quarter in which sales may occur. Delays in sales may cause us to expend resources without an acceptable financial return and make it difficult to plan expenses and forecast revenues.
We may require additional capital to continue to fund our operations. If we do not obtain additional capital, we may be required to substantially limit our operations.
Our business does not presently generate the cash needed to finance our current and anticipated operations. Based on our current operating plan and budgeted cash requirements, we believe that we will be able to fund our operations at least through 2008. We will require additional capital to continue to fund our operations in future periods. We expect that we will need to seek additional funding through public or private financings, including equity financings, and through other arrangements, including collaborative arrangements. Poor financial results, unanticipated expenses or unanticipated opportunities could require additional financing sooner than we expect. Such financing may be unavailable when we need it or may not be available on acceptable terms. If we raise additional funds by issuing equity or convertible debt securities, the percentage ownership of our existing stockholders may be reduced, and these securities may have rights superior to those of our common stock. If adequate funds are not available to satisfy either short-term or long-term capital requirements, or if planned revenues are not generated, we may be required to limit our operations substantially. These limitations of operations may include reductions in capital expenditures and reductions in staff and discretionary costs.
We currently rely heavily on a small number of development contracts with the U.S. Department of Defense and government contractors. The termination or non-renewal of one or more of these contracts could significantly reduce our revenue.
In 2006, 2005, and 2004, 94%, 95%, and 99%, respectively, of our revenue was derived from performance on a limited number of development contracts with various agencies within the U.S. Department of Defense. Any significant disruption or deterioration of our relationships with the Department of Defense could significantly reduce
our revenues. Our government programs must compete with programs managed by other contractors for limited amounts and uncertain levels of funding. The total amount and levels of funding are susceptible to significant fluctuations on a year-to-year basis. Our competitors frequently engage in efforts to expand their business relationships with the government and are likely to continue these efforts in the future. In addition, our development contracts with government agencies are subject to potential profit and cost limitations and standard provisions that allow the U.S. government to terminate such contracts at any time at its convenience. Termination of our development contracts, a shift in government spending to other programs in which we are not involved, or a reduction in government spending generally or defense spending specifically could severely harm our business. We intend to continue to compete for government contracts and we expect such contracts will be a significant percentage of our revenue for the foreseeable future.
Our development contracts with various agencies within the U.S. Department of Defense require ongoing compliance with applicable federal procurement regulations. Violations of these regulations can result in civil, criminal or administrative proceedings involving fines, compensatory and punitive damages, restitution and forfeitures, as well as suspensions or prohibitions from entering into such development contracts. Also, the reporting and appropriateness of costs and expenses under these development contracts are subject to extensive regulation and audit by the Defense Contract Audit Agency, an agency of the U.S. Department of Defense. Any failure to comply with applicable government regulations could jeopardize our development contracts and otherwise harm our business.
Some of our products in development are directed at the telecommunications and networking markets, which continue to be subject to overcapacity and slow growth or decline.
We intend over the next several years to derive a substantial portion of our revenues from the sale of electro-optic devices to the telecommunications and networking markets. We have not yet made material sustainable commercial sales of these products, and developments that adversely affect the telecommunications or networking markets, including delays in traffic growth and changes in U.S. government regulation, could halt our efforts to generate revenue or cause revenue growth to be slower than anticipated from sales of electro-optic modulators and related products. Reduced spending and technology investment by telecommunications companies may make it more difficult for our products to gain market acceptance. Such companies may be less willing to purchase new technology such as ours or invest in new technology development when they have reduced capital expenditure budgets.
Our quarter-to-quarter performance may vary substantially, and this variance, as well as general market conditions, may cause our stock price to fluctuate greatly and potentially expose us to litigation.
Substantially all of our revenues to date have been generated from a limited number of development contracts with the U.S. government and government contractors. Our revenues have varied significantly based on when government contracts commence or end and whether they receive funding appropriations. Because we intend to expand into commercial sales of our potential products, we are unable to accurately estimate future quarterly revenue and operating expenses based on historical performance. Our quarterly operating results may vary significantly based on many factors, including:
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reductions or delays in funding of development programs involving new polymer materials technologies by the U.S. government;
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additions of new customers;
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fluctuating demand for our potential products and technologies;
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announcements or implementation by our competitors of technological innovations or new products;
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the status of particular development programs and the timing of performance under specific development agreements;
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timing and amounts relating to the expansion of our operations; and
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costs related to possible future acquisitions of technologies or businesses.
Our current and future expense estimates are based, in large part, on estimates of future revenue, which is difficult to predict. We expect to continue to make significant operating and capital expenditures in the area of
research and development and to invest in and expand production, sales, marketing and administrative systems and processes. We may be unable to, or may elect not to, adjust spending quickly enough to offset any unexpected revenue shortfall. If our increased expenses are not accompanied by increased revenue in the same quarter, our quarterly operating results would be harmed.
In one or more future quarters, our results of operations may fall below the expectations of investors and the trading price of our common stock may decline as a consequence. We believe that quarter-to-quarter comparisons of our operating results will not be a good indication of our future performance and should not be relied upon to predict the future performance of our stock price. In the past, companies that have experienced volatility in the market price of their stock have often been subject to securities class action litigation. We may be the target of this type of litigation in the future. Securities litigation against us could result in substantial costs and divert our management’s attention from other business concerns, which could seriously harm our business.
We cannot predict the pace of marketable products we may generate, and any inability to generate a sufficient number of marketable products would reduce our revenues and harm our business.
Our future revenues and profitability are dependent upon our ability to create marketable products, whether through our own research and development efforts or through collaborations with customers or industry partners. Because of the inherently uncertain nature of research and development activities, we cannot predict the pace of new product introductions. We must undertake additional research and development before we are able to develop additional products for commercial sale. Product development delays by us or potential product development partners, or the inability to enter into relationships with these potential partners, may delay or prevent us from introducing products for commercial sale. In addition, our product candidates may not result in products having the commercial potential we anticipate. Any of these factors could reduce our potential commercial sales and lead to inability to generate revenue and attain profitability.
The failure to compete successfully could harm our business.
We expect to face competitive pressures from a variety of companies in each of our target markets. Some of our present and potential competitors have or may have substantially greater research and product development capabilities, financial, scientific, marketing, manufacturing and human resources, name recognition and experience than we have. As a result, these competitors may:
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succeed in developing products that are equal to or superior to our potential products or that will achieve greater market acceptance than our potential products;
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devote greater resources to developing, marketing or selling their products;
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respond more quickly to new or emerging technologies or scientific advances and changes in customer requirements, which could render our technologies or potential products obsolete;
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introduce products that make the continued development of our potential products uneconomical;
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obtain patents that block or otherwise inhibit our ability to develop and commercialize our potential products;
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withstand price competition more successfully than we can;
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establish cooperative relationships among themselves or with third parties that enhance their ability to address the needs of our prospective customers; and
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take advantage of acquisitions or other opportunities more readily than we can.
The failure to compete successfully against these existing or future competitors could harm our business.
We may be unable to establish sales and marketing capabilities necessary to successfully commercialize our potential products.
We currently have limited sales and marketing capabilities. To date, we have relied on sales and marketing leadership from our Chief Executive Officer, Mr. Mino, and our Vice President of Sales and Marketing, Mr. Lykken. We will need to either hire more sales personnel with expertise in the markets we intend to address or contract with others to provide for sales support. Although our potential products are all based on our polymer
materials technology, the potential products themselves address different markets and can be offered through multiple sales channels. Addressing each market effectively will require sales and marketing resources tailored to the particular market and to the sales channels that we choose to employ. In addition, the markets in which we operate are highly complex and technical; we may not have sufficient expertise to adequately market our products. We may be unable to establish marketing and sales capabilities necessary to commercialize and gain market acceptance for our potential products. Co-promotion or other marketing arrangements with others to commercialize products could significantly limit the revenues we derive from these products, and these parties may fail to commercialize such products successfully.
We may be unable to obtain effective intellectual property protection for our potential products and technology.
Our intellectual property, or any intellectual property that we have or may acquire, license or develop in the future, may not provide meaningful competitive advantages. Our patents and patent applications, including those we license, may be challenged by competitors, and the rights granted under such patents or patent applications may not provide meaningful proprietary protection. For example, we are aware of numerous patents held by third parties that relate to polymer materials, biochips and electro-optic devices. These patents could be used as a basis to challenge the validity or limit the scope of our patents or patent applications. A successful challenge to the validity or limitation of the scope of our patents or patent applications could limit our ability to commercialize our polymer materials technology and, consequently, reduce our revenues.
Moreover, competitors may infringe our patents or those that we license, or successfully avoid these patents through design innovation. To combat infringement or unauthorized use, we may need to resort to litigation, which can be expensive and time-consuming and may not succeed in protecting our proprietary rights. In addition, in an infringement proceeding, a court may decide that our patents or other intellectual property rights are not valid or are unenforceable, or may refuse to stop the other party from using the intellectual property at issue on the ground that it is non-infringing. Policing unauthorized use of our intellectual property is difficult and expensive, and we may not be able to, or have the resources to, prevent misappropriation of our proprietary rights, particularly in countries where the laws may not protect these rights as fully as the laws of the United States.
We also rely on the law of trade secrets to protect unpatented technology and know-how. We try to protect this technology and know-how by limiting access to those employees, contractors and strategic partners with a need to know this information and by entering into confidentiality agreements with these parties. Any of these parties could breach the agreements and disclose our trade secrets or confidential information to our competitors, or these competitors might learn of the information in other ways. Disclosure of any trade secret not protected by a patent could materially harm our business.
We may be subject to patent infringement claims, which could result in substantial costs and liability and prevent us from commercializing our potential products.
Third parties may claim that our potential products or related technologies infringe their patents. Any patent infringement claims brought against us may cause us to incur significant expenses, divert the attention of our management and key personnel from other business concerns and, if successfully asserted against us, require us to pay substantial damages. In addition, as a result of a patent infringement suit, we may be forced to stop or delay developing, manufacturing or selling potential products that are claimed to infringe a patent covering a third party’s intellectual property unless that party grants us rights to use its intellectual property. We may be unable to obtain these rights on terms acceptable to us, if at all. Even if we are able to obtain rights to a third party’s patented intellectual property, these rights may be non-exclusive, and therefore our competitors may obtain access to the same intellectual property. Ultimately, we may be unable to commercialize our potential products or may have to cease some of our business operations as a result of patent infringement claims, which could severely harm our business.
If our potential products infringe the intellectual property rights of others, we may be required to indemnify customers for any damages they suffer. Third parties may assert infringement claims against our current or potential customers. These claims may require us to initiate or defend protracted and costly litigation on behalf of customers, regardless of the merits of these claims. If any of these claims succeed, we may be forced to pay damages on behalf of these customers or may be required to obtain licenses for the products they use. If we cannot obtain all necessary licenses on commercially reasonable terms, we may be unable to continue selling such products.
The technology we license from various third parties may be subject to government rights and retained rights of the originating research institution.
We license technology from the University of Washington and various other research institutions or companies. Many of our partners and licensors have obligations to government agencies or universities. Under their agreements, a government agency or university may obtain certain rights over the technology that we have developed and licensed, including the right to require that a compulsory license be granted to one or more third parties selected by the government agency.
In addition, our partners often retain certain rights under their licensing agreement with us, including the right to use the technology for noncommercial academic and research use, to publish general scientific findings from research related to the technology, and to make customary scientific and scholarly disclosures of information relating to the technology. It is difficult to monitor whether our partners limit their use of the technology to these uses, and we could incur substantial expenses to enforce our rights to our licensed technology in the event of misuse.
The loss of our chief executive officer, or any inability to attract and retain additional personnel, could impair our ability to maintain or expand our business.
Our future success depends to a significant extent on the continued service of our key management personnel, particularly Thomas D. Mino, our chief executive officer. We do not maintain key person life insurance on any of our executive officers other than Mr. Mino and do not intend to purchase any in the future.
Our future success will also depend on our ability to attract, retain and motivate highly skilled personnel. In particular, we will need to hire a significant number of technical personnel. Competition for highly educated qualified personnel in the polymer as well as bio-tech industries is intense. If we fail to hire and retain a sufficient number of qualified engineering, sales and technical personnel, we will not be able to maintain or expand our business.
If we fail to develop and maintain the quality of our manufacturing processes, our operating results would be harmed.
The manufacture of our potential products is a multi-stage process that requires the use of high-quality materials and advanced manufacturing technologies. Also, polymer-related device development and manufacturing must occur in a highly controlled, clean environment to minimize particles and other yield- and quality-limiting contaminants. In spite of stringent quality controls, weaknesses in process control or minute impurities in materials may cause a substantial percentage of a product in a lot to be defective. If we are not able to develop and continue to improve on our manufacturing processes or to maintain stringent quality controls, or if contamination problems arise, our operating results would be harmed.
If we decide to make commercial quantities of products at our facilities, we may be required to make significant capital expenditures to increase capacity or purchase wafers or components from contract manufacturers.
We lack the internal ability to manufacture products at a level beyond the stage of early commercial introduction. To the extent we do not have an outside vendor to manufacture our products, we will have to increase our internal production capacity and we will be required to expand our existing facilities or to lease or construct new facilities or to acquire entities with additional production capacities. These activities would require us to make significant capital investments and may require us to seek additional equity or debt financing. We cannot assure you that such financing would be available to us when needed on acceptable terms, or at all. If we are unable to expand internal production capacity on a timely basis to meet increases in demand, we could lose market opportunities for sales. Further, we cannot assure you that any increased demand for our potential products would continue for a sufficient period of time to recoup our capital investments associated with increasing our internal production capacity.
In addition, we do not have experience manufacturing our potential products in large quantities. In the event of significant demand for our potential products, large-scale production might prove more difficult or costly than we anticipate and lead to quality control issues and production delays.
We may not be able to manufacture products at competitive prices.
To date, we have produced limited quantities of products for research, development and demonstration purposes. The cost per unit for these products currently exceeds the price at which we could expect to profitably sell them. If we cannot substantially lower our cost of production as we move into sales of products in commercial quantities, our financial results will be harmed.
We conduct all of our operations at a single facility, and circumstances beyond our control may result in significant interruptions.
We conduct all of our research and development, internal manufacturing and management activities at a single facility in Bothell, Washington. A disaster such as a fire, flood, earthquake, volcanic eruption or severe storm at or near this facility could prevent us from further developing our technologies or manufacturing our potential products, which would harm our business.
We could be exposed to significant product liability claims that could be time-consuming and costly and impair our ability to obtain and maintain insurance coverage.
We may be subject to product liability claims if any of our potential products are alleged to be defective or harmful. Product liability claims or other claims related to our potential products, regardless of their outcome, could require us to spend significant time and money in litigation, divert our management’s time and attention from other business concerns, require us to pay significant damages, harm our reputation or hinder acceptance of our potential products. Any successful product liability claim may prevent us from obtaining adequate product liability insurance in the future on commercially reasonable terms. Any inability to obtain sufficient insurance coverage at an acceptable cost or otherwise to protect against potential product liability claims could impair our ability to commercialize our potential products.
If we fail to effectively manage our growth, our business could suffer.
Failure to manage our growth could harm our business. To date, substantially all of our activities and resources have been directed at the research and development of our technology and development of potential products. The transition from research and development to a vendor of products will require effective planning and management. In addition, future expansion will be expensive and will likely strain our management and other resources.
In order to effectively manage growth, we must:
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continue to develop an effective planning and management process to implement our business strategy;
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hire, train and integrate new personnel in all areas of our business; and
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expand our facilities and increase our capital investments.
We cannot assure you that we will be able to accomplish these tasks effectively or otherwise effectively manage our growth.
We are subject to regulatory compliance related to our operations.
We are subject to various U.S. governmental regulations related to occupational safety and health, labor and business practices. Failure to comply with current or future regulations could result in the imposition of substantial fines, suspension of production, alterations of our production processes, cessation of operations, or other actions, which could harm our business.
We may be unable to export our potential products or technology to other countries, convey information about our technology to citizens of other countries or sell certain products commercially, if the products or technology are subject to United States export or other regulations.
We are developing certain polymer-based products that we believe the United States government and other governments may be interested in using for military and information gathering or antiterrorism activities. United States government export regulations may restrict us from selling or exporting these potential products into other countries, exporting our technology to those countries, conveying information about our technology to citizens of
other countries or selling these potential products to commercial customers. We may be unable to obtain export licenses for products or technology if necessary. We currently cannot assess whether national security concerns would affect our potential products and, if so, what procedures and policies we would have to adopt to comply with applicable existing or future regulations.
We may incur liability arising from the use of hazardous materials.
Our business and our facilities are subject to a number of federal, state and local laws and regulations relating to the generation, handling, treatment, storage and disposal of certain toxic or hazardous materials and waste products that we use or generate in our operations. Many of these environmental laws and regulations subject current or previous owners or occupiers of land to liability for the costs of investigation, removal or remediation of hazardous materials. In addition, these laws and regulations typically impose liability regardless of whether the owner or occupier knew of, or was responsible for, the presence of any hazardous materials and regardless of whether the actions that led to the presence were taken in compliance with the law. In our business, we use hazardous materials that are stored on site. We use various chemicals in our manufacturing process which may be toxic and covered by various environmental controls. The waste created by use of these materials is transported off-site by an unaffiliated waste hauler. Many environmental laws and regulations require generators of waste to take remedial actions at an off-site disposal location even if the disposal was conducted lawfully. The requirements of these laws and regulations are complex, change frequently and could become more stringent in the future. Failure to comply with current or future environmental laws and regulations could result in the imposition of substantial fines, suspension of production, alteration of our production processes, cessation of operations or other actions, which could severely harm our business.
Acquisitions or investments may be unsuccessful and may divert our management’s attention and consume significant resources.
We may in the future acquire or make investments in other businesses as well as products and technologies to complement our current business. Any future acquisition or investment may require us to use significant amounts of cash, make potentially dilutive issuances of equity securities or incur debt. In addition, acquisitions involve numerous risks, any of which could harm our business, including:
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difficulties in integrating the operations, technologies and personnel of acquired businesses;
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diversion of our management’s attention from other business concerns;
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unavailability of favorable financing for future acquisitions;
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potential loss of key employees of acquired businesses;
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inability to maintain the key business relationships and the reputations of acquired businesses;
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responsibility for liabilities of acquired businesses;
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inability to maintain our standards, controls, procedures and policies; and
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increased fixed costs.
Our plan to develop relationships with strategic partners may not be successful.
As part of our business strategy, we have developed relationships and entered into agreements with strategic partners, such as with Helix BioPharma, the University of Washington and Arizona Microsystems, to conduct research and development of technologies and products. We expect to continue to evaluate similar opportunities. For these efforts to be successful, we must identify partners whose competencies complement ours. We must also successfully enter into agreements with them on terms attractive to us, and integrate and coordinate their resources and capabilities with our own. We may be unsuccessful in entering into agreements with acceptable partners or negotiating favorable terms in these agreements. Also, we may be unsuccessful in integrating the resources or capabilities of these partners. In addition, our strategic partners may prove difficult to work with or less skilled than we originally expected. If we are unsuccessful in our collaborative efforts, our ability to develop and market products could be severely limited.
As our business grows, if we need to establish global operations, we will be subject to various risks.
Many of the markets that we propose to address are global and may require us to conduct foreign operations, including the establishment of sales, manufacturing and possible research and development facilities in other countries. While the specific risks that will apply to these activities would depend on the circumstances, we could become subject to risks relating to foreign currency fluctuations, political and social unrest, local regulatory systems and varying standards for the protection of intellectual property. The existence of any of these risks will complicate our business and may lead to unexpected and adverse effects on our business. If we are required to conduct significant foreign operations, we will also need expertise in such operations, which we do not presently have.
Our limited operating history makes financial forecasting difficult for us and for others that may publish estimates of our future financial results.
As a result of our limited operating history, it is difficult to accurately forecast our revenue and results, including product sales and government contract revenue, cost of revenue, research and development expenses, marketing, general and administrative expenses and other financial and operating data. We have a limited amount of meaningful historical financial data upon which to base projected revenue or expenses. We base our current expense levels and estimates of future expense levels on our operating plans and estimates of future revenue, and our future expenses will be dependent in large part upon our future levels of product sales. Sales and results are difficult to forecast because we do not currently have any commercial customers, we are uncertain of the extent of orders for our products and the mix, volume and timing of any such orders, and we are uncertain of the receipt of and extent of performance under government contracts. As a result, we may be unable to make accurate financial forecasts of revenue or expenses. Financial analysts and others that may seek to project our future performance face similar difficulties. This inability to accurately forecast our revenue and expenses could cause our financial results to differ materially from any projected financial results and could cause a decline in the trading price of our common stock.
Item 1B.
Item 1B. Unresolved Staff Comments
Not Applicable.
Item 2.
Item 2. Properties
Our current facilities occupy approximately 32,000 square feet of space comprised of approximately 8,000 square feet reserved or dedicated to laboratory space for biology, materials design and characterization, clean room, device design and testing and manufacturing space, and 24,000 square feet of general office space at our headquarters facility in Bothell, Washington. We believe that our facilities, which are subject to a five year lease which began on April 7, 2006, will accommodate our office and laboratory space requirements for the foreseeable future. Additional manufacturing facilities may be required to produce large commercial quantities of our products.
Item 3.
Item 3. Legal Proceedings
We are subject to various claims and pending or threatened lawsuits in the normal course of business. We are not currently party to any legal proceedings that management believes the adverse outcome of which would have a material adverse effect on our financial position, results of operations or cash flows.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of shareholders during the fourth quarter of the year ending December 31, 2006.
Item 4A. Executive Officers
Executive officers are appointed by our Board of Directors and hold office until their successors are elected and duly qualified. Mr. Mino also serves as director of Lumera. The following persons serve as executive officers of Lumera:
Thomas D. Mino, age 60, has served as Chief Executive Officer, President and a director since September 2001. From November 1999 to September 2001, he served as Vice President and General Manager of the high-speed long-haul business unit of Agere Systems Inc., an optical components supplier. From 1991 to
October 1998, Mr. Mino served as President and Chief Executive Officer of Synergy Semiconductor Corp., a specialty high-speed semiconductor manufacturer. Mr. Mino has a B.S.E.E. degree in Electrical Engineering from the University of Pittsburgh.
Daniel C. Lykken, age 53, has served as Vice President of Sales and Marketing since April 2004. From February 2003 to February 2004, Mr. Lykken served as Vice President Worldwide Sales of TeleSym Inc., a voice-over-Internet Protocol software company. From February 2002 to February 2003, Mr. Lykken served as a Strategic Account Team Manager of WatchMark Corporation, a service assurance and operational support system software provider. From October 2000 to August 2001, Mr. Lykken served as Director of Sales of Talk2 Technologies, Inc., an enhanced services provider to telecommunication carriers. From November 1999 to October 2000, Mr. Lykken served as Partner and Director of Sales of Meridian Venture Catalyst, LLC, a venture catalyst firm. From June 1999 to November 1999, Mr. Lykken served as Senior Sales Executive of Hitachi Data Systems, a data storage company. Mr. Lykken served in sales and sales management positions over his eight plus years at Sequent Computer Systems. Prior to Sequent Computer Systems, Mr. Lykken served five years as Western Region OEM Sales Executive for NCR Corporation. Mr. Lykken has a B.S. degree in Economics from Concordia College.
Peter J. Biere, age 50, has served as Vice President, Chief Financial Officer and Treasurer of Lumera Corporation since August 2004. From September 2003 to August 2004, Mr. Biere acted as Interim CEO and CFO of Entrées, Inc. From February 2002 to August 2003, Mr. Biere provided financial consulting services. From July 1999 to January 2002, Mr. Biere served as Chief Financial Officer of Locate Networks, a location-based wireless service provider. From May 1993 to July 1999, Mr. Biere served as Senior Vice President and Chief Financial Officer of Zones, Inc., where he helped lead that company’s initial public offering. Mr. Biere has a B.A. in Accounting and an M.A. in Accounting from the University of Iowa.
PART II
Item 5.
Item 5. Market for the 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 “LMRA.” As of March 1, 2007 there were approximately 5,627 holders of record of 20,055,352 shares of Common Stock outstanding. We have never declared or paid cash dividends on our Common Stock. We currently anticipate that we will retain any future earnings to fund our operations and do not anticipate paying dividends on the Common Stock in the foreseeable future.
Our Common Stock began trading publicly on July 26, 2004. The quarterly high and low sales prices of our common stock as reported by the NASDAQ Global Market for the last eight quarterly periods are as follows:
The Company did not repurchase any of its equity securities during 2006.
Equity Compensation Plan Information
The information required by this item regarding equity compensation plans is incorporated by reference to the information set forth in Part III, Item 12 of this annual report on Form 10-K.
Stock Performance Graph
The performance graph below is required by the Securities and Exchange Commission and shall not be deemed to be incorporated by reference by any general statement incorporating by reference this annual report on Form 10-K into any filing under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent we specifically incorporate this information by reference and shall not otherwise be deemed soliciting material or filed under such acts.
The following graph compares the cumulative total shareholder return on an initial $100 investment in our common stock since July 26, 2004, the date of our initial public offering, to two indices: the NASDAQ Stock Market Index and an index of peer companies selected by the Company (“Peer Index”). The companies in the Peer Index are as follows: Applera Corporation, Ciphergen Biosytems, Inc., Avenex, Inc. and JDSU. The past performance of our common stock is not an indication of future performance. We cannot assure you that the price of our common stock will appreciate at any particular rate or at all in future years.
Item 6.
Item 6. Selected Financial Data
Selected financial data presented below has been derived from and should be read in conjunction with our audited financial statements and the accompanying notes, and Management’s Discussion and Analysis of Financial Condition and Results of Operations incorporated and included elsewhere in this report. Historical results are not necessarily indicative of the results to be expected in the future. A summary of selected annual financial data from January 1, 2002 through December 31 of each year-end is presented below:
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion of our financial condition and results of operations should be read together with our financial statements and related notes that are included elsewhere in this annual report on Form 10-K. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth in Item 1A. “Risk Factors” or in other parts of this annual report on Form 10-K. We assume no obligation to update the forward-looking statements or such risk factors.
Overview
We were established in 2000 to develop proprietary polymer materials and products based on these materials. We are currently developing products for two primary markets: bioscience and electro-optics. We design and synthesize polymer materials at the molecular level by using our expertise in nanotechnology, which is the development of products and production processes at a scale smaller than 100 nanometers (a nanometer is one-billionth of a meter). Our goal is to optimize the electrical, optical and surface properties of these materials. We use these materials to improve the design, performance and functionality of products for use in biochemical analysis and in optical communications networks and systems. We believe we have developed a proprietary intellectual property position based on a combination of patents, licenses and trade secrets relating to the design and characterization of polymer materials, methods of polymer synthesis and production of polymers in commercial quantities, as well as device design, characterization, fabrication, testing and packaging technology.
From our inception through December 31, 2003, we were considered to be in the development stage concentrating primarily on the development of our technology and potential products. Products for wireless networking and biochip applications became available for customer evaluation in early 2004; therefore, we were considered to have exited the development stage in 2004. To date, substantially all of our revenues have come from contracts to develop custom-made electro-optic materials and devices for government agencies. As we transition to a product-based company, we expect to record both revenue and expense from product sales, and to incur increased costs for sales and marketing and to increase general and administrative expense. Accordingly, the financial condition and results of operations reflected in our historical financial statements are not expected to be indicative of our future financial condition and results of operations.
In 2004, we also began the development of our label-free, high throughput detection system and related biochip products aimed primarily at the growing proteomics marketplace. We also continued the development of our polymer modulators, and pending demand for higher bandwidth and speeds from optical communications equipment suppliers, we have been developing other applications for our modulators such as millimeter wave detection and communication systems. We currently have products being evaluated by customers and potential customers in each of our product areas.
We were a subsidiary of Microvision, Inc. from our inception in early 2000 through our public offering in July 2004. Until December 31, 2004, we obtained certain administrative services from Microvision through an inter-company services arrangement. Our facilities were subleased from Microvision through April 6, 2006. We entered into a direct lease agreement which expanded our current facility on April 7, 2006. We no longer have any agreements with Microvision other than certain purchase agreements pursuant to which we purchase certain electronic components at fair market value.
The following table reflects payments made to Microvision for electronic components and other services under the former Microvision Agreement during 2006, 2005, and 2004:
During March of 2006, we changed the organizational structure of our business to focus on our primary markets, creating two distinct business segments: bioscience and electro-optics. The status of our product commercialization efforts in each of our business segments is summarized below.
Bioscience Segment
We are developing a high throughput Surface Plasmon Resonance (“SPR”) biosensor designed to enable discovery and characterization of proteins. In addition, the system is being designed to characterize possible drug candidates that target protein molecules and to facilitate biomarker discovery and protein pathway elucidation. Lumera’s competitive advantage is expected to be the ability to provide researchers kinetic information about protein interactions in a label free and high throughput format.
Our NanoCapture™ Arrays are a family of microarrays targeting specific applications. Our initial product is expected to be a NanoCapture™-Gold microarray on which users will print their own biological content. We envision that future generations of NanoCapture™ Arrays will have specific surface chemistry to enable and in some cases enhance the biological assay. Ultimately, we believe we will generate a significantly more valuable consumable.
In early 2005, we acquired exclusive rights within our markets to Helix Biopharma’s Heterodimer Protein Technology (“HPT”) which was recently branded with the trade name ExpressTag™. We believe this technology gives us the necessary basis by which to provide biological content on the microarray, specifically because ExpressTag™ enables proteins to properly orient on a surface allowing them to maintain function.
The traditional commercial markets - e.g., large pharmaceutical companies and biotech companies - look to recognized research organizations and universities for development and validation of core research methodologies. Our commercialization strategy is to place a number of pre-commercial devices with our collaboration partners and research institutions to generate data useful for external validation, to speed application development efforts and to strengthen the functionality of our upcoming commercial release. Demonstrating the value of our products through these opinion leaders will, therefore, allow us to be in a stronger position when we enter these commercial markets.
In 2005 we entered into a collaboration agreement with the Institute for Systems Biology (ISB), an internationally renowned non-profit research institute dedicated to the study and application of systems biology. This agreement was extended in 2006 and is now focused on biomarker discovery, specifically with identifying biomarkers associated with drug induced liver injury. Early results suggest that Lumera’s ProteomicProcessor™ platform can be used to identify new biomarkers. Experiments are ongoing to further quantify and validate the results.
Our collaboration with the Harvard University Medical School, which began informally in early 2005, is focused on integrating Harvard’s NAPPA (Nucleic Acid Programmable Protein Array) technology, which provides a simple and cost-effective way to generate a protein biochip, with the ProteomicProcessor™ to read and analyze the biochip. In October 2006, we released an update on Dr. LaBaer’s work in connection with the ProteomicProcessor™. Successful integration of NAPPA on the ProteomicProcessor™ was presented by Harvard researchers at the PepTalk conference in January 2007. Follow on research is focused on developing a new protein biochip containing kinase proteins for use in both kinase interaction studies as well as kinase inhibitor studies.
Currently our beta release devices are installed at the Institute for Systems Biology, Harvard, the Medical University of South Carolina and Baylor Institute for Immunology Research. Additional academic, as well as select commercial beta sites, have expressed an interest in the system.
Our life sciences product development and manufacturing team is focused on bringing all of the necessary features and functions to provide the market with a competitive product. We continue to work through a number of outstanding issues, which are demanding much of the team’s focus, including vendor qualification and building required quality control processes.
Electro-Optics Segment
We are developing a new generation of electro-optic modulators and other devices for optical networks and systems based on our proprietary polymer materials. The applications for these advanced materials include electro-optic components such as modulators and ring oscillators, polymer electronics such as high performance diodes and
transistors, and optical interconnects for high speed (greater than 20 billion cycles per second) inter and intra semiconductor chip communication. Our polymer-based modulators can operate at speeds up to five times faster than existing inorganic crystal-based electro-optic modulators and are smaller, lighter and more energy efficient than electro-optic modulators using inorganic crystals. We have designed and manufactured polymer-based electro-optic modulators that operate at speeds up to 95 GHz. We are continuing development efforts to enhance the speed, efficiency and power requirements of electro-optic materials and devices to meet evolving customer requirements and applications.
We are also developing millimeter wave systems which could be used in wireless communication systems applications and in security related applications, offering high data-rate wireless transmission at low cost compared to current last mile wire-line infrastructure. During the fourth quarter of 2006 we completed testing of our prototype millimeter wave wireless bridge, successfully transmitting 10 Gbps at 94 GHz through the use of Gigabit Ethernet and other standard protocols. We also successfully tested a prototype of our multiband, high data-rate adaptive millimeter-wave communication system during the fourth quarter of 2006. Potential customers for these systems include various telecommunications and broadcasting companies as well as defense and security agencies. We anticipate that commercial versions of our millimeter wave communications systems could be available within eighteen months.
In July 2006, the Defense Advanced Research Projects Agency (DARPA) awarded us an 18-month, $3.45 million contract which, based on the achievements of certain milestones, will be followed by a 12-month, $2.43 million contract for a total of $5.9 million over 30 months, less if milestones deliveries are accelerated. The objective of the project is to provide high performance polymer optical modulators that are critical in leading-edge defense applications, including terrestrial and satellite RF photonic links and phased array radar. The scope of the 30 month multi-phase project, which can be shortened with acceleration of deliverables, involves developing materials with unprecedented electro-optic coefficients, with qualified thermal and photo-stability and processing them into devices. The combination of reduced drive voltage and optical loss will enable defense applications that are impractical with currently available optical modulator technologies.
Historically, substantially all electro-optics segment revenue has been generated from cost plus fixed fee development contracts with several United States government agencies or with government contractors, primarily to develop specialized electro-optic polymer materials and devices.
Results of Operations
Revenue. Substantially all of our revenue since inception has been generated from cost plus fixed fee development contracts with several United States government agencies or with government contractors. Our projects have primarily been to develop specialized electro-optic polymer materials and devices. The following table summarizes the various contract awards we have received since its inception and the related revenue recognized:
Backlog on our governmental contracts totaled $1,672,000 at December 31, 2006. Our revenue from government contracting has fluctuated year to year and we expect that future periods could also fluctuate significantly.
We also generate revenue through sales of our products to research institutes - both private and in universities, original equipment manufacturers (“OEMs”), drug discovery and/or diagnostic companies, industry partners and through development contracts. We expect that future revenue from U.S. government contracts will decrease as a percentage of revenue and that product revenue from the sale of commercial products will increase both on a dollar
basis and as a percentage of revenue in future years. Revenue from product shipments was less than 10% of total revenues for all years.
Cost of Revenue. Historically, cost of revenue has consisted primarily of the direct and allocated indirect costs of performing on development contracts. Direct costs include labor, materials and other costs incurred directly in performing specific projects. Indirect costs include labor and other costs associated with our research and product development efforts and building our technical capabilities and capacity. The cost of revenue can fluctuate substantially from period to period depending on the level of both the direct costs incurred in the performance of projects and the level of indirect costs incurred. The cost of revenue as a percentage of revenue can fluctuate significantly from period to period depending on the contract mix, the cost of future planned products and the level of direct and indirect cost incurred.
Cost of product revenue includes direct labor and material costs and allocated indirect costs. We currently utilize our research and development facilities to manufacture our products until demand for these products justify separate manufacturing facilities. Indirect cost is allocated to the cost of product revenues based upon direct labor required during the manufacturing process, but only to the extent of product revenue. We record product costs in excess of revenues as research and development costs.
We expect that cost of revenue on a dollar basis will increase in the future as a result of anticipated sales of products, additional development contract work that we expect to perform, and commensurate growth in our personnel and technical capacity required to perform on these contracts.
Research and Development Expense. Research and development expense consists primarily of:
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laboratory operations, outsourced development and processing work;
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research fees paid to the University of Washington and other educational institutions for contract research;
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compensation for employees and contractors engaged in internal research and product development activities;
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costs incurred in acquiring and maintaining licenses; and
·
related operating expenses.
A significant portion of our research and development expense through June 2005 related to cash payments and a grant of common stock pursuant to our Sponsored Research Agreement with the University of Washington (the “UW”). We issued 802,414 shares of common stock in January 2001 to UW, recognizing $3.0 million of research and development expense through February 2004. Cash payments under the Sponsored Research Agreement, following several amendments, totaled $5.75 million. We have ongoing minimum royalty obligations required by a technology licensing agreement with the UW totaling $75,000 annually. We are currently funding researchers at the UW and other institutions to conduct ongoing research activities on a project basis.
We expect to continue to incur substantial research and development expense to develop commercial products using polymer materials technology. These expenses could increase as a result of continued development and commercialization of our polymer materials technology, including subcontracting work to potential development partners, expanding and equipping in-house laboratories, acquiring rights to additional technologies, hiring additional technical and support personnel and pursuing other potential business opportunities.
Marketing, General and Administrative Expense. Marketing, general and administrative expense consists primarily of compensation and support costs for management and administrative staff, and for other general and administrative costs, including accounting and legal fees, consulting fees and other operating expenses. It also consists of costs associated with corporate awareness campaigns such as web site development and participation at trade shows, corporate communications initiatives and efforts with potential customers and joint venture partners to identify and evaluate product applications in which our technology could be integrated or otherwise used.
We expect marketing, general and administrative expense to increase in 2007 and beyond as we:
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increase our product development and marketing staff to define, qualify, develop and market products that we commercialize;
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increase our sales staff to begin and develop customer relationships and sell our products in various geographies and marketplaces; and
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increase the level of corporate and administrative activity, including increases associated with our operation as a public company.
Interest Income. Interest income consists of earnings from investment securities. Dividend and interest income are recognized when earned. Realized gains and losses would be included in other income.
Income Taxes. From inception through December 31, 2006, we have generated federal net operating loss carry forwards of approximately $55.7 million and research and development credits of approximately $1.3 million. Our net operating loss carry forwards begin expiring in 2018 through 2026. In some circumstances, as specified in the Internal Revenue Code, a 50% or more ownership change by certain combinations of our shareholders during any three-year period would result in a limitation on our ability to use a portion of our net operating loss carry forwards. We have recorded a valuation allowance for the full amount of its potential future tax benefits.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been 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 liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, contract losses, bad debts, stock-based compensation, income taxes, investments and contingencies and litigation. We base our estimates on historical experience, terms of existing contracts, information provided by our current and prospective customers and strategic partners, information available from other outside sources, and on various other assumptions management believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values 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 the following accounting policies require our more significant judgments and estimates used in the preparation of our financial statements.
Revenue Recognition
We recognize revenue as work progresses on long-term, cost plus fixed fee and fixed price contracts using the percentage-of-completion method, which relies on estimates of total expected contract revenue and costs. We use this revenue recognition methodology because we can make reasonably dependable estimates of the revenue and costs. Recognized revenues are subject to revisions as the contracts progress to completion and actual revenue and cost become certain. Revisions in revenue estimates are reflected in the period in which the facts that give rise to the revisions become known.
Revenue from product shipments is recognized in accordance with Staff Accounting Bulletin No. 104 “Revenue Recognition”. Revenue is recognized when there is sufficient evidence of an arrangement, the selling price is fixed and determinable and collection is reasonably assured. Revenue for product shipments is recognized upon acceptance of the product by the customer or expiration of the contractual acceptance period, after which there are no rights of return. Provisions are made for warranties at the time revenue is recorded. Warranty expense and the associated liability recorded was not material for any periods presented.
Contract Estimates
We estimate contract costs based on the experience of our professional researchers, the experience we have obtained in our internal research efforts, and our performance on previous contracts. We believe this allows us to reasonably estimate the tasks required and the contract costs; however, there are uncertainties in estimating these costs, such as the ability to identify precisely the underlying technical issues hindering development of the technology; the ability to predict all the technical factors that may affect successful completion of the proposed tasks; and the ability to retain researchers having enough experience to complete the proposed tasks in a timely manner. Should actual costs differ materially from our estimates, we may have to adjust the timing and amount of revenue we recognize. To date, we have mitigated the risk of failing to perform under these contracts by negotiating best efforts provisions, which do not obligate us to complete contract deliverables.
Stock-based Compensation
We adopted the fair value recognition provisions of Financial Accounting Standards Board (“FASB”) Statement No. 123(R), Share-Based Payment, (“FAS 123R”) effective January 1, 2006 and have applied the provisions of Staff Accounting Bulletin No. 107 (“SAB 107”) issued by the SEC in March 2005. Prior to January 1, 2006, we accounted for stock-based employee compensation arrangements on the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees and related amendments and interpretations and we accounted for equity instruments issued to non-employees in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock Based Compensation and Emerging Issues Task Force (“EITF”) Issue No. 96-18. We also complied with the disclosure provisions of SFAS No. 123 which required fair value recognition for employee stock-based compensation.
We adopted FAS 123R using the modified prospective transition method. Under that transition method, compensation cost recognized in 2006 includes compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of FAS 123, and compensation cost for all share-based payments granted or modified subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of FAS 123R. We recorded $1,776,000 of employee stock-based compensation in operating expenses for the year ended December 31, 2006, increasing our loss per share by $0.10.
We elected to continue using the accelerated method of expense recognition pursuant to FASB Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans (“FIN 28”) as we used previously under the disclosure-only provisions of SFAS 123. Previously measured but unrecognized compensation expense for all unvested options outstanding as of January 1, 2006 and share-based payments granted subsequent to January 1, 2006, compensation expense, both based on the fair value on the date of grant, will be recognized on an accelerated basis over the requisite service period. As of December 31, 2006, there was $1.6 million of unrecognized compensation cost, net of expected forfeitures, with the majority of the remaining being recognized over the next four quarters. Going forward, stock compensation expenses may increase as we issue additional equity-based awards to continue to attract and retain key employees.
We continue to use the Black-Scholes option pricing model in determining the fair value of stock options, employing the following key assumptions. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant. We do not anticipate declaring dividends in the foreseeable future. The expected option term of 6.25 years is based on the vesting terms of the respective options and a contractual life of ten years using the simplified method calculation as defined by SAB 107. Expected volatility is determined by blending the annualized daily historical volatility of our stock price commensurate with the expected life of the option with volatility measures used by comparable peer companies. Our estimates of expected volatility rate ranged from 56% to 74% for the year ended December 31, 2006. Our stock price volatility and option lives involve management’s best estimates at that time, both of which impact the fair value of the option calculated under the Black-Scholes methodology and, ultimately, the expense that will be recognized over the life of the option.
FAS 123R also requires that we recognize compensation expense for only the portion of options or stock units that are expected to vest; therefore, we apply estimated forfeiture rates that are derived from historical employee termination behavior. Our estimated forfeiture rate is 4%. If the actual number of forfeitures differs from those we estimated, additional adjustments to compensation expense may be required in future periods. We did not make any forfeiture related adjustments to compensation expense for the year ended December 31, 2006. We may modify the method in which we issue incentive awards to our employees through stock-based compensation in future periods. The impact of forfeitures on previously recognized compensation expense for unvested options at January 1, 2006, was immaterial; therefore, we have not recorded a cumulative effect adjustment related to the change in accounting principle.
Comparison of Years ended December 31, 2006 and December 31, 2005
Revenue. Revenue increased by $1,847,000 to $3,356,000 for the year ended December 31, 2006 from $1,509,000 for the year ended December 31, 2005. Revenue on government contracts, which totaled $3,155,000 in 2006, increased by $1,722,000 over 2005 due primarily to our recently awarded DARPA contract. Product sales revenue totaled $201,000 in 2006, up $125,000 from 2005 due primarily to initial sales of beta-release Proteomic Processors. Our contract revenue backlog totaled $1,672,000 at December 31, 2006.
Cost of Revenue. Cost of revenue increased by $989,000 to $1,911,000 for the year ended December 31, 2006 from $922,000 for the year ended December 31, 2005. Cost of contract revenue, which totaled $1,785,000, in 2006 increased by $899,000 over 2005 due primarily to higher labor costs and related overhead allocation associated with higher levels of government contract activities during 2006.
Research and Development Expense. Research and development expense increased $194,000 to $6,734,000 for the year ended December 31, 2006, from $6,540,000 for the year ended December 31, 2005. Product development costs, including professional fees and materials and equipment costs, which totaled $3,262,000 in 2006, increased by $1,853,000 over 2005 due primarily to an increase in consulting fees. Compensation costs, including bonus expense, associated with additional research personnel, which totaled $2,305,000 in 2006, increased by $153,000 over 2005. Facilities and general and administrative expenses increased by $134,000 to $1,197,000 in 2006 due primarily to increased facilities costs to accommodate growth. Non-cash compensation increased by $272,000 in 2006 to $367,000 due primarily to the adoption of FAS 123R. Labor related overhead costs reclassified to the cost of government contracts totaled $1,303,000 in 2006 or $707,000 more than in 2005 due to a higher level of government contracting activities. Expenses associated with our various agreements with the University of Washington (UW) decreased by approximately $606,000 in 2006 due primarily to the cessation of payments under our Sponsored Research Agreement with the UW which ended during 2005. Depreciation expense decreased by $500,000 in 2006 as our fixed asset base is becoming more fully depreciated. License and royalty fees decreased by $409,000 in 2006 due to primarily to technology transfer expenses associated with our Sensium license acquisition incurred during 2005.
The following table summarizes the payments made and expenses recognized under the various UW Agreements for the comparative periods:
Marketing, General and Administrative Expense. Marketing, general and administrative expense increased $2,516,000 to $7,670,000 for the year ended December 31, 2006 from $5,155,000 for the year ended December 31, 2005. Non-cash compensation expense increased in 2006 by $1,034,000 due to the adoption of FAS 123R. Compensation costs, including bonus expense, associated with additional marketing and finance personnel and our business segment realignment increased by $947,000 to $3,133,000 in 2006, compared to $2,186,000 in 2005.
General and administrative expenses, including professional fees, depreciation, travel and insurance costs, increased by $303,000 in 2006 to $2,796,000 and facilities expense increased by $231,000 due to our facilities expansion.
Interest Income. Interest income increased $186,000 to $841,000 for the year ended December 31, 2006 from $655,000 in 2005 due primarily to increased investment returns in 2006 and to higher levels of investments following the completion of our November 2006 financing.
Comparison of Years ended December 31, 2005 and December 31, 2004
Revenue. Revenue increased by $520,000 to $1,509,000 for the year ended December 31, 2005 from $989,000 for the year ended December 31, 2004. Revenue on government contracts, which totaled $1,433,000 in 2005, increased by $461,000 over 2004; $399,000 of this additional revenue related to contracts that were continuing from 2004 and $62,000 related to contracts awarded in 2005. Product sales revenues totaled $76,000 for 2005 compared to $17,000 in 2004. Product sales during 2005 consisted entirely of sample sized orders of products used in further development efforts or commercial feasibility studies. Our contract revenue backlog totaled $1,323,000 on two government contracts at December 31, 2005.
Cost of Revenue. Cost of revenue increased by $271,000 to $922,000 for the year ended December 31, 2005 from $651,000 for the year ended December 31, 2004. Cost of contract revenue, which totaled $886,000 in 2005 increased by $235,000 over 2004 due primarily to higher labor costs and overhead allocations associated with higher levels of government contract activities during 2005. Cost of product revenue totaled $36,000 in 2005.
Research and Development Expense. Research and development expense increased $1,979,000 to $6,540,000 for the year ended December 31, 2005, from $4,561,000 for the year ended December 31, 2004. Expenses associated with our various agreements with the University of Washington increased by approximately $1.7 million in 2005 from 2004. Expenses under our Sponsored Research Agreement with the University of Washington, which ended during 2005, totaled $650,000 compared to a net benefit of $1.2 million in 2004. In 2004, we recorded a $2.4 million benefit in 2004 to reduce previously expensed costs as a result of an amended payment schedule which reduced total required payments to the UW from $9 million under the terms of the original agreement to $5.75 million. Consulting fees associated primarily with device and package design, which totaled $877,000 in 2005, increased by $614,000 over 2004. License and royalty fees associated primarily with our Sensium license agreement were $405,000 higher in 2005 and materials and supplies were $341,000 higher in 2005. Amortization of non-cash stock-based compensation expense associated with stock options granted to research personnel during 2004 at prices below market value totaled $95,000 during 2005, down $478,000 from $573,000 during 2004. Expenses associated with technology transfer and patent expense reimbursement with Arizona Microsystems totaled $322,000 in 2004. In addition, labor related overhead costs applied to the cost of government contracts was $ 258,000 higher in 2005 leading to a decline in research and development expense
The following table summarizes the payments made and expenses recognized under the various UW Agreements for the comparative periods:
Marketing, General and Administrative Expense. Marketing, general and administrative expense increased $567,000 to $5,155,000 for the year ended December 31, 2005 from $4,588,000 for the year ended December 31, 2004. The increased expense during 2005 which primarily relate to our first full year as a stand alone public company were audit, legal, insurance and investor relations activities which were $904,000 higher in 2005. Additionally, expenses associated with additional finance, sales and marketing headcount increased by $638,000 and general and administrative expenses increased by $524,000 in 2005. Non-cash amortization expenses related to 2004
stock option grants at below market prices declined by $946,000 in 2005. Incentive compensation expenses related to 2005 declined by $361,000 to align expected payouts with performance. In 2004 we incurred $185,000 of financial consulting expense associated with 2004 fundraising activities which did not recur in 2005.
Interest Income. Interest income increased $418,000 to $655,000 for the year ended December 31, 2005 from $237,000 in 2004 due to higher levels of investments following our public offering in July 2004.
Interest Expense. There was no interest expense in 2005. Interest expense in 2004 totaled $349,000 due primarily to interest on $2,300,000 of 6.5% Convertible Notes issued in April 2004. The Notes were repaid in August 2004 following our public offering. We incurred $345,000 of interest expense associated with the Notes in 2004, $44,000 of which was paid in cash for the stated interest on the Notes and $301,000 of non-cash debt issuance costs associated with the value of the warrants issued with the Notes.
Segment Revenues and Operating Loss
During March 2006, we changed the organizational structure of our business to focus on primary markets, creating two distinct segments: bioscience and electro-optics. Revenue and operating loss amounts in this section are presented on a basis consistent with accounting principles generally accepted in the United States of America and include certain allocations attributable to each segment. Segment information in Note 13 - Segment Information in the Financial Statements is presented on a basis consistent with our internal management reporting and in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 131, Disclosures about Segments of an Enterprise and Related Information. Certain corporate level expenses have been excluded from our segment operating results and are analyzed separately. Periods prior to March 2006 have been revised to reflect our best estimates of segment activity as if they had been in existence during the comparative periods and are being restated to reflect our internal organization changes to conform to the current period presentation.
Comparison of the Years Ended December 31, 2006 and December 31, 2005
Summary
Bioscience Segment
Revenue. Revenue increased by $110,000 to $119,000 for the year ended December 31, 2006 from $9,000 for the year ended December 31, 2005 primarily due to initial sales of beta release ProteomicProcessorÔ during 2006.
Operating Loss. Our Bioscience segment operating loss increased by $1,793,000 to $4,383,000 for the year ended December 31, 2006 from $2,590,000 for the year ended December 31, 2005 primarily due to additional personnel expenses and efforts associated with commercializing our ProteomicProcessorÔ and related applications. Compensation costs, including bonus expense, associated with additional research personnel increased by $828,000 in 2006. Product development costs, including professional fees and general administrative expenses, increased by $1,052,000 during 2006. Non-cash share-based compensation costs increased by $181,000 in 2006, due primarily to the adoption of FAS 123R. Our Sensium license acquisition fees decreased by $404,000 in 2006. Labor related overhead costs applied to the cost of product development was $86,000 higher in 2006 leading to a decline in research and development expense.
Electro-optics Segment
Revenue. Revenue increased by $1,737,000 to $3,237,000 for the year ended December 31, 2006 from $1,500,000 for the year ended December 31, 2005. Aggregate revenue on governmental contracts, which totaled $3,155,000 in 2006, increased by $1,722,000 over 2005 primarily due to our recently awarded DARPA contract. Product revenue, which totaled $82,000 and $67,000 in 2006 and 2005, respectively, was constituted by sales of research quantities of polymer materials and modulator chips and devices. Backlog on our governmental contracts totaled $1,672,000 at December 31, 2006.
Operating Loss. Our Electro-optics segment operating loss decreased by $1,156,000 to $3,097,000 for the year ended December 31, 2006, from $4,254,000 for the year ended December 31, 2005. Gross profit increased by $845,000 in 2006 due primarily to higher levels of government contract revenues during the year. Expenses associated with our various agreements with the University of Washington decreased by $606,000 for the year ended December 31, 2006 as our sponsored research agreement with the University of Washington ended on June 2005. Product development costs, including professional fees and general administrative expenses, increased by $528,000 in 2006. Compensation costs, including bonus expense, decreased by $14,000, and non-cash share-based compensation costs increased by $175,000 due to our adoption of FAS 123R, all during the year ended December 31, 2006. Depreciation decreased by $478,000 in 2006 as our asset base is becoming more fully depreciated. Labor related overhead costs applied to the cost of government contracts was $621,000 higher in 2006 leading to a decline in research and development expense.
Corporate Expenses
Corporate expenses. Certain corporate expenses are not allocated to our segments, primarily consisting of executive management and human resources, investor relations, legal, finance, information technology, purchasing and other general corporate activities.
Total corporate expenses increased by $1,215,000 to $5,479,000 for the year ended December 31, 2006, from $4,264,000 in 2005. Non-cash stock based compensation costs increased by $950,000 for the year ended December 31, 2006 due to our adoption of FAS 123R in 2006. Compensation costs, including bonus expense, increased by $286,000 due to an increase in headcount for the year ended December 31, 2006 from the prior year comparative period. Professional fees decreased $65,000 for the year ended December 31, 2006 due primarily to lower legal fees and audit fees. General administrative fees including facilities, depreciation and insurance increased $43,000 for the year ended December 31, 2006 from the year ended December 31, 2005.
Comparison of Years Ended December 31, 2005 and December 31, 2004
Summary
Bioscience Segment
Revenue. Revenue totaled $9,000 for the year ended December 31, 2005 as we began selling sample sized orders of micro arrays. We had no Bioscience revenue in 2004.
Operating Loss. Our Bioscience segment operating loss increased by $1,768,000 to $2,590,000 for the year ended December 31, 2005, from $822,000 in 2004. Compensation costs, including bonus expense, associated with additional research personnel increased by $455,000 in 2005. Product development costs, including professional fees and general administrative expenses, increased by $937,000 during the year ended December 31, 2005. License and royalty fees associated primarily with our Sensium license agreement were $405,000 higher in 2005.
Electro-optics Segment
Revenue. Revenue increased by $511,000 to $1,500,000 for the year ended December 31, 2005, from $989,000 in 2004 primarily due to the increased level of government contract activity. Aggregate revenue on governmental contracts, which totaled $1,433,000 in 2005, increased by $461,000 over 2004 primarily due to increased activity on our various contracts. Product revenue, which totaled $67,000 and $17,000 in 2005 and 2004, respectively, consisted of sales of sample sized orders of polymer materials and modulator chips and devices. Backlog on our governmental contracts totaled $1,323,000 at December 31, 2005.
Operating Loss. Our Electro-optics segment operating loss increased by $855,000 to $4,254,000 for the year ended December 31, 2005, from $3,399,000 in 2004. Gross profit increased by $248,000 in 2005 due primarily to higher levels of government contract revenues during the year. Expenses associated with our various agreements with the University of Washington increased by $1,725,000 in 2005. Expenses under our Sponsored Research Agreement with the University of Washington, which ended during 2005, totaled $650,000 compared to a net benefit of $1.2 million in 2004. Product development costs, including other professional fees and general administrative expenses, increased by $313,000 primarily due to increased materials and supplies expense and increased subcontractor and consulting expense. Compensation costs, including bonus expense, decreased by $387,000, and non-cash share-based compensation costs decreased by $403,000 in 2005. Labor related overhead costs applied to the cost of government contracts was $144,000 higher in 2005 leading to a decline in research and development expense.
Corporate Expenses
Corporate expenses. Certain corporate expenses are not allocated to our segments, primarily consisting of executive management and human resources, investor relations, legal, finance, information technology, purchasing and other general corporate activities.
Total corporate expenses decreased by $326,000 to $4,264,000 for the year ended December 31, 2005, from $4,590,000 in 2004. Compensation costs increased by $337,000 due to an increase in headcount for the year ended December 31, 2005 and incentive compensation decreased by $356,000 from the prior year ended December 31, 2004 to align expected payouts and performance. Non-cash amortization expenses related to 2004 stock option grants at below market prices declined by $983,000 in 2005. Professional fees increased $130,000 for the year ended December 31, 2005 due primarily to an increase in legal fees and accounting and audit fees. General administrative fees including facilities, depreciation and insurance increased $549,000 for the year ended December 31, 2005 from the year ended December 31, 2004.
Liquidity and Capital Resources
We have funded our operations to date primarily through the sale of common stock and convertible preferred stock and, to a lesser extent, through revenues from development contracts and sales of products. Our accumulated deficit, which represents the cumulative net loss since our inception, totaled $60.8 million at December 31, 2006.
In November 2006, we issued 2,825,000 shares of our common stock at a purchase price of $6.00 per share for an aggregate purchase price of $16,950,000. Cash proceeds from the offering totaled $15.7 million, after transaction expenses. The securities, which were not registered for sale at the time of the offering, were registered under the Securities Act of 1933 with the SEC in December 2006.
We had $26.3 million in cash and cash equivalents and investment securities at December 31, 2006, all of which are classified as short term with maturities less than 12 months beyond the balance sheet date.
Operating Activities. We used $9.6 million, $8.2 million and $7.3 million in cash and cash equivalents to fund operating activities during the years ending December 31, 2006, 2005 and 2004, respectively.
The following table summarizes the net cash used from operating activities by business segment for the years ended December 31 2006 and 2005:
Net cash used to fund operating activities increased by $1.4 million to $9.6 million for the twelve months ended December 31, 2006, from $8.2 million in the prior year period. We used $4.0 million in cash to fund our Bioscience segment activities during 2006, an increase of $1.6 million over the prior year period, primarily due to higher costs associated with product development activities and additional headcount related compensation expenses. We used $2.3 million in cash to fund our Electro-optics segment activities during 2006, a decrease of $851,000 primarily due to higher government contract revenues in the current period. We used $3.2 million in cash to fund corporate activities during 2006, an increase of $575,000 primarily due to changes in working capital accounts and additional headcount related compensation expenses.
The following table summarizes the net cash used from operating activities by business segment for the years ended December 31, 2005 and 2004:
Net cash used to fund operating activities increased by $866,000 to $8.2 million for the twelve months ended December 31, 2005, from $7.3 million in the prior year period. We used $2.4 million in cash to fund our Bioscience segment activities during 2005, an increase of $1.8 million over the prior year period, primarily due to higher costs associated with product development activities and additional headcount related compensation expenses. We used $3.2 million in cash to fund our Electro-optics segment activities during 2005, an increase of $1.2 million primarily due to contract research fees associated with our agreement with the University of Washington. We used $2.6 million in cash to fund corporate activities during 2005, a decrease of $2.2 million primarily due to a decrease in the amortization of non-cash compensation and bonus expense combined with an increase in interest income for the year ended December 31, 2005 and an increase in working capital for the year ended December 31, 2005.
Investing Activities. Investing activities used $1.8 million in cash in 2006, provided cash totaling $9.2 million in 2005 and used $27.2 million in cash in 2004. During 2006 we funded our operating activities primarily with cash from investment maturities. We invested approximately $2.4 million in leasehold improvements and laboratory equipment in 2006. Purchases of investment securities following our November 2006 financing more than offset cash provided for operating losses and capital expenditures. The cash provided in 2005 was primarily due to the sale of investment securities, net of reinvestments. The cash used in 2004 was primarily due to net investments of cash following our initial public offering in July 2004.
Historically, capital expenditures have been used to make leasehold improvements to leased office space and to purchase production equipment, computer hardware and software, laboratory equipment and furniture and fixtures to support our growth. Capital expenditures will decrease during 2007 due to the completion of leasehold improvements in our new facilities during 2006.
Financing Activities. Financing activities provided cash totaling $17.0 million in 2006, $437,000 in 2005 and $37.5 million in 2004. In November 2006, we completed the sale of 2,825,000 shares of our common stock, receiving approximately $15.7 million in cash, net of financing costs. We received cash from the exercise of stock options totaling $1.3 million in 2006 and $437,000 in 2005, issuing 482,236 and 201,686 shares of common stock, respectively.
During 2004, we received $37.5 million in cash from the following activities:
·
In March 2004, we raised $500,000 from the sale of Series B preferred stock.
·
In April 2004, we issued $2.3 million of 6.5% convertible promissory notes, together with warrants to purchase 115,000 shares of common stock. These notes were payable on demand upon completion of our initial public offering. The warrants carry an exercise price of $7.20 and expire in 2009. All of the Notes were repaid following our July stock offering.
·
In July 2004, we completed our IPO, raising $37 million, net of underwriter’s discounts and offering expenses.
Forward-looking Statements. Our future expenditures and capital requirements will depend on numerous factors, including: the progress of our research and development efforts; the rate at which we can, directly or through arrangements with original equipment manufacturers, introduce and sell products incorporating our polymer materials technology; the costs of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights; market acceptance of our products and competing technological developments; and our ability to establish cooperative development, joint venture and licensing arrangements.
We expect that our cash used in operations will increase during 2007, compared to 2006, and beyond as a result of:
·
increased production spending as our products are accepted and sold;
·
increased spending on marketing activities as our products are introduced into our target markets;
·
the addition of sales, marketing, technical and other staff to sell products, meet production needs and continue with future development efforts;
·
purchases of additional laboratory and production equipment;
·
the development of strategic relationships with systems and equipment manufacturers; and
·
increased general and administrative activities related to our operations as a public company and related corporate compliance requirements.
Our business does not presently generate the cash needed to finance our current and anticipated operations. We expect that cash and investments held for sale, along with revenues from our existing contractual relationships, will be sufficient to fund our operations at least through the end of 2008 (See Item 1A - Risk Factors). We may seek additional funding through public or private financings, including equity financings, and through other arrangements, including collaborative arrangements. If we raise additional funds by issuing equity or convertible debt securities, the percentage ownership of our existing stockholders may be reduced, and these securities may have rights superior to those of our common stock.
Contractual Obligations. The following table lists our contractual obligations as of December 31, 2006:
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Royalty and license obligations continue through the lives of the underlying patents.
Off-Balance Sheet Arrangements. We do not use off-balance-sheet arrangements with unconsolidated entities or related parties, nor do we use other forms of off-balance-sheet arrangements such as special purpose entities and research and development arrangements. Accordingly, our liquidity and capital resources are not subject to off-balance-sheet risks from unconsolidated entities.
Recent Accounting Pronouncements
In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”), which provides criteria for the recognition, measurement, presentation and disclosure of uncertain income tax positions. A tax benefit from an uncertain income tax position may be recognized only if it is “more likely than not” that the position is sustainable based on its technical merits. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact that FIN 48 will have on our financial condition or results of operations.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”), “Considering the Effects of a Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements”, which allows for the adjustment of the cumulative effect of prior year immaterial errors in assets and liabilities as of the beginning of the fiscal year with an offsetting adjustment to the opening balance of retained earnings. There have been two common approaches used to quantify such errors. Under one approach, the error is quantified as the amount by which the current year income statement is misstated. The other approach quantifies the error as the cumulative amount by which the current year balance sheet is misstated. The adoption of SAB 108, which is effective for annual financial statements covering the first fiscal year ending after November 15, 2006, did not have a material impact on our financial statements.
In September of 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”. This Statement provides a single definition of fair value, together with a framework for measuring it, and requires additional disclosure about the use of fair value to measure assets and liabilities. SFAS No. 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority being quoted prices in active markets. Under the Statement, fair value measurements are disclosed by level within that hierarchy. While the Statement does not add any new fair value measurements, it does change current practice. Changes to practice include a requirement for an entity to include its own credit standing in the measurement of its liabilities and to adjust the value of restricted stock for the effect of the restriction even if the restriction lapses within one year. The Statement is effective January 1, 2008 and is to be applied prospectively. We are currently evaluating the impact that SFAS No. 157 will have on our financial condition or results of operations; however, we do not believe that the adoption of SFAS No. 157 will have a material impact given our net operating losses.
In December 2006, the FASB approved FASB Staff Position (“FSP”) No. EITF 00-19-2, “Accounting for Registration Payment Arrangements” (“FSP EITF 00-19-2”), which specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measure in accordance with SFAS No. 5, “Accounting for Contingencies.” FSP EITF 00-19-2 also requires additional disclosure regarding the nature of any registration payment arrangements, alternative settlement methods, the maximum potential amount of consideration and the current carrying amount of the liability, if any. This guidance is effective for financial statements issued for fiscal years beginning after December 15, 2006. The adoption of FSP EITF 00-19-2 is not expected to have a material effect on our financial statements.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115.” SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS No. 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We do not expect our adoption of this new standard to have a material impact on our financial position, results of operations or cash flows.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Substantially all of our cash equivalents and investment securities are at fixed interest rates, and as such, the fair value of these instruments is affected by changes in market interest rates. Due to the generally short-term maturities of these investment securities, however, we believe that the market risk arising from our holdings of these financial instruments is not material.
Our investment policy restricts investments to ensure principal preservation and liquidity. We invest cash that we expect to use within approximately sixty days in money market funds and U.S. treasury-backed instruments. We invest cash in excess of sixty days of our requirement in high-quality investment securities. The investment securities portfolio is limited to U.S. government and U.S. government agency debt securities and other liquid high-grade securities generally with maturities of two years or less.
Item 8.
Item 8. Financial Statements and Supplementary Data
LUMERA CORPORATION
Page
Report of Independent Registered Public Accounting Firm
Financial Statements
Balance Sheets
Statements of Operations
Statements of Changes in Mandatorily Redeemable Convertible Preferred Stock and
Shareholders’ Equity (Deficit)
Statements of Comprehensive Loss
Statements of Cash Flows
Notes to Financial Statements
Supplemental Schedule
Schedule II - Valuation and Qualifying Accounts and Reserves
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To Board of Directors
and Shareholders of
Lumera Corporation:
In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Lumera Corporation at December 31, 2006 and 2005, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements 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, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Prior to July 28, 2004, Lumera Corporation was a subsidiary of Microvision, Inc. As discussed in Note 3 to the financial statements, Lumera Corporation had transactions and relationships with that entity for each of the three years ended December 31, 2006.
As discussed in Note 1 to the financial statements, Lumera Corporation changed the manner in which it accounts for share-based compensation in 2006.
/s/ PRICEWATERHOUSECOOPERS LLP
Seattle, Washington
March 27, 2007
LUMERA CORPORATION
BALANCE SHEETS
The accompanying notes are an integral part of these financial statements.
LUMERA CORPORATION
STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these financial statements.
LUMERA CORPORATION
STATEMENTS OF CHANGES IN MANDATORILY REDEEMABLE CONVERTIBLE
PREFERRED STOCK AND SHAREHOLDERS’ EQUITY (DEFICIT)
The accompanying notes are an integral part of these financial statements.
LUMERA CORPORATION
STATEMENTS OF CHANGES IN MANDATORILY REDEEMABLE CONVERTIBLE
PREFERRED STOCK AND SHAREHOLDERS’ EQUITY (DEFICIT) - (continued)
The accompanying notes are an integral part of these financial statements.
LUMERA CORPORATION
STATEMENTS OF COMPREHENSIVE LOSS
The accompanying notes are an integral part of these financial statements.
LUMERA CORPORATION
STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements.
LUMERA CORPORATION
NOTES TO FINANCIAL STATEMENTS
1. Organization and Significant Accounting Policies
Lumera Corporation (the “Company” or “Lumera”) was incorporated in Washington State in early 2000 and reincorporated in Delaware in 2004, and was established to develop, manufacture and market devices using proprietary polymer materials. Until December 31, 2003, we were considered to be in the development stage. In early 2004, we commercialized devices for potential wireless networking and optical networking applications and had largely completed financial planning, establishing sources of supply, acquiring plant and equipment and recruiting personnel; therefore, we were considered to have exited the development stage in 2004. We were a majority owned subsidiary of Microvision, Inc. (“Microvision”) until our Initial Public Offering, completed July 28, 2004 (see Note 3).
The accompanying financial statements are presented on an accrual basis in conformity with accounting principles generally accepted in the United States of America.
Our business does not presently generate the cash needed to finance our current and anticipated operations. We expect that cash and investments held for sale, along with revenues from our existing contractual relationships, will be sufficient to fund our operations at least through the end of 2008. We may seek additional funding through public or private financings, including equity financings, and through other arrangements, including collaborative arrangements. If we raise additional funds by issuing equity or convertible debt securities, the percentage ownership of our existing stockholders may be reduced, and these securities may have rights superior to those of our common stock.
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 reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We also evaluate the requirement for allowances for uncollectible receivables, and the valuation allowances for deferred income tax assets.
Cash and Cash Equivalents - We consider all highly liquid investment securities with remaining maturities, at the date of purchase, of three months or less to be cash equivalents.
Investment Securities - Available for Sale - We have classified the entire investment portfolio as available for sale. Available for sale securities are stated at fair value based on the specific identification method. Management determines the appropriate classification of investment securities at the time of purchase and evaluates such designation as of each balance sheet date. We estimate the fair value of our investment securities using readily available market information. Unrealized gains and losses are included in shareholders equity as a component of other comprehensive income (loss), unless the loss is deemed to be other-than-temporary, in which case it is recognized immediately as an expense. Realized gains and losses are included in interest income or expense. Dividend and interest income are recognized when earned.
Concentration of Credit Risk - Financial instruments that potentially subject us to concentrations of credit risk are primarily cash and cash equivalents and investments. We have a cash investment policy that generally restricts investments to ensure preservation of principal and maintenance of liquidity. We typically do not require collateral from our customers. We make a provision for doubtful accounts when required. To date, we have not experienced any bad debts.
Revenue Recognition - Revenue has primarily been generated from research and development cost reimbursement contracts for the United States government. Revenue on such contracts is recorded using the percentage-of-completion method measured on a cost-incurred basis. Changes in contract performance, contract conditions, and estimated profitability, including those arising from contract penalty provisions and final contract settlements, may result in revisions to costs and revenues and are recognized in the period in which the revisions are determined. Profit incentives are included in revenue when realization is assured.
LUMERA CORPORATION
NOTES TO FINANCIAL STATEMENTS
1. Organization and Significant Accounting Policies - (continued)
Losses, if any, are recognized in full as soon as identified. Losses occur when the estimated direct and indirect costs to complete the contract exceed the unrecognized revenue on the contract. We evaluate the reserve for contract losses on a contract-by-contract basis. No losses have been incurred on any contracts to date.
The following table summarizes our contract revenue activity from our inception through December 31, 2006:
All of our current and prior contracts with the government have been or are cost plus fixed fee type contracts. Under the terms of a cost plus fixed fee contract, the United States government pays us for actual direct and indirect costs incurred in performing the contracted services. We are under no obligation to spend more than the contract value to complete the contracted services. In addition, completion of the contracted services is generally on a best efforts basis. If the services are not completed, the government has the option to negotiate a follow-on contract to complete the services or to not pursue the services further with us. Contract deliveries consist of monthly financial reports, periodic technical reports and any devices if they have been successfully fabricated. There are no contractual provisions for repayments of any amounts disbursed to date under these contracts. The United States government accounted for 94%, 95% and 99% of revenues in 2006, 2005 and 2004, respectively. Certain contracts awarded in one period may be partly performed in the next period.
Cost and estimated earnings in excess of billings on uncompleted contracts comprises amounts of revenue recognized on contracts that we have not yet billed to a customer because the amounts were not contractually billable at the balance sheet date. We were contractually able to bill 99%, 89% and 100% of the balance at December 31, 2006, 2005 and 2004, respectively, within 45 days of the respective year end.
Revenue from product shipments is recognized in accordance with Staff Accounting Bulletin No. 104 “Revenue Recognition”. Revenue is recognized when there is sufficient evidence of an arrangement, the selling price is fixed and determinable and collection is reasonably assured. Revenue for product shipments is recognized upon acceptance of the product by the customer or expiration of the contractual acceptance period, after which there are no rights of return. Provisions are made for warranties at the time revenue is recorded. Warranty expense and the associated liability recorded was not material for any periods presented.
Property and Equipment - Property and equipment is stated at cost. Depreciation is computed over the estimated useful lives of the assets (two to five years) using the straight-line method. Leasehold improvements are depreciated over the shorter of estimated useful lives or the lease term.
A summary of property and equipment at December 31, 2006 follows:
Depreciation expense was $875,000, $1,297,000, and $1,198,000 for December 31, 2006, 2005, and 2004 respectively.
LUMERA CORPORATION
NOTES TO FINANCIAL STATEMENTS
1. Organization and Significant Accounting Policies - (continued)
Restricted Investments - Restricted investments consist of $700,000 in satisfaction of the letter of credit provisions of our April 2006 facilities lease which has an initial term of five years. The investments consist of marketable securities classified as long term due to the length of the lease commitment.
Valuation of Long-Lived Assets - We review the carrying value of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Measurement of the impairment loss is based on the fair value of the asset, or group of assets. Generally, fair value will be determined using valuation techniques such as present value of expected future cash flows.
Research and Development - Research and development costs are expensed as incurred. As described in Note 10, we issued shares of common stock in connection with a research agreement. The value of these shares is amortized over the period of the research agreement to research and development expense.
Fair Value of Financial Instruments - Our financial instruments include cash and cash equivalents, investment securities, accounts receivable, accounts payable, and accrued liabilities. The carrying amounts of financial instruments approximate fair value due to their short maturities.
Income Taxes - We have filed separate company tax returns since our inception. We follow the liability method of accounting for income taxes. This liability method requires recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.
Net Loss per Share - Basic net loss per share is calculated on the basis of the weighted-average number of common shares outstanding during the periods. Net loss per share assuming dilution is calculated on the basis of the weighted-average number of common shares outstanding and the dilutive effect of all potentially dilutive securities, including common stock equivalents and convertible securities.
Basic and diluted net loss per share is the same because all potentially dilutive securities outstanding are anti-dilutive. Potentially dilutive securities not included in the calculation of diluted earnings per share include options and warrants to purchase common stock for all periods presented, and Series A and Series B convertible preferred stock for periods prior to the IPO in 2004. Total common stock options and common stock warrants not included in the calculation of diluted earnings per share were 3,831,916 for the year ended December 31, 2006, and were 3,160,502 and 2,664,176 for the years ended December 31, 2005 and 2004, respectively.
Stock-based Compensation - We adopted the fair value recognition provisions of Financial Accounting Standards Board (“FASB”) Statement No. 123(R), Share-Based Payment, (“FAS 123R”) effective January 1, 2006 and have applied the provisions of Staff Accounting Bulletin No. 107 (“SAB 107”) issued by the SEC in March 2005. Prior to January 1, 2006, we accounted for stock-based employee compensation arrangements on the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees and related amendments and interpretations and we accounted for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force (“EITF”) Issue No. 96-18. We also complied with the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, which required fair value recognition for employee stock-based compensation.
We adopted FAS 123(R) using the modified prospective transition method. Under that transition method, compensation cost recognized in 2006 includes compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of FAS 123, and compensation cost for all share-based payments granted or modified subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of FAS 123(R). We recorded $1,776,000 of employee stock-based compensation in operating expense for the year ended December 31, 2006, reducing our earnings per share by $0.10.
LUMERA CORPORATION
NOTES TO FINANCIAL STATEMENTS
1. Organization and Significant Accounting Policies - (continued)
We elected to continue using the accelerated method of expense recognition pursuant to FASB Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans (“FIN 28”) as we used previously under the disclosure-only provisions of SFAS 123. Previously measured but unrecognized compensation expense for all unvested options outstanding as of January 1, 2006 and share-based payments granted subsequent to January 1, 2006, compensation expense, both based on the fair value on the date of grant, will be recognized on an accelerated basis over the requisite service period. As of December 31, 2006, there was $1.6 million of unrecognized compensation cost, net of forfeitures with the majority of the remainder being recognized over the next four quarters. Going forward, stock compensation expenses may increase as we issue additional equity-based awards to continue to attract and retain key employees.
We continue to use the Black-Scholes option pricing model in determining the fair value of stock options, employing the following key assumptions. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant. We do not anticipate declaring dividends in the foreseeable future. The expected option term of 6.25 years is based on the vesting terms of the respective option and a contractual life of ten years using the simplified method calculation as defined by SAB 107. Expected volatility is determined by blending the annualized daily historical volatility of our stock price commensurate with the expected life of the option with volatility measures used by comparable peer companies. Our estimates of expected volatility rate ranged from 56% to 74% for the year ended December 31, 2006. Our stock price volatility and option lives involve management’s best estimates at that time, both of which impact the fair value of the option calculated under the Black-Scholes methodology and, ultimately, the expense that will be recognized over the life of the option.
FAS 123(R) also requires that we recognize compensation expense for only the portion of options or stock units that are expected to vest. Therefore, we apply estimated forfeiture rates that are derived from historical employee termination behavior. Our estimated forfeiture rate for the year ended December 31, 2006 is 4%. If the actual number of forfeitures differs from those we estimated, additional adjustments to compensation expense may be required in future periods. We may also modify the method in which we issue incentive awards to our employees through stock-based compensation in future periods. The impact of forfeitures on previously recognized compensation expense for unvested options at January 1, 2006, was immaterial; therefore, we have not recorded a cumulative effect adjustment related to the change in accounting principle.
Recent Accounting Pronouncements - In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes”, an interpretation of FASB Statement No. 109, which provides criteria for the recognition, measurement, presentation and disclosure of uncertain income tax positions. A tax benefit from an uncertain income tax position may be recognized only if it is “more likely than not” that the position is sustainable based on its technical merits. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact that FIN 48 will have on our financial condition or results of operations.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”), which allows for the adjustment of the cumulative effect of prior year immaterial errors in assets and liabilities as of the beginning of the fiscal year with an offsetting adjustment to the opening balance of retained earnings. There have been two common approaches used to quantify such errors. Under one approach, the error is quantified as the amount by which the current year income statement is misstated. The other approach quantifies the error as the cumulative amount by which the current year balance sheet is misstated. The adoption of SAB 108, which is effective for annual financial statements covering the first fiscal year ending after November 15, 2006, did not have a material impact on our financial statements.
In September 2006, the FASB issued Statement on Financial Standards No. 157 (“SFAS 157”), which provides a single definition of fair value, together with a framework for measuring it, and requires additional disclosure about the use of fair value to measure assets and liabilities. SFAS No. 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority being quoted prices in active markets. Under SFAS 157, fair value measurements are disclosed by level within that
LUMERA CORPORATION
NOTES TO FINANCIAL STATEMENTS
1. Organization and Significant Accounting Policies - (continued)
hierarchy. While SFAS 157 does not add any new fair value measurements, it does change current practice. Changes to practice include a requirement for an entity to include its own credit standing in the measurement of its liabilities and to adjust the value of restricted stock for the effect of the restriction even if the restriction lapses within one year. SFAS 157 is effective January 1, 2008 and is to be applied prospectively. We are currently evaluating the impact that SFAS 157 will have on our financial condition or results of operations; however, we do not believe that the adoption of SFAS 157 will have a material impact given our net operating losses.
In December 2006, the FASB approved FASB Staff Position (“FSP”) No. EITF 00-19-2, “Accounting for Registration Payment Arrangements” (“FSP EITF 00-19-2”), which specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measure in accordance with SFAS No. 5, “Accounting for Contingencies.” FSP EITF 00-19-2 also requires additional disclosure regarding the nature of any registration payment arrangements, alternative settlement methods, the maximum potential amount of consideration and the current carrying amount of the liability, if any. This guidance is effective for financial statements issued for fiscal years beginning after December 15, 2006. The adoption of FSP EITF 00-19-2 is not expected to have a material effect on our financial statements.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115.” SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS No. 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We do not expect our adoption of this new standard to have a material impact on our financial position, results of operations or cash flows.
2. Investment Securities - Available For Sale
Investment securities with maturities of less than one year totaled $15,788,000 at December 31, 2006, and $16,871,000 at December 31, 2005. We estimate the fair value of our investment securities using readily available market information. All investment securities have been classified as available for sale and are carried at estimated fair value with unrealized gains and losses included as a component of accumulated other comprehensive income in shareholders’ equity. We had an unrealized gain on investment securities of $1,000 for the year ended December 31, 2006, an unrealized loss on investment securities of $18,000 for the year ended December 31, 2005. We have concluded that these unrealized investment losses are temporary due to our ability to hold these investments to maturity.
We had no net realized gains (losses) on investment securities for the years ended December 31, 2006, 2005 and 2004.
3. Related Party Transactions
From inception until July 2004 we were a majority owned subsidiary of Microvision, Inc. The percentage of common stock owned by Microvision, Inc. was 8.73%, 27.6% and 32.84% for the years ended December 31, 2006, 2005 and 2004, respectively.
In 2004, we entered into a sublease agreement with Microvision for its corporate facilities at a base rate of approximately $25,000 per month, plus common area charges, which was effective through April 6, 2006. In 2006, we entered into a five year lease with an unrelated party to expand our current facilities which began April 7, 2006. We no longer have any agreements with Microvision other than certain purchase agreements pursuant to which we purchase certain electronic components at fair market value.
LUMERA CORPORATION
NOTES TO FINANCIAL STATEMENTS
3. Related Party Transactions - (continued)
The following table reflects payments made to Microvision and for electronic components and other services under the former Microvision Agreement during 2006, 2005, and 2004:
In July 2004, all outstanding shares of the our Series A convertible preferred stock, Series B convertible preferred stock and Class B common stock were automatically converted to common stock upon completion of our IPO in July 2004. Prior to the IPO, Microvision owned approximately 52% of our outstanding common stock on an as if converted basis. In January 2006, Microvision sold 2.55 million of its shares, or approximately 16% of our outstanding shares; most of Microvision’s remaining Lumera shares, which total approximately 9% of our outstanding shares as of March 1, 2007, are pledged as collateral under agreements which remain in effect until March 2007. Until January 2006, Richard F. Rutkowski was the Chief Executive Officer and a director of Microvision as well as a director of Lumera.
In February 2004, we agreed to pay Mr. Rutkowski a $5,000 monthly retainer to supplement our management team during our public offering. During this retainer period, which ended in July 2004, Mr. Rutkowski also performed his role as Chief Executive Officer of Microvision. We also paid Mr. Rutkowski a one-time fee of $100,000 upon the successful completion of our convertible note financing in April 2004. We recognized $130,000 of administrative expense related to these fees in 2004. In addition, we paid Mr. Rutkowski a one-time fee of $100,000 upon the participation in and successful completion of our initial public offering, which was treated as a cost of raising capital. The boards of both Microvision and Lumera approved paying Mr. Rutkowski these fees.
4. Accrued Liabilities
Accrued liabilities consist of the following at December 31:
LUMERA CORPORATION
NOTES TO FINANCIAL STATEMENTS
5. Income Taxes
No provision for income taxes has been recorded for any periods presented since we have incurred net losses from the date of our inception.
Deferred taxes consist of the following at December 31:
At December 31, 2006, we had $55.7 million of federal net operating loss carry forwards, which may be used to offset future taxable income. These carry forwards expire beginning in 2018 through 2026. The Internal Revenue Code places certain limitations on the annual amount of net operating loss carry forwards that can be utilized if certain changes in our ownership occur. At December 31, 2006, we had $1,350,000 of research and experimentation credits carry forwards which begin to expire in 2019 through 2026.
We have recorded a valuation allowance for the full amount of our deferred tax assets at December 31, 2006 and 2005, as we believe it is more likely than not that the deferred tax assets will not be realized. The valuation allowance and the research and experimentation credits account for substantially all of the difference between our effective income tax rate and the Federal statutory rate of 34%.
6. Shareholders’ Equity
At December 31, 2006, our authorized capital consisted of 120 million shares of Common Stock, of which 3,000,000 shares are reserved for our 2000 Stock Option Plan and 3,000,000 shares are reserved for our 2004 Equity Incentive Plan. We also have 30,000,000 shares of authorized undesignated preferred stock, none of which have been issued.
In July 2004, we completed our initial public offering (the “IPO”), issuing 6 million shares of common stock at $6.95 per share. Upon completion of the IPO all outstanding shares of our Common A and B and Preferred A and B shares were automatically converted to common shares. At December 31, 2006, there were 20,055,352 shares of common stock outstanding.
Common Stock - On November 10, 2006, we issued 2,825,000 shares of our common stock at a purchase price of $6.00 per share for an aggregate purchase price of $16,950,000, before issuance costs of $1,259,000 and before warrants to purchase common stock issued to the placement agents with an approximate fair value of $714,000. The warrants issued to the placement agents in the private placement are exercisable any time over the next seven years at a price of $6.25 per share. In addition, we issued warrants to purchase 423,750 shares of common stock, with an approximate fair value of $1,898,000, to purchasers in the private placement which are exercisable at any time over the next five years at a price of $6.25 per share. The securities issued in the private placement were subsequently registered under the Securities Act of 1933, as amended (the “Securities Act”) in December 2006.
Convertible Preferred Stock - In August through October 2003, we raised $2,670,000 (before issuance costs of $67,000) from the sale of 1,335,025 shares of Series B convertible preferred stock to private investors. In March 2004, we raised $500,000 from the sale of 250,000 shares of Series B convertible preferred stock to private investors issued in March 2004. The $2 per share conversion price of the Series B convertible preferred stock issued was less than the fair value of the Class A common stock on the issuance date. As a result, we recorded a $500,000 beneficial conversion feature upon issuance of the preferred stock. This amount was immediately recorded as a deemed dividend to preferred shareholders because the Series B convertible preferred stock had no stated term and was immediately convertible into Class A common stock.
LUMERA CORPORATION
NOTES TO FINANCIAL STATEMENTS
6. Shareholders’ Equity - (continued)
Upon our initial public offering in July 2004 all shares of convertible preferred stock were automatically converted to Common Stock. Each Series A Preferred share was converted into 1.14 shares of common stock in accordance with anti-dilution provisions enacted upon the sale of the Preferred B shares resulting in 2,727,291 shares of common stock issued in exchange for 2,400,000 Series A Preferred shares. Each share of Series B Preferred was exchanged for common shares on a one-for-one basis, resulting in the issuance of 1,585,025 shares of common stock issued in exchange for the Series B Preferred shares.
Dividends - No dividends on convertible preferred stock or common stock have been declared from inception through December 31, 2006.
Arizona Microsystems, L.L.C. warrants exercised - In October 2002, we issued a warrant to purchase 164,000 shares of Class A common stock at an exercise price of $3.65 per share to Arizona Microsystems, L.L.C. for use of certain technology. These warrants were exercised in a cashless transaction for 38,935 shares of common stock in July 2004.
7. Stock Options
Stock-Based Compensation - We have two share based compensation plans described below. Prior to January 1, 2006, we accounted for stock-based employee compensation arrangements on the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees and related amendments and interpretations. In accordance with APB 25, no compensation cost was required to be recognized for options granted that had an exercise price equal to the market value of the underlying common stock on the date of grant. We also complied with the disclosure provisions of Statement of Financial Accounting Standards No. 123 (“SFAS 123”), Accounting for Stock-Based Compensation, which required fair value recognition for employee stock-based compensation. We account for equity instruments issued to non-employees in accordance with the provisions of Emerging Issues Task Force (“EITF”) Issue No. 96-18.
We adopted the provisions of Financial Accounting Standards Board (“FASB”) Statement No. 123(R), Share-Based Payment, (“FAS 123R”) on January 1, 2006 and have applied the provisions of Staff Accounting Bulletin No. 107 (“SAB 107”) issued by the SEC in March 2005. We adopted FAS 123R using the modified prospective transition method. Under this transition method, compensation cost recognized in 2006 includes compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS 123, and compensation cost for all share-based payments granted or modified subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of FAS 123R. Prior period results have not been revised.
Description of Share-based Payment Plans - In 2000, we adopted the 2000 Stock Option Plan (the “2000 Plan”). The 2000 Plan provided for the granting of stock options to our employees, consultants and non-employee directors. We reserved 3,000,000 shares of Class A Common Stock for issuance pursuant to the 2000 Plan. Following the adoption of the 2004 Equity Incentive Plan in July 2004, option issuances under the 2000 Stock Option Plan ceased. Grants, net of shares exercised and forfeited, under our 2000 Stock Option Plan totaled 752,669 shares at December 31, 2006.
In July 2004, we adopted the 2004 Equity Incentive Plan (the “2004 Plan”). Awards under the Plan can be a combination of stock options, stock appreciation rights , restricted stock, unrestricted stock, stock units (including restricted stock units), performance awards, cash awards and other awards not described that are convertible into or otherwise based on the value of our stock. To date, only stock option awards have been granted under the Plan. Options under both the 2000 plan and the 2004 Plan may be exercisable for periods up to ten years. Options granted under either plan may be either Incentive Stock Options (“ISO’s”) or non-qualified stock options. The exercise price of an ISO cannot be less than 100% of the estimated fair value of the common stock at the date of grant. To date, options granted to employees generally vest over four years. Grants, net of shares exercised and forfeited, under our 2004 Equity Incentive Plan totaled 1,628,701.
LUMERA CORPORATION
NOTES TO FINANCIAL STATEMENTS
7. Stock Options - (continued)
The 2004 Plan established an initial option pool of 2,000,000 shares plus an annual increase (i) 13.4% of the number of shares of Stock outstanding as of our immediately preceding fiscal year, or (ii) such lesser amount, if any, as the Board may determine. At December 31, 2006, there were 3,000,000 shares reserved for 2004 Plan grants. Our Board of Directors elected to limit the increase in the option share pool by 500,000 shares in 2007, bringing the shares in the pool to a total of 3,500,000.
Options under both the 2000 plan and the 2004 Plan may be granted for periods up to 10 years. Options granted under either plan may be either Incentive Stock Options (“ISO’s”) or non-qualified stock options. The exercise price of an ISO cannot be less than 100% of the estimated fair value of the common stock at the date of grant. To date, options granted to employees generally vest over four years.
Impact of the Adoption of FAS 123R - The following table shows the share-based compensation expense related to employee, directors and third party grants for the period presented:
Our basic and diluted earnings per share was $0.10 lower for the year ended December 31, 2006 after reflecting the provisions of FAS 123R than it would have been under the provisions of APB 25.
Cash received from the exercise of options totaled $1,285,000, $437,000, and $23,000 for the years ended December 31, 2006, December 31, 2005 and December 31, 2004, respectively. No tax benefit was recognized related to share-based compensation expense since we have never reported taxable income and have established a full valuation allowance to offset all of the potential tax benefits associated with our deferred tax assets. Additionally, no share-based compensation expenses were capitalized during the periods presented.
Valuation assumptions - We determine the fair value of share-based payments using the Black-Scholes option pricing model which requires the use of several complex and subjective variables including the risk free interest rate, the expected stock price volatility, the expected life of option grants which is impacted by actual and estimated forfeitures and option exercise behaviors and our expected dividend policies.
The weighted average risk-free rates, based on the U.S. Treasury yield curve in effect at the time of grant, were 4.9% for the year ended December 31, 2006, 4.1% for the year ended December 31, 2005 and 3.2% for the year ended December 31, 2004. The weighted-average expected terms were 6.25 years, 5.6 years and 5.2 years for the years ended December 31, 2006, 2005 and 2004, respectively. Expected volatility is determined by blending the annualized daily historical volatility of our stock price commensurate with the expected life of the option with volatility measures used by comparable peer companies. Our stock price volatility and option lives involve
LUMERA CORPORATION
NOTES TO FINANCIAL STATEMENTS
7. Stock Options - (continued)
management’s best estimates at that time, both of which impact the fair value of the option calculated under the Black-Scholes methodology and, ultimately, the expense that will be recognized over the life of the option. Our weighted average estimates of volatility is 65% for the year ended December 31, 2006 and were 83% during both 2005 and 2004 periods. We do not anticipate declaring dividends in the foreseeable future.
Share-based Payment Award Activity - The following table summarizes the activity under our Option Plans for the year ended December 31, 2006.
The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the quoted price of the Company’s common stock for all options that were in-the-money at December 31, 2006.
The weighted average grant date fair value of options granted was $2.51 and $3.56 for the years ended December 31, 2006 and December 31, 2005, respectively, and between $0.65 and $4.19 for the year ended December 31, 2004. The aggregate intrinsic value of stock options exercised during the year ended December 31, 2006, 2005 and 2004 was $1,955,000, $510,000 and $137,000, respectively, determined as of the date of option exercise. The aggregate intrinsic value, at December 31, 2006, for options outstanding was $3,724,000 and for options exercisable was $1,571,000. The aggregate fair value of stock options vested during the years ended December 31, 2006, 2005 and 2004 was $1,533,000, $1,544,000 and $2,163,000, respectively.
As of December 31, 2006 there was approximately $1.6 million, net of estimated forfeitures, of total unrecognized compensation cost, the majority of which will be recognized over a weighted average period of 1.5 years.
Non-Employee Options - Included in the option disclosures above are options granted to certain non-employees under our plan, as follows:
In August 2003, we issued options to purchase an aggregate of 82,000 shares of common stock to a consultant in connection with certain consulting agreements. The options have an exercise price of $3.65 per share and a 10-year life. In aggregate, 20,500 of the options were vested on the grant date. The remaining 61,500 shares vested one-third on each subsequent annual anniversary of the grant date and were subject to re-measurement at each balance sheet date during the vesting period. The options are now fully vested. The aggregate value of the outstanding options was estimated at $68,000 at the grant date and $299,000 at December 31, 2005 and all options were fully vested prior to December 31, 2006. Total non-cash compensation expense related to these options was $299,000 of which $4,000 and $279,000 was recorded for the years ended December 31, 2005 and 2004, respectively. The fair values of the options were estimated at the grant date and on December 31, 2005 and December 31, 2004 and using the Black-Scholes option pricing model with the following weighted-average assumptions; dividend yield of 0%; expected volatility of 100%; risk-free interest rates of 4.3% and 4.62%; and expected lives of nine and eight years, for each of the measurement dates, respectively. The liability of $87,000 for unvested options was reversed in the quarter ended September 30, 2006 when the options vested.
LUMERA CORPORATION
NOTES TO FINANCIAL STATEMENTS
7. Stock Options - (continued)
Pro forma information for periods prior to the adoption of FAS 123R - The following table shows the pro forma effect on our net loss and net loss per share had compensation expense been determined based upon the fair value at the grant date for awards consistent with the methodology prescribed by SFAS 123 for the periods presented. Stock-based compensation for fiscal 2006 has been included in results of operations. The pro forma effect may not be representative of expense in future periods since the estimated fair value of stock options on the date of grant is amortized to expense over the vesting period, and additional options may be granted or options may be cancelled in future years:
8. Warrants
In October 2002, we issued a warrant to purchase 164,000 shares of common stock at an exercise price of $3.65 per share to Arizona Microsystems, L.L.C. for use of certain technology. These warrants were exercised in a cashless transaction for 38,935 common shares in July 2004.
In April 2004, we issued warrants to purchasers of our convertible promissory notes for an aggregate of 115,000 shares of common stock at an exercise price of $7.20 per share. The value of the warrants granted, which are exercisable through April 21, 2009, was estimated to be approximately $344,000 using the Black-Scholes option pricing model. The relative fair value of the warrants of $301,000 was treated as a debt issuance cost and amortized to interest expense over the one-year term of the debt.
In July 2004, we issued to the underwriters in our initial public offering warrants to purchase a total of 600,000 shares of our common stock at a purchase price of $8.34. The warrants are exercisable through July 28, 2009. These warrants were treated as a cost of raising capital.
Microvision holds a warrant to purchase a total of 170,546 shares of common stock at an exercise price of $8.80 per share. The warrant was originally issued in lieu of interest payments due on a convertible note. The warrant, all of which was outstanding at December 31, 2006, expires in March 2011.
In November 2006, in connection with our common stock financing, we issued warrants to purchase a total of 565,000 shares of common stock to purchasers and placement agents exercisable at price of $6.25 per share over five and seven years, respectively. The relative fair value of the warrants issued as partial compensation to the placement agents and exercisable over seven years, were estimated to be approximately $714,000 using the Black-Scholes option pricing model. The relative fair value of the warrants to purchasers, which are exercisable over five years, were estimated to be approximately $1,898,000 using the Black-Scholes option pricing model. We assessed the classification of the warrants in accordance with EITF-00-19 and determined the warrants qualify for equity classification.
LUMERA CORPORATION
NOTES TO FINANCIAL STATEMENTS
9. Convertible Notes Payable
In April 2004, we received cash proceeds from the issuance of convertible promissory notes in the aggregate principal amount of $2.3 million. The notes accrued interest at a rate of 6.5% per annum and were payable on demand at the earlier of March 31, 2005 or upon the closing of an underwritten public offering of our common stock. In connection with the sale of these convertible notes, we also issued warrants to purchase an aggregate of 115,000 shares of common stock at a price of $7.20 per share. Upon completion of our IPO in July 2004 the notes became due and payable. All of the note holders elected to receive cash payments, which resulted in principal and interest payments totaling $2,344,000 in August 2004. The unamortized debt issuance costs were recognized immediately as interest expense at that time. During 2004, we recognized a total of $345,000 of interest expense associated with the Notes.
10. Commitments and Contingencies
Agreements with the University of Washington - In October 2000, we entered into a license agreement (the “License Agreement”) and a research agreement (the “Sponsored Research Agreement” or the “SRA”) with the University of Washington (the “UW”). The License Agreement grants us rights to certain intellectual property including technology being developed under the sponsored Research Agreement whereby we have a royalty-bearing license to make, sell or sublicense the licensed technology. Under the terms of the License Agreement, we issued 802,414 shares of our Class A common stock to the UW. The shares, although initially subject to a vesting schedule tied to performance under the Sponsored Research Agreement, were vested in full by mutual agreement between the UW and Lumera on January 8, 2001. The shares issued were valued by management at $3,009,000, based on a value of $3.75 per share on the date of issuance. We considered a number of factors, including an independent valuation, projected cash flows from our technology and expected future products, general market conditions and the risks inherent in achieving our business plan in determining the fair value of the common shares issued. The value of the shares issued was recorded as prepaid stock-based research and development expense and was fully amortized to research and development expense as of March 31, 2004.
Under the terms of the License Agreement, we are also required to pay certain costs related to filing and processing of patents and copyrights related to the agreements. Additionally, we are required to pay certain ongoing royalty payments at a minimum of $75,000 per annum. We have not made any royalty payments to date in excess of these minimums. These payments have been expensed as incurred.
As part of the Sponsored Research Agreement, we agreed to pay an aggregate of $9,000,000 in quarterly payments over three years for research services. The first payment was made on February 26, 2001. We expensed the total expected payments on a straight-line basis because there was no more readily determinable pattern of the performance of the research services under the agreement. During 2002, 2003, and 2004, we entered into several amendments to the Sponsored Research Agreement. Total payments under the amended Sponsored Research Agreement, which terminated in June 2005, were $5,750,000 instead of the $9,000,000 under the terms of the original agreement.
Subsequent to each amendment noted above, we prospectively adjusted the amortization of the research payments to account for the extended period over which the payments would be made and services provided. As a result of the last amendment and the elimination of a contingent $2 million payment originally due in 2005, we recognized a credit to research and development expense of $2.4 million in 2004.
The following table summarizes payments made and expense recorded during the years ended December 31:
LUMERA CORPORATION
NOTES TO FINANCIAL STATEMENTS
10. Commitments and Contingencies - (continued)
Helix Biopharma/Sensium - We have a licensing agreement with Sensium Technologies, Inc., a subsidiary of Helix BioPharma, which gives us an exclusive worldwide royalty bearing license in our field of business to a number of patents and the related technology for use in our NanoCapture™ Arrays. Under the terms of the agreement, we paid $250,000 in license fees, half of which we paid upon signing in January 2005 and half in February 2006. We also paid a $125,000 in technology transfer fees during the first half of 2005. The Sensium licensing agreement contains minimum royalty provisions totaling $50,000 for the first royalty year, $100,000 for the second royalty year, $150,000 for the third royalty year and $200,000 thereafter. Our license exclusivity is based upon achieving certain minimum revenues by the fourth royalty year. The agreement also calls for a payment of $200,000 to Sensium upon the issuance of the latter of two patent applications.
Lease Commitments - We subleased our corporate facilities from Microvision at a base rate of approximately $25,000 per month, plus common area charges through April 6, 2006. We signed a five year lease to expand our current facilities which began April 7, 2006. Tenant improvements were substantially complete at December 31, 2006, expanding our facilities to approximately 32,175 square feet of space located in the same building we currently occupy. The total of the minimum rental payments over the life of the initial lease term is approximately $2.5 million. We have an option to extend our new lease for one additional five year period. We had no other significant operating or capital leases at December 31, 2006. The following table shows our lease commitment:
Claims and Litigation - We are subject to various claims and pending or threatened lawsuits in the normal course of business. We are not currently party to any legal proceedings that management believes the adverse outcome of which would have a material adverse effect on our financial position, results of operations or cash flows.
11. Retirement Savings Plan
On August 31, 2004, we established a retirement savings plan (the “Plan”), which qualifies under the Internal Revenue Code Section 401(k) and covers all qualified employees. The Plan allows us to match 50% of an employee’s contribution to the Plan up to a maximum 6% of the employee’s base salary. During 2006 and 2005, we contributed $69,000 and $57,000, respectively, to the Plan under the matching program. We contributed $21,000 from September through December 31, 2004 to the Plan under the matching program. Prior to August 31, 2004 our employees participated in the Microvision retirement savings plan; we contributed $33,000 in matching payments to the Microvision plan in the first eight months of 2004.
12. Segment Information
Prior to March 2006, we operated our business as a single segment. We changed our organizational structure during March 2006, creating two distinct business segments to exploit opportunities we are pursuing, Bioscience and Electro-optics. Each operating segment has separate management, research and development and sales and marketing team members, and each segment operates without regard to geographic region. Revenues and expenses associated with each business segment are recorded directly, while shared research and development and corporate expenses attributable to segment operations are allocated based upon actual labor costs recorded to each segment. Periods prior to March 2006 have been revised to reflect our best estimates of segment activity as if they had been in existence during the comparative periods.
LUMERA CORPORATION
NOTES TO FINANCIAL STATEMENTS
12. Segment Information - (continued)
The revenues, costs and profits by reportable segment are as follows:
Corporate expense includes certain amounts not allocated to our business segments, primarily consisting of executive management and human resources, investor relations, legal, finance, information technology, purchasing and other general corporate activities. Identifiable assets by segment are not used in management’s analysis of results, and, therefore, are excluded.
13. Quarterly Finanical Data (Unaudited)
The following table represents certain unaudited quarterly financial information for the two years ended December 31, 2006. In our opinion, this information has been prepared on the same basis as the audited financial statements and includes all adjustments (consisting only of normal recurring adjustments) necessary to fairly state the unaudited quarterly results of operations set forth herein.
Quarterly and annual earnings per share are calculated independently, based on the weighted average number of shares outstanding during the periods.
LUMERA CORPORATION
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
As of December 31, 2006, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(e) and 15d-15(e). Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that our disclosure controls and procedures are effective to provide reasonable assurance that information we are required to disclose in the reports filed or submitted by us under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Security and Exchange Commission’s rules and forms, and to provide reasonable assurance that information we are required to disclose in such reports 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.
There have been no changes in our internal controls or in other factors that could significantly affect internal controls over financial reporting during the quarter ended December 31, 2006, which could materially affect, or are reasonably likely to materially affect, our internal control over financial reporting.
We are required to review and evaluate the design and effectiveness of our disclosure controls and procedures on an ongoing basis and to improve our controls and procedures over time and to correct any deficiencies that we may discover in the future. Our goal is to ensure that our senior management has timely access to all material financial and non-financial information concerning our business. While we believe the present design of our disclosure controls and procedures is effective to achieve our goal, future events affecting our business may cause us to modify our disclosure controls and procedures.
We are in the process of implementing the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 which requires our management to assess the effectiveness of our internal control over financial reporting. Under the current rules defining when a filer is required to include an assertion as to the effectiveness of internal controls over financial reporting, we will be required to make such assertion in our 2007 annual report. If our market capitalization meets the minimum $75 million capitalization threshold at June 30, 2007, our independent registered public accounting firm would also be required to attest to whether our assessment of the effectiveness of our internal controls over financial reporting is fairly stated in all material respects and separately report on whether it believes we maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007; however, should our market capitalization not meet the $75 million capitalization our independent registered public accounting firm would not be required to attest to our assessment of the effectiveness of internal control over financial reporting until December 31, 2008. We are in the process of performing the system and process documentation, evaluation and testing required for management to make this assessment and for the registered public accounting firm to provide its attestation report. We have not completed this process or its assessment, and this process will require significant amounts of management time and resources. In the course of evaluation and testing, management may identify deficiencies that would need to be addressed and remediated.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors and Executive Officers and Corporate Governance
The information under the headings “Election of Directors,” “Section 16(a) Beneficial Ownership Reporting Compliance,” and “Audit Committee Report” in the Lumera Corporation definitive Proxy Statement to be filed with the Securities and Exchange Commission in connection with the next Annual Meeting of Shareholders to be held on June 1, 2007 (the “Proxy Statement”) is incorporated herein by reference. See Item 4A in Part 1 of this report for information regarding executive officers of the Company.
We have adopted a Code of Conduct applicable to all our employees. Our Code Conduct is available on our website at www.Lumera.com or upon written request, without charge to you, made to us at Lumera Corporation, 19910 North Creek Parkway, Suite 100, Bothell, Washington, 98011. Any waiver or amendment to our Code of Conduct that applies to our Chief Executive Officer or Chief Financial Officer and other officers providing financial information, will be disclosed on our website at www.lumera.com or in a report on Form 8-K filed with the SEC.
Item 11.
Item 11. Executive Compensation
The information required by this item is incorporated by reference to the Proxy Statement under the heading “Executive Compensation.”
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The following table shows the number of shares of common stock that could be issued upon exercise of outstanding options and warrants, the weighted average exercise price of the outstanding options and warrants and the remaining shares available for future issuance as of December 31, 2006.
The other information required by this item is incorporated by reference in the Proxy Statement under the heading “Information about Lumera Common Stock Ownership.”
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by this item is incorporated by reference to the Proxy Statement under the heading “Certain Relationships and Related Transactions.”
Item 14.
Item 14. Principal Accounting Fees and Services
The information required by this Item is incorporated by reference to the Proxy Statement under the heading “Independent Registered Public Accounting Firm”.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
a) Documents filed as part of the report
(1) Financial Statements
Balance Sheets as of December 31, 2006 and 2005
Statements of Operations for the years ended December 31, 2006, 2005 and 2004
Statements of Changes in Mandatorily Redeemable Convertible Preferred Stock and Shareholders’
Equity (Deficit) for the years ended December 31, 2006, 2005 and 2004
Statements of Comprehensive Loss for the years ended December 31, 2006, 2005 and 2004
Statements of Cash Flows for the years ended December 31, 2006, 2005 and 2004
Valuation and Qualifying Accounts and Reserves for the years ended December 31, 2006, 2005
and 2004
(2) Financial Statement schedules have been omitted since they are either not required, not applicable, or the information is otherwise included.
(3) Exhibits
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.
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Thomas D. Mino, and Peter J. Biere, and each of them, as his true and lawful attorneys-in-fact and agents, with power to act with or without the others and with full power of substitution and resubstitution, to do any and all acts and things and to execute any and all instruments which said attorneys and agents and each of them may deem necessary or desirable to enable the registrant to comply with the U.S. Securities Exchange Act of 1934, as amended, and any rules, regulations and requirements of the U.S. Securities and Exchange Commission thereunder in connection with the registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006 (the “Annual Report”), including specifically, but without limiting the generality of the foregoing, power and authority to sign the name of the registrant and the name of the undersigned, individually and in his capacity as a director or officer of the registrant, to the Annual Report as filed with the U.S. Securities and Exchange Commission, to any and all amendments thereto, and to any and all instruments or documents filed as part thereof or in connection therewith; and each of the undersigned hereby ratifies and confirms all that said attorneys and agents and each of them shall do or cause to be done by virtue hereof.
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.
Signature
Title
Date
/s/ Thomas D. Mino
President, Chief Executive Officer and Director
(Principal Executive Officer)
March 28, 2007
Thomas D. Mino
/s/ Peter J. Biere
Vice President, Treasurer and Chief Financial Officer
(Principal Financial Officer and Principal Accounting Officer)
March 28, 2007
Peter J. Biere
/s/ C. James Judson
Chairman of the Board of Directors
March 28, 2007
C. James Judson
/s/ Fraser Black
Director
March 28, 2007
Fraser Black
/s/ Donald Guthrie
Director
March 28, 2007
Donald Guthrie
/s/ Robert Ratliffe
Director
March 28, 2007
Robert Ratliffe
/s/ Kimberly D.C. Trapp
Director
March 28, 2007
Kimberly D.C. Trapp
/s/ Sanjiv Sam Gambhir
Director
March 28, 2007
Sanjiv Sam Gambhir
/s/ Joseph J. Vallner
Director
March 28, 2007
Joseph J. Vallner
INDEX TO EXHIBITS
The following documents are filed herewith or have been included as exhibits to previous filings with the Securities and Exchange Commission and are incorporated by reference as indicated below.
Exhibit Number
Description
3.1
Form of Amended and Restated Certificate of Incorporation of the Registrant. Filed previously with the Registrant’s Registration Statement on Form S-1 filed on May 19, 2004, SEC File No. 333-115650.
3.2
Form of Amended and Restated Bylaws of the Registrant. Filed previously with the Registrant’s Registration Statement on Form S-1 filed on May 19, 2004, SEC File No. 333-115650.
4.1
Form of Common Stock Certificate. Filed previously with Amendment No. 5 to the Registrant’s Registration Statement on Form S-1 filed on July 15, 2004, SEC File No. 333-115650.
4.2
Form of Representative’s Warrant. Filed previously with the Registrant’s Registration Statement on Form S-1 filed on May 19, 2004, SEC File No. 333-115650.
4.3
Form of Common Stock Warrant dated November 7, 2006. Filed previously with the Registrant’s Current Report on Form 8-K filed on November 8, 2006.
10.1
2000 Stock Option Plan of the Registrant. Filed previously with Amendment No. 1 to the Registrant’s Registration Statement on Form S-1 filed on June 24, 2004, SEC File No. 333-115650.
10.2
2004 Equity Incentive Plan of the Registrant. Filed previously with Amendment No. 1 to the Registrant’s Registration Statement on Form S-1 filed on June 24, 2004, SEC File No. 333-115650.
10.3
Sublease effective January 1, 2004, by and between Microvision, Inc. and the Registrant for facilities located at 19910 North Creek Parkway, Bothell, WA. Filed previously with the Registrant’s Registration Statement on Form S-1 filed on May 19, 2004, SEC File No. 333-115650.
10.4
Lease Agreement, dated as of July 11, 2005, by and between S/I North Creek and the Registrant for facilities located at 19910 North Creek Parkway, Bothell, WA. Filed previously with the Registrant’s Current Report on Form 8-K filed on July 12, 2005.
10.5
First Amended and Restated Employment Agreement effective September 3, 2004, by and between Thomas D. Mino and the Registrant. Filed previously with the Registrant’s Current Report on Form 8-K filed on November 5, 2004.
10.6
Sponsored Research Agreement effective October 20, 2000, by and between the University of Washington and the Registrant. Filed previously with the Registrant’s Registration Statement on Form S-1 filed on May 19, 2004, SEC File No. 333-115650.
10.7
Exclusive Licensing Agreement effective October 20, 2000, by and between the University of Washington and the Registrant. Filed previously with the Registrant’s Registration Statement on Form S-1 filed on May 19, 2004, SEC File No. 333-115650.
10.8
Sponsored Research Agreement Research Plan effective March 1, 2001, by and between the University of Washington and the Registrant. Filed previously with Amendment No. 1 to the Registrant’s Registration Statement on Form S-1 filed on June 24, 2004, SEC File No. 333-115650.
10.9
Letter Agreement dated February 26, 2002, by and between the University of Washington and the Registrant. Filed previously with the Registrant’s Registration Statement on Form S-1 filed on May 19, 2004, SEC File No. 333-115650.
Exhibit Number
Description
10.10
Agreement Amending Sponsored Research Agreement, Research Plan, and Exclusive Licensing Agreement dated August 28, 2002, by and between the University of Washington and the Registrant. Filed previously with the Registrant’s Registration Statement on Form S-1 filed on May 19, 2004, SEC File No. 333-115650.
10.11
Second Amendment to Sponsored Research Agreement, Research Plan, and Exclusive Licensing Agreement effective March 25, 2003, by and between the University of Washington and the Registrant. Filed previously with the Registrant’s Registration Statement on Form S-1 filed on May 19, 2004, SEC File No. 333-115650.
10.12
Letter Agreement dated November 6, 2003, by and between the University of Washington and the Registrant. Filed previously with the Registrant’s Registration Statement on Form S-1 filed on May 19, 2004, SEC File No. 333-115650.
10.13
Fourth Amendment to Sponsored Research Agreement, Research Plan, and Exclusive Licensing Agreement effective April 12, 2004, by and between the University of Washington and the Registrant. Filed previously with the Registrant’s Registration Statement on Form S-1 filed on May 19, 2004, SEC File No. 333-115650.
10.14
Consulting Agreement dated October 1, 2002, by and between Arizona Microsystems, L.L.C. and the Registrant. Filed previously with the Registrant’s Registration Statement on Form S-1 filed on May 19, 2004, SEC File No. 333-115650.
10.15
License Agreement effective March 27, 2004, by and between Arizona Microsystems, L.L.C. and the Registrant. Filed previously with the Registrant’s Registration Statement on Form S-1 filed on May 19, 2004, SEC File No. 333-115650.
10.16
Form of Note and Warrant Purchase Agreement effective April 20, 2004, by and between the Registrant and the Lenders, as defined therein. Filed previously with the Registrant’s Registration Statement on Form S-1 filed on May 19, 2004, SEC File No. 333-115650.
10.17
Amended and Restated Investors’ Rights Agreement dated August 25, 2003, by and between the Registrant and the Investors, as defined therein. Filed previously with the Registrant’s Registration Statement on Form S-1 filed on May 19, 2004, SEC File No. 333-115650.
10.18
Wideband Polymer Modulator Development Agreement with an agency of the U.S. Department of Defense, dated July 22, 2001. Filed previously with Amendment No. 4 to the Registrant’s Registration Statement on Form S-1 filed on July 14, 2004, SEC File No. 333-115650.
10.19
Polymer-Based Linearized EO Modulator Agreement, dated August 4, 2003. Filed previously with Amendment No. 1 to the Registrant’s Registration Statement on Form S-1 filed on June 24, 2004, SEC File No. 333-115650.
10.20
Amendment to 2000 Stock Option Plan of the Registrant. Filed previously with Amendment No. 1 to the Registrant’s Registration Statement on Form S-1 filed on June 24, 2004, SEC File No. 333-115650.
10.21
Form of Convertible Promissory Note. Filed previously with Amendment No. 1 to the Registrant’s Registration Statement on Form S-1 filed on June 24, 2004, SEC File No. 333-115650.
10.22
Form of Common Stock Warrant. Filed previously with Amendment No. 1 to the Registrant’s Registration Statement on Form S-1 filed on June 24, 2004, SEC File No. 333-115650.
Exhibit Number
Description
10.23
Warrant to Purchase 150,000 shares of Series A Preferred Stock, dated March 14, 2001. Filed previously with Amendment No. 3 to the Registrant’s Registration Statement on Form S-1 filed on July 12, 2004, SEC File No. 333-115650.
10.24
Warrant to Purchase 164,000 shares of Class A Common Stock, dated October 1, 2002. Filed previously with Amendment No. 3 to the Registrant’s Registration Statement on Form S-1 filed on July 12, 2004, SEC File No. 333-115650.
10.25
Indemnification Agreement between Newbridge Securities Corporation and each of the Registrant and Paulson Investment Company, Inc. on behalf of the Underwriters, dated July 22, 2004. Filed previously with Amendment No. 6 to the Registrant’s Registration Statement on Form S-1 filed on July 22, 2004, SEC File No. 333-115650.
10.26
Modulators Incorporating Polymers with Exceptionally High Electro-Optic Coefficients Development Agreement with the Defense Advanced Research Projects Agency dated June 30, 2006.
10.27
Form of Securities Purchase Agreement by and among the Registrant and the Purchasers thereto dated November 7, 2006. Filed previously with the Registrant’s Current Report on Form 8-K filed on November 8, 2006.
Code of Conduct. Filed previously with the Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004.
23*
Consent of PricewaterhouseCoopers LLP.
24.1*
Powers of Attorney (included on the signature pages hereto)
31.1*
Chief Executive Officer certification pursuant to Rule 13a-14(a)/15d-14a of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2*
Chief Financial Officer certification pursuant to Rule 13a-14(a)/15d-14a of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1*
Chief Executive Officer certification pursuant to Rule 13a-14(b) or Rule 13d-14(b) and Section 1350, Chapter 63 of Title 18 United States Code (18 U.S.C. 1350) as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002.
32.2*
Chief Financial Officer certification pursuant to Rule 13a-14(b) or Rule 15d-14(b) and Section 1350, Chapter 63 of Title 18 United States Code (18 U.S.C. 1350) as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002.
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Confidential treatment requested as to certain portions. The term “confidential treatment” and the mark “[REDACTED]” as used throughout the indicated Exhibit mean that material has been omitted and separately filed with the Commission.
*
Filed herewith.