Item 1.
Business
Overview
We develop and market aesthetic treatment systems that are used by physicians and other practitioners to perform non-invasive procedures to remove hair, treat vascular lesions, rejuvenate skin through the treatment of shallow vascular lesions and pigmented lesions, temporarily reduce the appearance of cellulite, treat wrinkles, skin texture, skin discoloration and skin tightening, and to perform minimally invasive procedures for LaserBodySculpting and for the removal of unwanted fat. Our systems incorporate a broad range of laser and other light-based energy sources, including Alexandrite, pulse dye, Nd:Yag and diode lasers, as well as intense pulsed light. We believe that we are one of only a few companies that currently offer aesthetic treatment systems utilizing Alexandrite and pulse dye lasers, which are particularly well suited for some applications and skin types. We offer single energy source systems as well as workstations that incorporate two or more different types of lasers or pulsed light technologies. We offer multiple technologies and system alternatives at a variety of price points depending primarily on the number and type of energy sources included in the system. Our newer products are designed to be easily upgradeable to add additional energy sources and handpieces, which provides our customers with technological flexibility as they expand their practices. As the aesthetic treatment market evolves to include new customers, such as aesthetic spas and additional physician specialties, we believe that our broad technology base and tailored solutions will provide us with a competitive advantage.
We sell over 15 different aesthetic treatment systems and have focused our development and marketing efforts on offering leading, or flagship, products for each of the major aesthetic procedure categories that we address. Our flagship products are:
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the Apogee Elite system for hair removal;
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the Cynergy system for the treatment of vascular lesions;
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the TriActive LaserDermology system for the temporary reduction of the appearance of cellulite;
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the Affirm system for anti-aging, including treatments for wrinkles, skin texture, skin discoloration and skin tightening; and
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the Smartlipo system for LaserBodySculptingsm and the removal of unwanted fat.
In addition to their primary applications, the Apogee Elite and Cynergy systems can each be used by practitioners for a variety of other applications.
We sell our products through a direct sales force in North America, four European countries, Japan and China and through international distributors in 51 other countries. As of December 31, 2006, we had sold more than 5,900 aesthetic treatment systems worldwide.
Our company was founded in 1991. We launched our first three products, a pulse dye laser aesthetic treatment system for the treatment of vascular lesions, a pulse dye laser system for the treatment of pigmented lesions and an Alexandrite laser system for tattoo removal, in the United States and international markets in 1992. We launched four additional products in 1993 and, since then, have offered aesthetic treatment systems based on a range of laser and light-based technologies in the United States and international markets.
In 2002, El.En. S.p.A., an Italian company listed on the techSTAR segment of the Italian stock market, Borsa Italiana, that itself and through subsidiaries develops and markets laser systems for medical and industrial applications, acquired a majority of our capital stock. In September 2003, we recruited a new management team that has implemented a comprehensive reorganization of our company. The reorganization has included the redesign of existing and the introduction of new products, the streamlining of our manufacturing process, and the reorganization and expansion of our research and development, sales and marketing and customer service capabilities. Our revenues have increased from $27.1 million in 2003 to
$78.4 million in 2006, a compound annual growth rate of 42.5%, and our gross profit margin has improved from 48% in 2003 to 58% in 2006.
See Note 6 to our Consolidated Financial Statements for revenue, net asset and long-lived asset information by geographic region.
Corporate Information
We were incorporated under the laws of the State of Delaware in July 1991. Our principal executive offices are located at 5 Carlisle Road, Westford, Massachusetts 01886, and our telephone number is (978) 256-4200.
We are subject to the informational requirements of the Exchange Act, and, accordingly, file reports, proxy statements and other information with the Securities and Exchange Commission. Such reports, proxy statements and other information can be read and copied at the public reference facilities maintained by the Securities and Exchange Commission at the Public Reference Room, 100 F Street, NE, Room 1580, Washington, D.C. 20549. Information regarding the operation of the Public Reference Room may be obtained by calling the Securities and Exchange Commission at 1-800-SEC-0330. The Securities and Exchange Commission maintains a website (http://www.sec.gov) that contains material regarding issuers that file electronically with the Securities and Exchange Commission.
Our website address is www.cynosure.com. The information on our website is not a part of this Annual Report. We make available free of charge on our website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.
Industry
Aesthetic Market Opportunity
Michael Moretti/Medical Insight, Inc., an independent aesthetic treatment market research firm, estimates that the number of non-invasive aesthetic treatment procedures worldwide using laser and other light-based technologies will grow from nearly 20 million in 2003 to over 53 million in 2008, representing a compound annual growth rate of over 20%. We estimate that the worldwide market for aesthetic treatment systems based on laser and other light-based technologies exceeded $800 million in 2006. We base this estimate on published market research reports, revenue figures for public companies and our conversations with the managements of private companies that compete in the aesthetic treatment equipment market.
Key factors contributing to growth in the markets for aesthetic treatment procedures and aesthetic laser equipment include:
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the aging population of industrialized countries and the rising discretionary income of the “baby boomer” demographic segment;
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the desire of many individuals to improve their appearance;
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the development of technology that allows for safe and effective aesthetic treatment procedures;
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the impact of managed care and reimbursement on physician economics, which has motivated physicians to establish or expand their elective aesthetic practices with procedures that are paid for directly by patients; and
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reductions in cost per procedure, which has attracted a broader base of clients and patients for aesthetic treatment procedures.
Expansion Into Non-Traditional Physician Customer and Medi-Spa Markets
Aesthetic treatment procedures that use lasers and other light-based equipment have traditionally been performed by dermatologists and plastic surgeons. Based on published membership information from professional medical organizations, there are more than 18,000 dermatologists and plastic surgeons in the United States. More recently, a broader group of physicians in the United States, including primary care physicians, obstetricians, gynecologists, ophthalmologists and ear, nose and throat specialists, have incorporated aesthetic treatment procedures into their practices. These non-traditional physician customers are largely motivated to offer aesthetic procedures by the potential for a reliable revenue stream that is unaffected by managed care and government payor reimbursement economics. We believe that there are approximately 200,000 of these potential non-traditional physician customers in the United States and Canada, representing a significant market opportunity that is only beginning to be addressed by suppliers of lasers and other light-based aesthetic equipment. Some physicians are electing to open medical spas, often adjacent to their conventional office space, where they perform aesthetic procedures in an environment designed to feel less like a health care facility.
The International Spa Association, known as ISPA, estimates that there were approximately 600 of these medical spas in North America in 2004 and that the number of medical spas more than doubled between 2002 and 2004. An aesthetic spa market is also rapidly developing and growing in the United States at dedicated day spa facilities and hotels and resorts. In addition to conventional massage and cosmetic treatments, aesthetic spas are also beginning to offer non-invasive light-based procedures performed by spa technicians and other non-medical professionals. ISPA estimates that there were approximately 12,000 aesthetic spas in North America in 2004, an increase of approximately 26% from 2002. We believe that non-traditional physician customers and spa customers currently represent at least one-half of the North American laser and other light-based aesthetic treatment systems market.
The Structure of Skin and Conditions that Affect Appearance
The human skin consists of several layers. The epidermis is the outer layer and contains the cells that determine pigmentation, or skin color. The dermis is a thicker inner layer that contains hair follicles and large and small blood vessels. Beneath the dermis is a layer that contains subdermal fat and collagen, which provides strength and flexibility to the skin.
The appearance of the skin may change over time due to a variety of factors, including age, sun damage, circulatory changes, deterioration of collagen and the human body’s diminished ability to repair and renew itself. These changes include:
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unwanted hair growth;
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uneven pigmentation;
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wrinkles;
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blood vessels and veins that are visible at the skin’s surface; and
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the appearance of cellulite.
Changes to the skin caused by pigmentation are called pigmented lesions and are the result of the accumulation of excess melanin, the substance that gives skin its color. Pigmented lesions are characterized by the brown color of melanin and include freckles, solar lentigines, also known as sun spots or age spots, and café au lait birthmarks. Changes to the skin caused by abnormally large or numerous blood vessels located under the surface of the skin are called vascular lesions. Vascular lesions are characterized by blood vessels that are visible through the skin or that result in a red appearance of the skin. Vascular lesions may be superficial and shallow in the skin or deep in the skin. Shallow vascular lesions include small spider veins, port wine birthmarks, facial veins and rosacea, a chronic skin condition that causes rosy coloration and acne-like pimples on the face. Deep vascular lesions include large spider veins and leg veins.
People with undesirable skin conditions or unwanted hair growth often seek aesthetic treatments, including treatments using non-invasive laser and light-based technologies.
Non-Invasive Laser and Light-Based Aesthetic Treatments
A laser is a device that creates and amplifies a narrow, intense beam of light. Lasers have been used for medical and aesthetic applications since the 1960s. Intense pulsed light technology was introduced in the 1990s and uses flashlamps, rather than lasers, to generate multiple wavelengths of light with varying pulse durations, or time intervals, over which the energy is delivered.
By producing intense bursts of highly focused light, lasers and other light-based technologies selectively target hair follicles, veins or collagen in or below the dermis, as well as cells responsible for pigmentation in the epidermis. When the target absorbs sufficient energy, it is destroyed. The degree to which energy is absorbed in the skin depends upon the skin structure targeted - e.g., hair follicle or blood vessel - and the skin type - e.g., light or dark. Different types of lasers and other light-based technologies are needed to effectively treat the spectrum of skin types and conditions. As a result, an active aesthetic practice may require multiple laser or other light-based systems in order to offer treatments to its entire client base.
Different types of lasers are currently used for a wide range of aesthetic treatments. Each type of laser operates at its own wavelength, measured in nanometers, which corresponds to a particular emission and color in the light spectrum. The most common lasers used for non-invasive aesthetic treatments are:
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Pulse dye lasers - produce a yellow light that functions at a shallow penetration depth.
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Alexandrite lasers - produce a near infrared invisible light that functions with high power at a deep penetration depth.
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Diode lasers - produce a near infrared invisible light that functions at a deep penetration depth.
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Nd:Yag lasers - produce a near infrared invisible light that functions over a wide range of penetration depths.
In addition to selecting the appropriate wavelength for a particular application, laser and other light-based treatments require an appropriate balance among three other parameters to optimize safety and effectiveness for aesthetic treatments:
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energy level - the amount of light emitted to heat the target;
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pulse duration - the time interval over which the energy is delivered; and
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spot size - the diameter of the energy beam.
As a result of the wide spectrum of aesthetic applications, patient skin types and users of technology, customer purchasing objectives for aesthetic treatment systems are diverse. We believe that as aesthetic spas and non-traditional physician customers play increasingly important roles as purchasers of aesthetic treatment systems, the market for these products will become even more diverse. Specifically, we expect that owners of different types of aesthetic treatment practices will place different emphases on various system attributes, such as breadth of treatment applications, return on investment, upgradeability and price. Accordingly, we believe that there is significant market opportunity for a company that tailors its product offerings to meet the needs of a wide range of market segments.
Our Solution
We offer tailored customer solutions to address the market for non-invasive light-based aesthetic treatment applications, including hair removal, treatment of vascular lesions, skin rejuvenation through the treatment of shallow vascular lesions and pigmented lesions and temporary reduction of the appearance of cellulite. We believe our laser and other light-based systems are reliable, user friendly and easily incorporated into both physician practices and spas. We complement our product offerings with comprehensive and responsive service
offerings, including assistance with training, aesthetic practice development consultation and product maintenance. As of December 31, 2006, we had sold more than 5,900 aesthetic treatment systems.
In 2006, we derived approximately 89% of our revenues from sales of products that we develop and manufacture, 5% of our revenues from service and 6% of our revenues from our distribution relationship with El.En.
We believe that the following factors enhance our market position:
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Broad Technology Base. Our products are based on a broad range of technologies and incorporate different types of lasers, such as Alexandrite, pulse dye, Nd:Yag and diode, as well as intense pulsed light devices. We believe we are one of a few companies that currently offer aesthetic treatment systems using Alexandrite and pulse dye lasers, which are particularly well suited for some applications and skin types. The following table provides information regarding the principal energy sources used in laser and other light-based aesthetic treatments that we offer and the primary application of each of these energy sources. The table also indicates how many of the six largest competitors in our industry we believe also offer products using this energy source. See “- Competition” below. We base our belief as to the six largest competitors in our industry and their product offerings on public company filings and information available on company websites.
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Expansive Portfolio of Aesthetic Treatment Systems. We sell over 15 different aesthetic treatment systems so that customers can select the product best suited to their practice or business. Our product portfolio includes single energy source systems as well as workstations that incorporate two or more different types of lasers or light-based technologies. By offering multiple technologies and system alternatives at a variety of price points, we seek to provide customers with tailored solutions that meet the specific needs of their practices while providing significant flexibility in their level of investment.
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Upgrade Paths Within Product Families. We have designed our new products to facilitate upgrading within product families. For example, our redesigned single energy source Acclaim 7000 and Apogee
5500 laser systems are each upgradeable to our Apogee Elite workstation, which includes a combination of these two laser systems. Similarly, our two laser Cynergy system, which is a combination of our VStar and Acclaim 7000 laser systems, is upgradeable to our Cynergy III multi-energy source workstation through the addition of an intense pulsed light module. We began shipping these new upgradeable systems in mid-2005. We also recently expanded our anti-aging aesthetic solution to include the addition of a new 1320 nm wavelength Nd:YAG laser to the Affirm workstation. The Affirm product family now incorporates three energy sources, and the new deep-heating component provided by the new 1320 nm wavelength Nd:YAG laser allows for tissue tightening as a result of tissue coagulation, which complements the current 1440 nm Nd:YAG laser for fractional micro-rejuvenation and the Xenon Pulsed Light system for discoloration. We expect to begin shipping these new upgradeable systems in 2007.
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Global Presence. We have offered our products in international markets for over 15 years, with approximately 42% of our revenue generated from product sales outside of North America in 2006. We target international markets through a direct sales force in four European countries, Japan and China and through international distributors in 51 other countries.
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Strong Reputation Established Over 15-Year History. We have been in the business of developing and marketing aesthetic treatment systems for over 15 years. As a result of this history, we believe the Cynosure brand name is associated with a tradition of technological leadership.
Our Business Strategy
Our goal is to become the worldwide leader in providing non-invasive aesthetic treatment systems. The key elements of our business strategy to achieve this goal are to:
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Offer a Full Range of Tailored Aesthetic Solutions. We believe that we have one of the broadest product portfolios in the industry, with multiple product offerings incorporating a range of laser and light sources at various price points across many aesthetic applications. Our approach is designed to allow our customers to select products that best suit their client base, practice size and the types of treatments that they wish to offer. This allows us to address the needs of the traditional physician customer market as well as the growing non-traditional physician customer market. Many of our newer products can be upgraded to systems with greater functionality as our customers’ practices expand.
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Launch Innovative New Products and Technologies for Emerging Non-Invasive Aesthetic Applications. Our research and development team builds on our broad range of laser and light-based technologies to target unmet needs in significant aesthetic treatment markets. Since 2002, we have introduced 13 new products. We launched the Apogee Elite system, our flagship product for hair removal, in March 2004; the Cynergy system, our flagship product for the treatment of vascular lesions, in February 2005, and the Affirm system, our flagship product for anti-aging, in April 2006. In addition, we began to distribute the TriActive LaserDermology system, our flagship product for the temporary reduction of the appearance of cellulite, in North America in February 2004. In November 2006, we began to distribute the Smartlipo system, which provides a minimally invasive procedure for LaserBodySculpting and the removal of unwanted fat. We are also working on new technologies for other emerging aesthetic applications, such as tattoo removal and acne.
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Provide Comprehensive, Ongoing Customer Service. We support our customers with a worldwide service organization that includes 20 field service engineers in North America and 48 international field service engineers working directly for us or our international distributors. The field service engineers install our products and respond rapidly to service calls to minimize disruption to our customers’ businesses. Most of our new products are modular in design to enable quick and efficient service and support. In addition, we have engaged a third party consulting firm to assist our North American customers with training and the development of business and marketing plans to establish and grow their aesthetic treatment businesses. We plan to bolster our existing service infrastructure by establishing new training and inventory hubs in Europe and the Asia/Pacific region.
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Generate Additional Revenue from Existing Customer Base. We believe that there are opportunities for us to generate additional revenue from existing customers who are already familiar with our products. Many of our existing traditional and non-traditional customers may be purchasers of additional aesthetic treatment systems to address increasing treatment volumes or new treatment applications. We also expect that customers purchasing our new modular products will be candidates for technology upgrades to enhance the capabilities of their systems. In addition, as we continue to grow our service organization, we are seeking to increase the percentage of our customers that enters into service contracts, which would provide additional recurring customer revenue.
Products
We offer a broad portfolio of aesthetic treatment systems that address a wide variety of applications. From our entry-level, standalone pulsed light products that cost as little as approximately $30,000, to our multi-laser, multi-application workstations that we sell for over $100,000, we can address a wide range of markets and applications.
The following table provides information concerning our products and their applications. We use the flagship designation for our products that are our leading products for a particular application.
(1)
We consider skin rejuvenation to be the treatment of shallow vascular lesions and pigmented lesions to rejuvenate the skin’s appearance.
(2)
We distribute the Cynergy PL product worldwide pursuant to a distribution agreement with El.En.
(3)
We distribute the PhotoLight, PhotoSilk Plus, TriActive LaserDermology and Smartlipo systems in North America pursuant to a distribution agreement with El.En.
System Components
Each of our systems consists of a control console and one or more handpieces. Our control consoles are each comprised of a graphical user interface, a laser or other light source, control system software and high voltage electronics. The graphical user interface allows the practitioner to set the appropriate laser or flashlamp
parameters to meet the requirements of a particular application and patient. The laser or other light source consists of electronics, a visible aiming beam, a focusing lens and a laser or flashlamp. Using the graphical user interface, the practitioner can independently adjust the system’s power level and pulse duration to optimize the desired treatment’s safety and effectiveness. The graphical user interface on our multiple energy workstations also allows the practitioner to change energy sources with the press of a button. The graphical user interfaces on our intense pulsed light systems offer practitioners a choice between using programmed preset treatment settings that address a variety of skin types and treatment options or manually adjusting the energy level and pulse duration settings. The control system software communicates the operator’s instructions from the graphical user interface to the system’s components and manages system performance and calibration.
The handpieces on our laser systems deliver the laser energy through a maneuverable optical fiber to the treatment area. These handpieces weigh approximately eight ounces and are ergonomically designed to allow the practitioner to use the system with one hand and without becoming fatigued. Other features of our laser system handpieces include:
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interchangeable components that permit the practitioner to easily adjust the spot size; and
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an integrated aiming beam of harmless visible light that allows the practitioner to verify the treatment area, thereby reducing the risk of unintended skin damage and potentially reducing treatment time.
The handpieces for our intense pulsed light systems consist of the flashlamp, a wavelength filter and, on some models, an integrated flashlamp cooling system. These handpieces weigh approximately two pounds and also are ergonomically designed to be operated with one hand.
Practitioners generally use our laser systems in combination with a cooling system. We offer our customers our SmartCool treatment cooling system, which we purchase from a third party supplier and sell as a private label product under the Cynosure SmartCool brand. Our SmartCool product has six variable settings and allows the practitioner to provide a continuous flow of chilled air before, during and after treatment to cool and comfort the patient’s skin. The SmartCool handpiece, which is specially designed for use with our laser systems, interlocks with the laser handpiece. In contrast to some competitive cooling systems, there are no disposable supplies required to use our SmartCool system. In North America, our SmartCool system is generally packaged and sold with our laser aesthetic treatment systems, and nearly all of our North American customers purchase a SmartCool system when they purchase one of our laser aesthetic treatment systems. Outside of North America, our customers either purchase our SmartCool system when they purchase one of our aesthetic treatment systems or they purchase another cooling system from a third party supplier. Our PhotoSilk Plus system provides contact cooling for patient comfort. Practitioners generally do not use our other intense pulsed light systems in combination with cooling systems or treatments.
Applications
Practitioners use our products to perform a variety of non-invasive procedures to remove hair, treat vascular and pigmented lesions, rejuvenate skin through the treatment of shallow vascular lesions and pigmented lesions and temporarily reduce the appearance of cellulite. These applications of our products are described below.
Hair Removal. In a typical laser or pulsed light hair removal treatment, the target area is first cleaned and shaved. The practitioner then selects appropriate laser or pulsed light parameters based on the patient’s skin and hair types and pre-cools the treatment area. The practitioner next applies the handpiece to the target area and delivers laser or pulsed light energy to the selected area. The laser or pulsed light removes hair by directing energy to the target melanin pigment of the hair follicle, destroying the hair follicle without harming the surrounding skin. This procedure can last from a few minutes to one hour depending on the size of the treatment area and laser or pulsed light spot size. Chilled air is applied to the treatment area on a continuous basis to cool and comfort the patient’s skin. Generally, for permanent reduction, hair removal requires three to six treatments spaced four to six weeks apart.
Our Apogee Elite workstation is our flagship product for hair removal. It is a two-in-one laser system that contains both an Alexandrite laser, which is best suited for hair removal for patients with light skin types, and an Nd:Yag laser, which is best suited for hair removal for patients with medium and dark skin types or tanned skin. The practitioner can switch between these two energy sources simply by pressing a button on the system console. Features of the Apogee Elite system include:
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A wide range of separately adjustable power and pulse duration settings. This allows the practitioner to select the best settings for safe and efficient hair removal depending on the patient’s skin and hair type. Some competitive systems do not permit pulse duration adjustment, which we believe may reduce the effectiveness of the treatment, particularly for thicker hair.
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A large, 15 millimeter spot size and a laser beam that distributes energy evenly over the entire treatment area. This allows the practitioner to treat a targeted area in an efficient manner. Some competitive systems have smaller spot sizes or beams that concentrate the energy in the middle of the treatment area of each pulse of light, which requires more overlap of the treatment areas of the individual pulses of light to achieve an effective result.
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A rapid pulse rate. This permits the practitioner to cover the treatment area quickly, which is particularly important when removing hair from large areas, such as backs and legs.
In addition to the Apogee Elite system, each of our Apogee 5500, Acclaim 7000, Apogee 9300 and Acclaim 9300 systems can be used for hair removal.
Treatment of Vascular Lesions. To treat vascular lesions the practitioner generally first pre-cools the target area and then applies the system handpiece to deliver laser energy to the treatment area. Depending on the size of the treatment area, procedures last between 20 and 30 minutes. In some cases, a topical anesthetic is applied to the treatment area to minimize pain. For spider veins, redness and rosacea, patients generally receive between two and four treatments spaced over two to three weeks. For port wine birthmarks, patients may receive ten or more treatments.
Our Cynergy workstation is our flagship product for the treatment of vascular lesions. The Cynergy system combines a pulse dye laser, which is best suited for treating shallow vascular lesions, such as port wine birthmarks, facial veins and rosacea, and an Nd:Yag laser, which is best suited for treating large or deep veins, such as leg veins. The practitioner can switch between these two energy sources simply by pressing a button on the system console. Other features of the Cynergy system include:
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A wide range of separately adjustable power and pulse duration settings. This allows the practitioner to select the best settings for safe and efficient treatment depending on the particular type and depth of the vascular lesion to be treated.
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One of the most powerful pulse dye lasers currently available in the aesthetic treatment system market. The power of this laser allows a practitioner to provide treatment with a spot size that is larger than would be effective with a less powerful laser, thereby enhancing treatment efficiency.
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SixPulsetm technology in the pulse dye laser, which distributes the power of one long pulse of energy into six micro pulses. This allows the practitioner to deliver more energy with less patient discomfort.
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A choice of five different spot sizes that are easily selected through the use of interchangeable headpiece components. This allows the practitioner to select the appropriate spot size for the particular vascular lesion to be treated. For example, a large spot size is generally used for a large leg vein, while a small spot size is normally used for facial veins.
In March 2006, we obtained FDA clearance for our innovative Multiplextm energy delivery system that is now available on the Cynergy system. Our Multiplex system mixes the energy from the two lasers included in Cynergy system by quickly following a pulse of energy from the pulse dye laser with a pulse of energy from the Nd:Yag laser. Clinical studies that we conducted have shown that Multiplex delivery allows for more efficient treatment of vascular lesions by reducing the amount of laser power required and allowing the laser energy to penetrate deeper into the target.
In addition to the Cynergy system, each of our Apogee Elite, Acclaim 7000, Cynergy III, VStar, Cynergy PL, PhotoSilk Plus, Acclaim 9300, PhotoLight and PhotoGenica MiniV systems can be used for the treatment of vascular lesions.
Anti-Aging. We believe the marketplace is moving towards a more non-invasive system with anti-aging procedures, including wrinkle reduction, pigmentation, redness and overall skin rejuvenation. Our Affirm was created to address the needs of the anti-aging demand. Anti-aging treatments were historically performed by physicians who could only target one condition and one skin layer during each treatment. Previously, patients often faced longer, more painful procedures that penetrated into the dermal layers and could damage potentially healthy skin.
Our Affirm system is our flagship product for anti-aging, including treatments for wrinkles, skin texture, skin discoloration and skin tightening. The Affirm system is the first micro-rejuvenation system, which includes our patent pending mid-infrared Combined Apex Pulsetm, or CAP, laser technology and Xenon Pulsed Light, or XPL, technology in one system. Our proprietary CAP technology stimulates collagen production throughout the entire treatment area. Through precise thermal manipulation of the epidermal and dermal tissue, it remodels collagen through the papillary dermis to promote collagen production and skin tightening. The laser energy employed by our CAP technology is delivered through a durable and disposable tip that can treat an average of ten clients - allowing for longer instrument life and reduced equipment expenses. The XPL portion of the system effectively eradicates dyschromia, a common condition associated with aging skin. The XPL provides enhanced outcomes by targeting superficial pigments, veins and the blush of rosacea associated with sun damaged skin.
We also recently expanded our anti-aging aesthetic solution to include a new 1320 nm wavelength Nd:YAG laser. The Affirm product family now incorporates three energy sources and the new deep-heating component provided by the new 1320 nm wavelength Nd:YAG laser allows for tissue tightening, as a result of tissue coagulation, which complements the current 1440 nm Nd:YAG laser for fractional micro-rejuvenation and the Xenon Pulsed Light system for discoloration. We expect to begin shipping these new upgradeable systems in 2007.
Skin Rejuvenation. Skin rejuvenation involves the treatment of shallow vascular lesions and pigmented lesions to rejuvenate the skin’s appearance. In a skin rejuvenation procedure, the practitioner applies the system handpiece to the target area and delivers laser or pulsed light energy. The energy destroys the shallow vascular lesions and pigmented lesions and rejuvenates the skin’s appearance without damage to the treated or surrounding area through the improvement in skin texture and reduction or elimination of skin irregularities. Cooling is generally not required. Patients typically receive between four to six treatments of approximately 30 minutes each. Treatments are spaced two to four weeks apart.
Each of our Apogee Elite, Acclaim 7000, Cynergy III, Cynergy, Cynergy PL, Acclaim 9300 and PhotoLight systems can be used for skin rejuvenation through the treatment of shallow vascular lesions and pigmented lesions.
Temporary Reduction of Appearance of Cellulite. Cellulite is a deposit of fat that causes a dimple or other uneven appearance of the skin on women, typically around the thighs, hips and buttocks. According to published reports, an estimated 80% of women have some degree of cellulite. In a treatment for the temporary reduction of the appearance of cellulite, the practitioner applies the multifunction handpiece to deliver diode laser energy, as well as suction and manipulation therapy, to the treatment area. The laser energy and suction and manipulation therapy enhance micro-circulation in the area of the cellulite. Treatment for the temporary reduction in the appearance of cellulite requires a series of treatments of approximately 30 to 45 minutes each, depending on the treatment area and patient response.
Our TriActive LaserDermology system is our flagship product for temporarily reducing the appearance of cellulite. The TriActive system contains six low-energy diode lasers, mechanical massage and suction features and localized cooling. The TriActive system is one of only two light-based systems, and the only laser-based system, cleared by the FDA for use for the temporary reduction in the appearance of cellulite. In addition, the FDA has cleared TriActive system as an over-the-counter device, for sale and use without physician
supervision, because its diode lasers are sealed and do not pose a risk of exposure to operators’ eyes. We believe that TriActive system is the only light-based system for this application that has been so cleared by the FDA, which significantly facilitates our marketing of TriActive system to the growing aesthetic spa market.
Other Aesthetic Applications. We are developing flagship products based on laser technologies in two other areas:
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tattoo removal, which we consider a large and growing market opportunity as a result of the increasing popularity of tattoos and the limitations on effectiveness of current laser treatments; and
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acne, for which we believe laser treatment may be seen as an attractive alternative to Accutane because of safety issues with this drug.
Currently, our VStar product is used for the treatment of acne and our Affinity QS system, which has not received regulatory clearance in the United States, is used for tattoo removal.
LaserBodySculpting and Removal of Unwanted Fat. We believe the demand for liposuction and body sculpting procedures that remove or reduce fat cells is increasing.
Our Smartlipo system is our flagship product for LaserBodySculpting and the removal of unwanted fat. The Smartlipo system is the first and only laser lipolysis system to offer a minimally invasive procedure for the removal of unwanted fat. The Smartlipo LaserBodySculptingsm procedure enables aesthetic surgeons to treat localized deposits of fat through tissue coagulation, resulting in tissue tightening. The Smartlipo LaserBodySculpting procedure is performed by inserting a very small cannula, or metal tube, which contains a laser fiber and placing it under the skin in direct contact with the treatment area. The laser’s energy causes the fat cells to rupture and drain away. In addition, the laser’s energy promotes collagen shrinkage and causes a tissue tightening effect. Due to the device’s miniaturization, LaserBodySculpting is a minimally invasive procedure. Therefore, it can be performed under local anesthesia with minimal trauma in comparison to alternative liposuction procedures.
Original Equipment Manufacturing and Other Relationships
We are collaborating with third parties in connection with surgical uses of our laser products. Specifically:
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In 2004, we began supplying our surgical pulse dye lasers on an original equipment manufacturer basis to PENTAX Medical Company, which sells these lasers for use with its endoscopic video imaging system in North America and South America for use in treating recurrent respiratory papilloma and glottal dysplasia. Recurrent respiratory papilloma is a disease characterized by tumor growth in the larynx, vocal cords and trachea. Glottal dysplasia is a disease characterized by abnormal changes in the cells that line the glottis, or middle part of the larynx, caused by damage to the lining of the larynx. In these treatments, the PENTAX endoscope is inserted through the nose to access the larynx. A disposable, flexible optical fiber is then passed through the endoscope. Our system is used to deliver laser energy through the optical fiber to target and destroy the tumors or abnormal cells. The FDA has cleared the use of our laser for these indications.
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In 2004, we began supplying our lasers on an original equipment manufacturer basis to Solx, Inc., an entity that was purchased by OccuLogix, Inc. in 2006, which is using the lasers with its systems for the treatment of glaucoma. Glaucoma is an eye disease associated with the degeneration of the retinal cells responsible for transmitting images from the eye to the brain. This treatment involves the implantation of the Solx system in the eye and the use of laser energy to activate the system to reduce intraocular pressure associated with some types of glaucoma. Solx is marketing our lasers in Europe, where their use in this procedure has been approved. Clinical trials of our lasers for this procedure are ongoing in the United States.
Sales and Marketing
We sell our aesthetic treatment systems to the traditional physician customer base of dermatologists and plastic surgeons as well as to the increasing number of non-traditional physician customers who are providing aesthetic services using laser and light-based technology. Non-traditional physician customers include primary care physicians, obstetricians, gynecologists, ophthalmologists and ear, nose and throat specialists.
We target potential customers through office visits, trade shows and trade journals. We also conduct clinical workshops featuring recognized expert panelists and opinion leaders to promote existing and new treatment techniques using our products. We believe that these workshops enhance customer loyalty and provide us with new sales opportunities. We also use direct mail programs to target specific segments of the market that we seek to access, such as members of medical societies and attendees at meetings sponsored by medical societies or associations. In addition, we have recently implemented a public relations program that has resulted in treatments based on our products being featured in magazines such as Elle, Harper’s Bazaar and Redbook.
We do not provide financing to our customers to purchase our products. If a potential customer requests financing, we refer the customer to third party financing sources.
Physician Sales
We sell our products to physicians in North America through a direct sales force. Outside of North America, we sell our products to physicians through a direct sales force in four European countries, Japan and China and through independent distributors in 51 other countries.
We conduct our own international sales and service operations through wholly-owned subsidiaries in the United Kingdom, France, Germany, Spain, Japan and China. We seek distributors in international markets where we do not believe that a direct sales presence is warranted or feasible. In those markets, we select distributors that have extensive knowledge of our industry and their local markets. Our distributors sell, install and service our products. We require our distributors to invest in service training and equipment, to stock and supply maintenance and service parts for our systems, to attend exhibitions and industry meetings and, in some instances, to commit to minimum sales amounts to gain or retain exclusivity. Currently, we have written distribution agreements with 16 of our 19 third party distributors. Generally, the written agreements with our distributors have terms of between one and two years.
Service and Support
We support our customers with a range of services, including installation and product training, business and practice development consulting and product service and maintenance. In North America, our field service organization has 20 field service engineers. Outside of North America, our sales and service subsidiaries and our trained distributors employ 48 field service engineers.
In connection with direct sales of our aesthetic treatment systems, we arrange for the installation of the system and initial product training. Generally, installation and initial training take less than three hours. The installation is conducted by our field service engineers. We have engaged a third party consulting firm to provide advice to North American purchasers of our systems on the development of their aesthetic treatment businesses and marketing plans. We have found that this service is particularly appealing to the non-traditional physician customer and aesthetic spa segments of the market, which have less familiarity with the business aspects of laser and light-based aesthetic treatments than dermatologists and cosmetic surgeons. The cost of installation, initial training and, for North American purchasers, the basic consulting package of this third party consultant are all included in the purchase price of our systems. We also offer for an additional charge a more comprehensive package of services from the third party consultant.
We strive to respond to all service calls within 24 hours to minimize disruption of our customers’ businesses. We have designed our new products in a modular fashion to enable quick and efficient service and support. Specifically, we build these products with several separate components that can easily be removed and replaced when the product is being serviced. We provide initial warranties on our products to cover parts
and service, and we offer extended warranty packages that vary by type of product and level of service desired. Our base warranty covers parts and service for one year. We offer extended warranty arrangements through service plans. We believe that we have a significant opportunity to increase our recurring customer revenues by increasing the percentage of our customers that enter into service contracts for our systems.
Research and Development
Our research and development team consists of 21 employees with a broad base of experience in lasers and optoelectronics. Our research and development team works closely with opinion leaders and customers, both individually and through our sponsored seminars, to understand unmet needs and emerging applications in the field of aesthetic skin treatments and to develop new products and improvements to our existing products. They also conduct and coordinate clinical trials of our products. Our research and development team builds on the significant base of patented and proprietary intellectual property that we have developed in the fields of laser and other light-based technologies since our inception in 1991.
Our research and development expenses were approximately $4.7 million in 2006, $3.2 million in 2005 and $3.2 million in 2004, none of which was customer sponsored. We expect our research and development expenditures to increase as we continue to devote resources to research and develop new products and technologies.
Manufacturing and Raw Materials
We manufacture all of our products, other than the Cynergy PL, PhotoLight, PhotoSilk Plus, Affinity QS, TriActive LaserDermology and Smartlipo systems, which are manufactured by El.En. and which we sell and market under our distribution agreement with El.En. We manufacture our products with components and subassemblies purchased from third party suppliers. Accordingly, our manufacturing operations consist principally of assembly and testing of our systems and integration of our proprietary software.
We recently redesigned a number of our products, including our Apogee, Cynergy, Acclaim and VStar product families, so that they are built in a modular fashion using fewer components. We began shipping these redesigned products in the second quarter of 2005. This new approach enables us to manufacture our products more efficiently. Specifically, we have:
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reduced our assembly part counts and our direct labor costs;
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reduced our service parts inventories; and
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increased our ability to test our products during the manufacturing process.
We purchase many of our components and subassemblies from third party manufacturers on an outsourced basis. We use one third party to assemble and test many of the components and subassemblies for our Apogee, Cynergy, Acclaim and VStar product families. We also depend exclusively on sole source suppliers for Alexandrite rods, which we use in the manufacture of our Apogee products, and for our SmartCool treatment cooling systems.
We do not have long-term contracts with our third party manufacturers or sole source suppliers. We generally purchase components and subassemblies as well as our other supplies on a purchase order basis. If for any reason, our third party manufacturers or sole source suppliers are not willing or able to provide us with components, subassemblies or supplies in a timely fashion, or at all, our ability to manufacture and sell many of our products could be impaired. To date, we have been able to obtain adequate outsourced manufacturing services and supplies of Alexandrite rods and air cooling systems from our third party manufacturers and suppliers in a timely manner. We believe that over time alternative component and subassembly manufacturers and suppliers can be identified if our current third party manufacturers and suppliers fail to fulfill our requirements.
El.En. Commercial Relationship
The Cynergy PL, PhotoLight, PhotoSilk Plus, TriActive LaserDermology and Smartlipo systems sold by us were developed, and associated intellectual property rights are owned, by El.En. El.En. manufactures, and we distribute, these products pursuant to distribution agreements between us and El.En. These agreements provide us with exclusive worldwide distribution rights for the Cynergy PL system, exclusive distribution rights in the United States and Canada for the PhotoLight, TriActive LaserDermology and Smartlipo systems, and non-exclusive distribution rights for the PhotoSilk Plus system. The transfer prices for products that we currently distribute under the agreements are specified in the agreement; however, they may be changed by El.En. at its discretion upon 30 days’ notice.
El.En. is required to provide us with training, marketing and other sales support for the products we distribute under these agreements. We are required to use best efforts to sell and promote these products, and we are responsible for obtaining and maintaining regulatory approvals for them. If El.En. wishes to discontinue producing products that we distribute, it must make reasonable efforts to provide us with one year’s notice of its plan to do so.
Each of the distribution agreements has an initial term that expires in January 2012. The distribution agreement relating to the PhotoLight, PhotoSilk Plus, TriActive LaserDermology and Smartlipo systems will automatically renew for additional one-year terms unless either party provides notice of termination at least six months prior to the expiration of the initial term or any subsequent renewal term. The distribution agreement relating to the Cynergy system will automatically renew for additional one year terms unless either party provides notice of termination at least one year prior to the expiration of the initial term or any subsequent renewal term. We or El.En. may terminate the distribution agreements at any time based upon material uncured breaches by, or the insolvency of, the other party. In addition, El.En. may terminate the distribution agreement for the PhotoLight, TriActive LaserDermology and Smartlipo systems if we do not meet annual minimum purchase obligations specified in the agreements.
Patents, Proprietary Technology and Trademarks
Our success depends in part on our ability to obtain and maintain proprietary protection for our products, technology and know-how, to operate without infringing the proprietary rights of others and to prevent others from infringing our proprietary rights. Our policy is to seek to protect our proprietary position by, among other methods, filing United States and foreign patent applications related to our proprietary technology, inventions and improvements that are important to the development of our business. We also rely on trade secrets, know-how, continuing technological innovation and in-licensing opportunities to develop and maintain our proprietary position.
As of December 31, 2006, we owned a total of 38 United States patents, as well as foreign counterparts to 21 of these patents. Our patent portfolio includes patents and patent applications with claims directed to:
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the design and method of use and operation of our pulse dye laser systems;
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the design and method of use and operation of our Alexandrite laser systems for hair removal;
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our Multiplex energy delivery system for our pulse dye lasers; and
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the design of endoscopic laser and light delivery systems.
The expiration dates for our issued United States patents range from 2013 to 2022. Additionally, El.En. has applied for a patent covering the methods of use and operation of the TriActive LaserDermology system. We do not consider any single patent or patent application that we hold to be material to our business.
The patent positions of companies like ours are generally uncertain and involve complex legal and factual questions. Our ability to maintain and solidify our proprietary position for our technology will depend on our success in obtaining effective patent claims and enforcing those claims once granted. We do not know whether any of our patent applications or those patent applications that we license will result in the issuance of any patents. Our issued patents and those that may issue in the future, or those licensed to us, may be challenged,
invalidated or circumvented, which could limit our ability to stop competitors from marketing related products or shorten the term of patent protection that we may have for our products. In addition, the rights granted under any issued patents may not provide us with competitive advantages against competitors with similar technology. Furthermore, our competitors may independently develop similar technologies or duplicate any technology developed by us. Because of the extensive time required for development, testing and regulatory review of a potential product, it is possible that, before any of our products under development can be commercialized, any related patent may expire or remain in force for only a short period following commercialization, thereby reducing any advantage of the patent.
In July 2004, Palomar Medical Technologies, Inc. sent us a letter proposing to enter into negotiations with us regarding the grant of a nonexclusive license under specified United States and foreign patents owned or licensed by Palomar with respect to our Apogee Elite, Apogee 5500, PhotoLight and Acclaim 7000 products, and also with respect to our SmartEpil II product, which we no longer offer. In subsequent letters from Palomar in September 2004 and March 2005, Palomar reiterated its willingness to negotiate a license under these patents and, in its March 2005 letter, stated that it continued to believe that we need a license under these patents for each of the products listed in the July 2004 letter, as well as for our PhotoSilk, PhotoSilk Plus, Cynergy, Cynergy PL and Cynergy III systems.
On November 6, 2006, we entered into a patent cross-license agreement with Palomar. Under the cross-license agreement, we obtained a non-exclusive license to integrate into our products certain hair removal technology covered by specified U.S. and foreign patents held by Palomar and Palomar obtained a non-exclusive license under certain U.S. and foreign patents held by us. In November 2006, we made a payment to Palomar of $10 million for royalties related to sales prior to October 1, 2006 of hair removal-only systems including our Apogee family of products, PhotoLight, Acclaim 7000 and the PhotoSilk Plus. In connection with this agreement, we also agreed to pay royalties to Palomar on future sales of certain hair removal-only products. The royalty rate for future sales of hair removal products will range from 3.75% to 7.5% of net sales beginning October 1, 2006, depending upon product configuration and the number of energy sources. Our revenue from systems that do not include hair removal capabilities and revenue from service is not subject to any past or future royalties under this agreement.
We rely, in some circumstances, on trade secrets to protect our technology. Trade secrets, however, are difficult to protect. We seek to protect our proprietary technology and processes, in part, by confidentiality agreements with our employees, consultants, scientific advisors and other contractors. These agreements may be breached, and we may not have adequate remedies for any breach. In addition, our trade secrets may otherwise become known or be independently discovered by competitors. To the extent that our employees, consultants or contractors use intellectual property owned by others in their work for us, disputes may arise as to the rights in related or resulting know-how and inventions.
We use trademarks on nearly all of our products and believe that having distinctive marks is an important factor in marketing our products. We have registered our Cynosure®, Apogee®, PhotoGenica® and SmartCool® marks, among others, in the United States. Our other trademarks include Affinitytm, Acclaimtm, Apogee Elitetm, Cynergytm, CynosureSpatm, PhotoLighttm, PhotoSilktm, PhotoSilk Plustm, Smartlipotm, Affirmtm and LaserDermologysm. We have also registered some of our marks in a number of foreign countries. In addition, El.En. has registered the TriActive® mark in the United States. Although we have a foreign trademark registration program for selected marks, we may not be able to register or use such marks in each foreign country in which we seek registration.
Competition
Our industry is subject to intense competition. Our products compete against laser and other light-based products offered by public companies, such as Candela Corporation, Cutera, Inc., Laserscope, Lumenis Ltd., Palomar Medical Technologies, Inc., Syneron Medical Ltd. and Thermage, Inc., as well as several smaller specialized private companies, such as Radiancy, Inc. Some of these competitors have significantly greater financial and human resources than we do and have established reputations, as well as worldwide distribution channels and sales and marketing capabilities that are larger and more established than ours. Additional
competitors may enter the market, and we are likely to compete with new companies in the future. Our products also compete against non-light-based medical products, such as BOTOX® and collagen injections, and surgical and non-surgical aesthetic procedures, such as face lifts, chemical peels, abdominoplasty, liposuction, microdermabrasion, sclerotherapy and electrolysis.
Competition among providers of aesthetic laser and other light-based products is characterized by significant research and development efforts and rapid technological progress. There are few barriers that would prevent new entrants or existing competitors from developing products that would compete directly with ours. There are many companies, both public and private, that are developing innovative devices that use both light-based and alternative technologies for aesthetic and medical applications. Accordingly, our success depends in part on developing and commercializing new and innovative applications of laser and other light-based technology and identifying new markets for and applications of existing products and technology.
To compete effectively, we have to demonstrate that our products are attractive alternatives to other devices and treatments by differentiating our products on the basis of performance, reputation, quality of customer support and price. Breadth of product offering is also important. We believe that we perform favorably with respect to each of these factors. However, we have encountered and expect to continue to encounter potential customers who, due to pre-existing relationships with our competitors, are committed to, or prefer the products offered by these competitors. Potential customers also may decide not to purchase our products, or to delay such purchases, based on a decision to recoup the cost of expensive products that they may have already purchased from our competitors. In addition, we expect that competitive pressures may result in price reductions and reduced margins over time for our products.
Government Regulation
Our products are medical devices subject to extensive and rigorous regulation by the FDA, as well as other regulatory bodies. FDA regulations govern the following activities that we perform and will continue to perform to ensure that medical devices distributed domestically are safe and effective for their intended uses.
FDA’s Regulation of Manufacturing
The FDA requires that we manufacture our products in accordance with its Quality System Regulation, or QSR. The QSR covers the methods and documentation of the design, testing, control, manufacturing, labeling, quality assurance, packaging, storage and shipping of our products. The FDA enforces the QSR through periodic unannounced inspections. Based on our communication with the FDA, we expect an inspection of our new facility to occur in the near future.
Our failure to maintain compliance with the QSR requirements could result in the shut down of, or restrictions on, our manufacturing operations and the recall or seizure of our products, which would have a material adverse effect on our business. In the event that one of our suppliers fails to maintain compliance with our quality requirements, we may have to qualify a new supplier and could experience manufacturing delays as a result.
We maintain quality assurance and quality management certifications to enable us to market our products in the member states of the European Union, the European Free Trade Association and some countries that have entered into Mutual Recognition Agreements with the European Union. In November 1998, our former facility was awarded the ISO 9001 and EN 46001 certifications. In October 2003, we received our ISO 9001 updated certification as well as our certification for ISO 13485, which replaced our EN 46001 certification. We are in the process of transferring these certifications to our new facility and are currently able to conduct our manufacturing activities in the normal course.
FDA’s Premarket Clearance and Approval Requirements
Unless an exemption applies, each medical device we wish to distribute commercially in the United States requires either prior 510(k) clearance or premarket approval from the FDA. The FDA classifies medical devices into one of three classes. Devices deemed to pose lower risks are placed in either class I or II, which
requires the manufacturer to submit to the FDA a premarket notification requesting permission to distribute the device commercially. This process is generally known as 510(k) clearance. Class I devices are subject to general controls such as labeling and adherence to FDA’s QSR. Class II devices are subject to special controls such as performance standards and FDA guidelines as well as general controls. The FDA exempts some low risk devices from premarket notification requirements and the requirement of compliance with certain provisions of the QSR. The FDA places devices in class III, requiring premarket approval, if insufficient information exists to determine that the application of general controls or special controls are sufficient to provide reasonable assurance of safety and effectiveness and they are life-sustaining, life-supporting or implantable devices, or devices deemed not substantially equivalent to a previously cleared 510(k) device or to a “preamendment” class III device in commercial distribution before May 28, 1976, for which premarket approval applications have not been required. All of our current products are class II devices. Both premarket notifications and premarket approval applications when submitted to FDA must be accompanied by a user fee, unless exempt.
510(k) Clearance Pathway
When a 510(k) clearance is required, we must submit a premarket notification to the FDA demonstrating that our proposed device is substantially equivalent to a previously cleared 510(k) device or a device that was in commercial distribution before May 28, 1976 for which the FDA has not yet called for the submission of premarket approval applications, or premarket approval. By regulation, the FDA must clear or deny a 510(k) premarket notification within 90 days of submission of the application. As a practical matter, clearance often takes significantly longer. The FDA may require further information, including clinical data, to make a determination regarding substantial equivalence.
Laser devices used for aesthetic procedures, such as hair removal, have generally qualified for clearance under 510(k) procedures.
Premarket Approval Pathway
If the device cannot be cleared through the 510(k) process, the sponsor must submit a premarket approval application, which is known as a PMA. The sponsor must support the PMA with extensive data, including but not limited to, technical, preclinical, clinical trials, manufacturing and labeling to demonstrate to the FDA’s satisfaction the safety and effectiveness of the device.
No device that we have developed has required premarket approval, nor do we currently expect that any future device or indication will require premarket approval.
Product Modifications
After a device receives 510(k) clearance or a PMA approval, any modification that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, will require a new clearance or approval. The FDA requires each manufacturer to make this determination initially, but the FDA can review any such decision and can disagree with a manufacturer’s determination. We have modified aspects of various products since receiving regulatory clearance and believe that new 510(k) clearances are not required for these modifications. If the FDA disagrees with our determination not to seek a new 510(k) clearance or PMA approval, the FDA may retroactively require us to seek 510(k) clearance or premarket approval. The FDA could also require us to cease marketing and distributing the modified device, and the recall any sold devices, until 510(k) clearance or premarket approval is obtained. Also, in these circumstances, we may be subject to significant regulatory fines or penalties.
Clinical Trials
We perform clinical trials to provide data to support the FDA clearance process for our products and for use in our sales and marketing efforts. Human clinical studies are generally required in connection with approval of class III devices and may be required for clearance of class I and II devices. When FDA clearance or approval of a device requires human clinical trials, and if the device presents a “significant risk,” as defined
by the FDA, to human health, the FDA requires the device sponsor to file an investigational device exemption, or IDE, application with the FDA and obtain IDE approval prior to commencing the human clinical trials. The sponsor must support the IDE application with appropriate data, such as animal and laboratory testing results, showing that it is safe to test the device in humans and that the testing protocol is scientifically sound. The sponsor also must obtain approval from the institutional review board overseeing the clinical trial.
To date, we have not submitted any IDEs because we believe our devices present only “non-significant” risks and, therefore, do not require IDE submission to the FDA. Instead, only institutional review board approval is required. Future clinical trials of our products may require that we submit and obtain approval of an IDE from the FDA prior to commencing clinical trials. The FDA, and the Institutional Review Board at each institution at which a clinical trial is being performed, may suspend a clinical trial at any time for various reasons, including a belief that the subjects are being exposed to an unacceptable health risk.
All clinical investigations of devices to determine safety and effectiveness must be conducted in accordance with the FDA’s IDE regulations which govern investigational device labeling, prohibit promotion of the investigational device, and specify an array of recordkeeping, reporting and monitoring responsibilities of study sponsors and study investigators. Clinical trials must further comply with FDA’s regulations for institutional review board approval and for informed consent. Required records and reports are subject to inspection by the FDA. The results of clinical testing may be unfavorable or inconclusive or, even if the intended safety and effectiveness success criteria are achieved, may not be considered sufficient for the FDA to grant approval or clearance of a product. The commencement or completion of any of our clinical trials may be delayed or halted, or be inadequate to support approval of a PMA application, or 510(k) clearance, for numerous reasons, including, but not limited to, the following:
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patients do not enroll in clinical trials or there is not patient follow-up at the rate we expect;
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patients do not comply with trial protocols;
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patients experience adverse side effects;
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institutional review boards and third party clinical investigators may delay or reject our trial protocol;
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third party clinical investigators decline to participate in a trial or do not perform a trial on our anticipated schedule or consistent with the clinical trial protocol, good clinical practices, or other FDA requirements;
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regulatory inspections of our clinical trials or manufacturing facilities, which may, among other things, require us to undertake corrective action or suspend or terminate our clinical trials or invalidate our clinical trials; and
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changes in governmental regulations or administrative actions.
Our clinical trials may not generate favorable data to support any PMA or 510(k), and we may not be able to obtain such approvals or clearances on a timely basis, or at all. Delays in receipt of or failure to receive such approvals or clearances or failure to comply with existing or future regulatory requirements would have a material adverse effect on our business, financial condition and results of operations. Even if granted, the approvals or clearances may include significant limitations on the intended use and indications for use for which our products may be marketed.
Clinical studies conducted on 510(k) cleared devices, when used or investigated in accordance with the devices’ labeled instructions, are exempt from most of the FDA’s IDE requirements.
Pervasive and Continuing Regulation
After a device is placed on the market, numerous regulatory requirements apply. These include:
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establishment registration and device listing;
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the quality system regulation, which requires manufacturers, including third-party manufacturers, to follow stringent design, testing, control, documentation and other quality assurance procedures during all aspects of the manufacturing process;
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labeling regulations and FDA prohibitions against the promotion of products for uncleared, unapproved or “off-label” uses, and other requirements related to promotional activities;
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medical device reporting regulations, which require that manufacturers report to the FDA if their device may have caused or contributed to a death or serious injury or malfunctioned in a way that would likely cause or contribute to a death or serious injury if the malfunction were to recur;
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corrections and removal reporting regulations, which require that manufacturers report to the FDA field corrections and product recalls or removals if undertaken to reduce a risk to health posed by the device or to remedy a violation of the Federal Food, Drug, and Cosmetic Act that may present a risk to health; and
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post-market surveillance regulations, which apply when necessary to protect the public health or to provide additional safety and effectiveness data for the device.
The FDA may require us to maintain a system for tracking our products through the chain of distribution to the patient level. The FDA has broad post-market and regulatory enforcement powers. We are subject to unannounced inspections by the FDA to determine our compliance with the QSR and other regulations. These inspections may include the manufacturing facilities of our subcontractors. Thus, we must continue to spend time, money and effort to maintain compliance. In the past, our prior facility has been inspected and observations were noted. The FDA has accepted our responses to these observations, and we believe that we are in substantial compliance with the QSR. The FDA has not inspected our current manufacturing facility, although we understand that the FDA intends to inspect this facility in the near future. Since 1994, we have received five untitled letters from the FDA regarding alleged violations caused by our promotional activities. We have responded to these letters and the FDA found our responses acceptable.
We are also regulated under the Radiation Control for Health and Safety Act, which requires laser products to comply with performance standards, including design and operation requirements. The law also requires manufacturers to certify in product labeling and in reports to the FDA that their products comply with all such standards. The law and applicable federal regulations also require laser manufacturers to file new product and annual reports, maintain manufacturing, testing and sales records, and report product defects. Various warning labels must be affixed and certain protective devices installed, depending on the class of the product.
Failure to comply with applicable regulatory requirements can result in enforcement action by the FDA, which may include any of the following sanctions:
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untitled letters, warning letters, fines, injunctions, consent decrees and civil penalties;
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repair, replacement, refunds, recall or seizure of our products;
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operating restrictions, partial suspension or total shutdown of production;
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refusing or delaying our requests for 510(k) clearance or premarket approval of new products or new intended uses;
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withdrawing 510(k) clearance or premarket approvals that are already granted; and
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criminal prosecution.
The FDA also has the authority to require us to repair, replace or refund the cost of any medical device that we have manufactured or distributed. If any of these events were to occur, they could have a material adverse effect on our business.
We are also subject to a wide range of federal, state and local laws and regulations, including those related to the environment, health and safety, land use and quality assurance. We believe that compliance with
these laws and regulations as currently in effect will not have a material adverse effect on our capital expenditures, earnings and competitive and financial position.
International
International sales of medical devices are subject to foreign governmental regulations, which vary substantially from country to country. The time required to obtain clearance or approval by a foreign country may be longer or shorter than that required for FDA clearance or approval, and the requirements may be different.
The primary regulatory environment in Europe is that of the European Union, which consists of 25 countries encompassing most of the major countries in Europe. The European Union has adopted numerous directives, and European Standardization Committees have promulgated voluntary standards, regulating the design, manufacture, clinical trials, labeling and adverse event reporting for medical devices. Devices that comply with the requirements of a relevant directive will be entitled to bear CE conformity marking, indicating that the device conforms to the essential requirements of the applicable directives and, accordingly, can be commercially distributed throughout the member states of the European Union and the member states of the European Free Trade Association, including Switzerland.
The method of assessing conformity varies depending on the type and class of the product, but normally involves a combination of self-assessment by the manufacturer and a third party assessment by a Notified Body, an independent and neutral institution appointed by a country to conduct the conformity assessment. This third party assessment may consist of an audit of the manufacturer’s quality system and specific testing of the manufacturer’s device. An assessment by a Notified Body in one member state of the European Union or the European Free Trade Association is required in order for a manufacturer to distribute the product commercially throughout these countries. ISO 9001 and ISO 13845 certification are voluntary harmonized standards. Compliance establishes the presumption of conformity with the essential requirements for a CE Marking. In November 1998, our former facility was awarded the ISO 9001 and EN 46001 certifications. In October 2003, we received our ISO 9001 updated certification as well as our certification for ISO 13485, which replaced our EN 46001 certification.
Employees
As of December 31, 2006, we had 213 employees, including 72 employees in sales and marketing functions, 21 employees in research, development and engineering functions, 82 employees in manufacturing and service functions and 38 employees in general and administrative functions. We believe that our future success will depend in part on our continued ability to attract, hire and retain qualified personnel. None of our employees is represented by a labor union, and we believe our employee relations are good.
ITEM 1A.
ITEM 1A.
Risk Factors.
The following important factors, among others, could cause our actual operating results to differ materially from those indicated or suggested by forward-looking statements made in this Annual Report or presented elsewhere by management from time to time.
Risks Related to Our Business and Industry
We have a history of operating losses, and we may not maintain profitability.
Although we were profitable in 2004 and 2005, we incurred operating losses in three of the last five years. Our net losses were approximately $0.7 million in 2006, $0.5 million in 2003, and $1.9 million in 2002. We may not be able to sustain or increase profitability on a quarterly or annual basis. If we are unable to maintain profitability, the market value of our stock will decline, and you could lose all or a part of your investment.
If we fail to obtain Alexandrite rods or our air cooling system from our sole suppliers, our ability to manufacture and sell our products and components would be impaired.
We use Alexandrite rods to manufacture the lasers for our Apogee products. We depend exclusively on Northrop Grumman SYNOPTICS to supply Alexandrite rods to us, and we are aware of no alternative supplier meeting our quality standards. We offer our SmartCool® treatment cooling systems for use with our laser aesthetic treatment systems, and we depend exclusively on Zimmer Elektromedizin GmbH to supply SmartCool systems to us. Both Alexandrite lasers and our SmartCool systems are important to our business.
We do not have long-term arrangements with Northrop Grumman SYNOPTICS or Zimmer Elektromedizin for the supply of Alexandrite rods or SmartCool systems, but instead purchase from them on a purchase order basis. Northrop Grumman SYNOPTICS and Zimmer Elektromedizin are not required, and may not be able or willing, to meet our future requirements at current prices, or at all. Any extended interruption in our supplies of Alexandrite rods or our SmartCool treatment cooling systems could materially harm our business.
We compete against companies that have longer operating histories, more established products and greater resources than we do, which may prevent us from achieving further market penetration or improving operating results.
Competition in the aesthetic laser industry is intense. Our products compete against products offered by public companies, such as Candela Corporation, Cutera, Inc., Laserscope, Lumenis Ltd., Palomar Medical Technologies, Inc., Syneron Medical Ltd. and Thermage, Inc., as well as several smaller specialized private companies, such as Radiancy, Inc. Some of these competitors have significantly greater financial and human resources than we do and have established reputations, as well as worldwide distribution channels and sales and marketing capabilities that are larger and more established than ours. Additional competitors may enter the market, and we are likely to compete with new companies in the future. We also face competition from medical products, such as BOTOX® and collagen injections, and surgical and non-surgical aesthetic procedures, such as face lifts, sclerotherapy, electrolysis, microdermabrasion and chemical peels. We may also face competition from manufacturers of pharmaceutical and other products that have not yet been developed. As a result of competition with these companies, products and procedures, we could experience loss of market share and decreasing revenue as well as reduced prices and profit margins, any of which would harm our business and operating results.
Our ability to compete effectively depends upon our ability to distinguish our company and our products from our competitors and their products. Factors affecting our competitive position include:
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product performance and design;
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ability to sell products tailored to meet the applications needs of clients and patients;
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quality of customer support;
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product pricing;
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product safety;
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sales, marketing and distribution capabilities;
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success and timing of new product development and introductions; and
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intellectual property protection.
Some of our competitors have more established products and customer relationships than we do, which could inhibit our further market penetration efforts. For example, we have encountered, and expect to continue to encounter, situations where, due to pre-existing relationships, potential customers determine to purchase additional products from our competitors. If we are unable to compete effectively, our business and operating results will be harmed.
In addition, some of our current and potential competitors have significantly greater financial, research and development, manufacturing and sales and marketing resources than we have. Our competitors could
utilize their greater financial resources to acquire other companies to gain enhanced name recognition and market share, as well as to acquire new technologies or products that could effectively compete with our product lines.
If we do not continue to develop and commercialize new products and identify new markets for our products and technology, we may not remain competitive, and our revenues and operating results could suffer.
The aesthetic laser and light-based treatment system industry is subject to continuous technological development and product innovation. If we do not continue to be innovative in the development of new products and applications, our competitive position will likely deteriorate as other companies successfully design and commercialize new products and applications. Accordingly, our success depends in part on developing new and innovative applications of laser and other light-based technology and identifying new markets for and applications of existing products and technology. If we are unable to develop and commercialize new products and identify new markets for our products and technology, our products and technology could become obsolete and our revenues and operating results could be adversely affected.
To remain competitive, we must:
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develop or acquire new technologies that either add to or significantly improve our current products;
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convince our target customers that our new products or product upgrades would be attractive revenue-generating additions to their practices;
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sell our products to non-traditional customers, including primary care physicians, gynecologists and other specialists;
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identify new markets and emerging technological trends in our target markets and react effectively to technological changes; and
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maintain effective sales and marketing strategies.
If our new products do not gain market acceptance, our revenues and operating results could suffer.
The commercial success of the products and technology we develop will depend upon the acceptance of these products by providers of aesthetic procedures and their patients and clients. It is difficult for us to predict how successful recently introduced products, or products we are currently developing, will be over the long term. If the products we develop do not gain market acceptance, our revenues and operating results could suffer.
We expect that many of the products we develop will be based upon new technologies or new applications of existing technologies. It may be difficult for us to achieve market acceptance of some of our products, particularly the first products that we introduce to the market based on new technologies or new applications of existing technologies.
If demand for our aesthetic treatment systems by non-traditional physician customers and spas does not develop as we expect, our revenues will suffer and our business will be harmed.
Our revenues from non-traditional physician customers and spa purchasers of our products have increased significantly since January 1, 2004. We believe, and our growth expectations assume, that we and other companies selling lasers and other light-based aesthetic treatment systems have only begun to penetrate these markets and that our revenues from selling to these markets will continue to increase. If our expectations as to the size of these markets and our ability to sell our products to participants in these markets are not correct, our revenues will suffer and our business will be harmed.
We rely upon third party suppliers for the components and subassemblies of many of our products, making us vulnerable to supply shortages and price fluctuations, which could harm our business.
Many of the components and subassemblies that comprise our aesthetic treatment systems are currently manufactured for us by a limited number of suppliers. In addition, one third party supplier assembles and tests many of the components and subassemblies for our Apogee, Cynergy, Affirm, Acclaim and VStar product families. We do not have long-term contracts with any of these third parties, including the third party supplier that assembles many of our components and subassemblies, for the supply of parts or services. Any interruption in the supply of components or subassemblies, or our inability to obtain substitute components or subassemblies from alternate sources at acceptable prices in a timely manner, or our inability to obtain assembly and testing services, could impair our ability to meet the demand of our customers, which would have an adverse effect on our business and operating results.
We sell our products in numerous international markets. Our operating results may suffer if we are unable to manage our international operations effectively.
We sell our products in 57 foreign countries, and we therefore are subject to risks associated with having international operations. Sales of our products outside of North America accounted for 42% of our revenue for 2006, 41% of our revenue in 2005 and 45% of our revenue for 2004.
Our international sales are subject to a number of risks, including:
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foreign certification and regulatory requirements;
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difficulties in staffing and managing our foreign operations;
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import and export controls; and
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political and economic instability.
Revenue from our international sales could be adversely affected by fluctuations in currency exchange rates, which would cause our operating results to suffer.
We face risks associated with changes in foreign currency exchange rates. Revenues outside of North America that were recorded in U.S. dollars represented approximately 48% of our total 2006 revenues outside of North America. Substantially all of the remaining 52% of our total 2006 revenues outside of North America were sales in euros, British pounds and Japanese yen. Since we report our financial position and results of operations in U.S. dollars, our reported results of operations may be adversely affected by changes in the exchange rate between these currencies and the U.S. dollar. We have not historically engaged in hedging activities relating to our non-U.S. dollar operations. We may incur negative foreign currency translation charges as a result of changes in currency exchange rates, which could cause our operating results to suffer.
We rely on third party distributors to market, sell and service a significant portion of our products. If these distributors do not commit the necessary resources to effectively market, sell and service our products or if our relationships with these distributors are disrupted, our business and operating results may be harmed.
In North America, the United Kingdom, Germany, Spain, France, Japan and China, we sell our products through our internal sales organization. Outside of these markets, we sell our products through third party distributors. Our sales and marketing success in these other markets depends on these distributors, in particular their sales and service expertise and relationships with the customers in the marketplace. Sales of our aesthetic treatment systems by third party distributors represented 18% of our revenue in 2006, 17% of our revenue in 2005, and 13% of our revenue in 2004. We do not control these distributors, and they may not be successful in marketing our products. Third party distributors may terminate their relationships with us, or fail to commit the necessary resources to market and sell our products to the level of our expectations. Currently, we have written distributor agreements in place with 16 of our 19 third party distributors. The third party distributors
with which we do not have written distributor agreements may terminate their relationships with us and stop selling and servicing our products with little or no notice. If current or future third party distributors do not perform adequately, or if we fail to maintain our existing relationships with these distributors or fail to recruit and retain distributors in particular geographic areas, our revenue from international sales may be adversely affected and our operating results could suffer.
Because we do not require training for users of our products, and sell our products to non-physicians, there exists an increased potential for misuse of our products, which could harm our reputation and our business.
Federal regulations allow us to sell our products to or on the order of practitioners licensed by law to use or order the use of a prescription device. The definition of “licensed practitioners” varies from state to state. As a result, our products may be purchased or operated by physicians with varying levels of training and, in many states, by non-physicians, including nurse practitioners, chiropractors and technicians. Outside the United States, many jurisdictions do not require specific qualifications or training for purchasers or operators of our products. We do not supervise the procedures performed with our products, nor do we require that direct medical supervision occur. We and our distributors offer product training sessions, but neither we nor our distributors require purchasers or operators of our products to attend training sessions. The lack of required training and the purchase and use of our products by non-physicians may result in product misuse and adverse treatment outcomes, which could harm our reputation and expose us to costly product liability litigation.
Product liability suits could be brought against us due to a defective design, material or workmanship or due to misuse of our products. These lawsuits could be expensive and time consuming and result in substantial damages to us and increases in our insurance rates.
If our products are defectively designed, manufactured or labeled, contain defective components or are misused, we may become subject to substantial and costly litigation by our customers or their patients or clients. Misusing our products or failing to adhere to operating guidelines for our products can cause severe burns or other damage to the eyes, skin or other tissue. We are routinely involved in claims related to the use of our products. Product liability claims could divert management’s attention from our core business, be expensive to defend and result in sizable damage awards against us. Our current insurance coverage may not be sufficient to cover these claims. Moreover, in the future, we may not be able to obtain insurance in amount or scope sufficient to provide us with adequate coverage against potential liabilities. Any product liability claims brought against us, with or without merit, could increase our product liability insurance rates or prevent us from securing continuing coverage, could harm our reputation in the industry and reduce product sales. We would need to pay any product losses in excess of our insurance coverage out of cash reserves, harming our financial condition and adversely affecting our operating results.
We may incur substantial expenses if our past practices are shown to have violated the Telephone Consumer Protection Act.
We previously used facsimiles to disseminate information about our clinical workshops to large numbers of customers and potential customers. These facsimiles were transmitted by third parties retained by us, and were sent to recipients whose facsimile numbers were supplied by us as well as other recipients whose facsimile numbers we purchased from other sources. In May 2005, we stopped sending unsolicited facsimiles to customers and potential customers.
Under the federal Telephone Consumer Protection Act, or TCPA, recipients of unsolicited facsimile “advertisements” are entitled to damages of up to $500 per facsimile for inadvertent violations and up to $1,500 per facsimile for knowing or willful violations. Recipients of unsolicited facsimile advertisements may seek enforcement of the TCPA in state courts. The TCPA also permits states to initiate a civil action in a federal district court to enforce the TCPA against a party who engages in a pattern or practice of violations of the TCPA. In addition, complaints may be filed with the Federal Communications Commission, which has the power to assess penalties against parties for violations of the TCPA.
In May 2005, we were sued in Massachusetts state court by Dr. Ari Weitzner, individually and as putative representative of a purported class under the TCPA. The lawsuit alleges that we violated the TCPA by sending unsolicited advertisements by facsimile. Although we are continuing to investigate the number of facsimiles transmitted during the period for which the plaintiff in the lawsuit seeks class certification, and the number of these facsimiles that were “unsolicited” within the meaning of the TCPA, we expect the number of unsolicited facsimiles to be very large.
We are vigorously defending the Weitzner lawsuit, but litigation is subject to numerous uncertainties and we are unable to predict the ultimate outcome of this matter. Even if we prevail in this lawsuit, other individual or class action claims may be brought against us alleging past violations of the TCPA. Moreover, the amount of any potential liability in connection with this lawsuit or other possible lawsuits will depend, to a large extent, on whether a class in a class action lawsuit is certified and, if one is certified, on the scope of the class, neither of which we can predict at this time.
We have not recorded a liability related to this lawsuit or other possible future lawsuits. However, we may determine in the future that an accrual is required, and we may be required to pay damages in respect of this lawsuit or other possible future lawsuits arising out of our past transmission of facsimiles, any of which could materially and adversely affect our results of operations, cash flows and financial condition. Regardless of the outcome, this lawsuit or other possible future lawsuits may cause us to incur significant expenses and divert the attention of our management and key personnel from our business operations.
We have tendered a claim with respect to the Weitzner lawsuit to our general liability insurance carrier and coverage has been disputed. Although the carrier has previously provided coverage for several small individual claims brought against us under the TCPA, the carrier has denied coverage for this claim. Even if coverage is determined to apply, since the potential liability under this claim and other possible future claims could be substantial, our coverage may not be sufficient to satisfy any damages that we may be required to pay.
Our financial results may fluctuate from quarter to quarter, which makes our results difficult to predict and could cause our results to fall short of expectations.
Our financial results may fluctuate as a result of a number of factors, many of which are outside of our control. For these reasons, comparing our financial results on a period-to-period basis may not be meaningful, and you should not rely on our past results as an indication of our future performance. Our future quarterly and annual expenses as a percentage of our revenues may be significantly different from those we have recorded in the past or which we expect for the future. Our financial results in some quarters may fall below our expectations or the expectations of market analysts or investors. Any of these events could cause our stock price to fall. Each of the risk factors listed in this “Risk Factors” section, and the following factors, may adversely affect our financial results:
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continued availability of attractive equipment leasing terms for our customers, which may be negatively influenced by interest rate increases;
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increases in the length of our sales cycle; and
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reductions in the efficiency of our manufacturing processes.
If there is not sufficient demand for the procedures performed with our products, practitioner demand for our products could decline, which would adversely affect our operating results.
Most procedures performed using our aesthetic treatment systems are elective procedures that are not reimbursable through government or private health insurance. The cost of these elective procedures must be borne by the patient. As a result, the decision to undergo a procedure that utilizes our products may be influenced by a number of factors, including:
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patient awareness of procedures and treatments;
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the cost, safety and effectiveness of the procedure and of alternative treatments;
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the success of our and our customers’ sales and marketing efforts to purchasers of these procedures; and
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consumer confidence, which may be affected by economic and other conditions.
If there is not sufficient demand for the procedures performed with our products, practitioner demand for our products would be reduced, which would adversely affect our operating results.
Our business and operations are experiencing rapid growth. If we fail to effectively manage our growth, our business and operating results could be harmed.
We have experienced significant growth in the scope of our operations and the number of our employees. For example, our revenue increased from $27.1 million in 2003 to $78.4 million in 2006, and the number of our employees increased from 138 at the beginning of 2003 to 213 as of December 31, 2006. This growth has placed significant demands on our management, as well as our financial and operational resources. If we do not effectively manage our growth, the efficiency of our operations and the quality of our products could suffer, which could adversely affect our business and operating results. To effectively manage this growth, we will need to continue to:
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implement appropriate operational, financial and management controls, systems and procedures;
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expand our manufacturing capacity and scale of production;
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expand our sales, marketing and distribution infrastructure and capabilities; and
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provide adequate training and supervision to maintain high quality standards.
We may be unable to attract and retain management and other personnel we need to succeed.
Our success depends on the services of our senior management and other key research and development, manufacturing, sales and marketing employees. The loss of the services of one or more of these employees could have a material adverse effect on our business. We consider retaining Michael R. Davin, our president and chief executive officer, to be key to our efforts to develop, sell and market our products and remain competitive. We have entered into an employment agreement with Mr. Davin; however, the employment agreement is terminable by him on short notice and may not ensure his continued service with our company. Our future success will depend in large part upon our ability to attract, retain and motivate highly skilled employees. We cannot be certain that we will be able to do so.
Any acquisitions that we make could disrupt our business and harm our financial condition.
From time to time, we evaluate potential strategic acquisitions of complementary businesses, products or technologies, as well as consider joint ventures and other collaborative projects. We may not be able to identify appropriate acquisition candidates or strategic partners, or successfully negotiate, finance or integrate any businesses, products or technologies that we acquire. We do not have any experience with acquiring companies or products. Any acquisition we pursue could diminish our cash available to us for other uses or be dilutive to our stockholders, and could divert management’s time and resources from our core operations.
El.En. has substantial control over us. In addition, El.En. and our executive officers and directors have the ability to control all matters submitted to stockholders for approval.
In addition to the factors discussed above regarding El.En.’s ability to control the election of a majority of the members of our board of directors, El.En. and our executive officers and directors, in the aggregate, beneficially own approximately 35% of our outstanding common stock. As a result, if these stockholders were to act together, they would be able to control all matters submitted to our stockholders for approval. For example, these persons could control any amendment of our certificate of incorporation and bylaws and approval of any merger, consolidation or sale of all or substantially all of our assets. This concentration of voting power could delay or prevent an acquisition of our company on terms that other stockholders may
desire. Please also see the discussion under “Risks Related to Our Relationship with El.En. - El.En. has substantial control over us and could delay or prevent a change of control.”
Provisions in our corporate charter documents and under Delaware law may delay or prevent attempts by our stockholders to change our management and hinder efforts to acquire a controlling interest in us.
Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger, acquisition or other change in control that stockholders may consider favorable, including transactions in which you might otherwise receive a premium for your shares. These provisions may also prevent or frustrate attempts by our stockholders to replace or remove our management. These provisions include:
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a dual class capital structure that allows El.En. to control the election of a majority of the members of our board of directors;
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the classification of the members of our directors who are elected by holders of our class A common stock and class B common stock, voting together as a single class;
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limitations on the removal of directors who are elected by holders of our class A common stock and class B common stock, voting together as a single class;
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advance notice requirements for stockholder proposals and nominations;
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the inability of class A stockholders to act by written consent or to call special meetings; and
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the ability of our board of directors to designate the terms of and issue new series of preferred stock without stockholder approval, which could be used to institute a “poison pill” that would work to dilute the stock ownership of a potential hostile acquirer, effectively preventing acquisitions that have not been approved by our board of directors.
The affirmative vote of the holders of at least 75% of our shares of capital stock entitled to vote is necessary to amend or repeal the above provisions of our certificate of incorporation, and the right of the holders of shares of our class B common stock to elect a majority of the members of our board of directors may not be modified without the approval of the holders of at least a majority of the shares of our class B common stock outstanding. In addition, absent approval of our board of directors, our bylaws may only be amended or repealed by the affirmative vote of the holders of at least 75% of the voting power of our shares of capital stock entitled to vote and the affirmative vote of holders of at least a majority of the shares of class B common stock outstanding.
In addition, Section 203 of the Delaware General Corporation Law prohibits a publicly held Delaware corporation from engaging in a business combination with an interested stockholder, generally a person which together with its affiliates owns or within the last three years has owned 15% of our voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. Accordingly, Section 203 may discourage, delay or prevent a change in control of our company.
Our stock price may be volatile.
Our class A common stock price may be volatile. The stock market in general has experienced extreme volatility that has often been unrelated to the operating performance of particular companies. The market price for our class A common stock may be influenced by many factors, including:
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the success of competitive products or technologies;
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regulatory developments in the United States and foreign countries;
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developments or disputes concerning patents or other proprietary rights;
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the recruitment or departure of key personnel;
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variations in our financial results or those of companies that are perceived to be similar to us;
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market conditions in the our industry and issuance of new or changed securities analysts’ reports or recommendations; and
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general economic, industry and market conditions.
A significant portion of our total outstanding shares are restricted from immediate resale but may be sold into the market in the near future. This could cause the market price of our class A common stock to drop significantly, even if our business is doing well.
Sales of a substantial number of shares of our class A common stock, including shares of our class B common stock that have been converted into shares of our class A common stock, in the public market could occur at any time. These sales, or the perception in the market that the holders of a large number of shares intend to sell shares, could reduce the market price of our class A common stock. We also intend to register all shares of our class A common stock that we may issue under our employee benefit plans.
Risks Related to Our Relationship with El.En.
El.En. has substantial control over us and could delay or prevent a change of control.
El.En., our largest stockholder, is able to control the election of a majority of the members of our board of directors. El.En. owns 95% of our outstanding class B common stock, which comprises 35% of our aggregate outstanding common. Until El.En. beneficially owns less than 20% of the aggregate number of shares of our class A common stock and class B common stock outstanding or less than 50% of the number of shares of our class B common stock outstanding, El.En., as holder of a majority of the shares of our class B common stock, will have the right:
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to elect a majority of the members of our board of directors;
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to approve amendments to our bylaws adopted by our class A and class B stockholders, voting as a single class; and
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to approve amendments to any provisions of our restated certificate of incorporation relating to the rights of holders of common stock, the powers, election and classification of the board of directors, corporate opportunities and the rights of holders of class A common stock and class B common stock to elect and remove directors, act by written consent and call special meetings of stockholders.
In addition, the holders of shares of our class B common stock will vote with our class A stockholders for the election of the remaining directors.
Because El.En. is the holder of a majority of the shares of our class B common stock, El.En.’s approval will be required for any of the actions described above. In addition, because El.En. will be able to control the election of a majority of our board, and because of its substantial holdings of our capital stock, El.En. will likely have the ability to delay or prevent a change of control of our company that may be favored by other directors or stockholders and otherwise exercise substantial control over all corporate actions requiring board or stockholder approval.
El.En. and its subsidiaries market and sell products that compete with our products, and any competition by El.En. could have a material adverse effect on our business.
El.En. is a leading laser manufacturer in Europe and a leading light-based medical device manufacturer worldwide. El.En. and its subsidiaries develop and produce laser systems with scientific, industrial, commercial and medical applications. Although we have exclusive North American distribution rights for our PhotoLight, PhotoSilk Plus, TriActive LaserDermology and Smartlipo products, El.En. may compete with us in North America with its other products. In the event that our distribution agreements with El.En. terminate, El.En. may compete with us in North America with these products. El.En. markets, sells, promotes and licenses products that compete with our products outside of North America. El.En. has significantly greater financial, technical and human resources than we have and is better equipped to research, develop, manufacture and
commercialize products. In addition, El.En. has more extensive experience in light-based technologies. Our business could be materially and adversely affected by competition from El.En.
Conflicts of interest may arise between us and El.En., and these conflicts might ultimately be resolved in a manner unfavorable to us.
For financial reporting purposes, our financial results are included in El.En.’s consolidated financial statements. One of our directors, Andrea Cangioli, and the spouse of one of our directors, Leonardo Masotti, are also officers or directors of El.En. These two directors own or have an interest in substantial amounts of El.En. stock. Ownership interests of our directors in El.En. stock, or service as a director of our company while at the same time serving as, or being the spouse of, a director or officer of El.En., could give rise to conflicts of interest when a director or officer is faced with a decision that could have different implications for the two companies.
Conflicts may arise with respect to possible future distribution and research and development arrangements with El.En. or another El.En. affiliated company in which the terms and conditions of the arrangements are subject to negotiation between us and El.En. or such other El.En. affiliated company. These potential conflicts could also arise, for example, over matters such as:
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the nature, timing, marketing, distribution and price of our products and El.En.’s products that compete with each other;
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intellectual property matters; and
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business opportunities that may be attractive to both El.En. and us.
In order to address potential conflicts of interest between us and El.En., our restated certificate of incorporation contains provisions regulating and defining the conduct of our affairs as they may involve El.En. and El.En. affiliated companies and El.En.’s officers and directors who serve as our directors. These provisions recognize that we and El.En. and El.En. affiliated companies engage and may continue to engage in the same or similar business activities and lines of business and will continue to have contractual and business relations with each other. These provisions expressly permit El.En. and its affiliated companies to compete against us and narrowly limit corporate opportunities that El.En. or its directors or officers who serve as our directors must make available to us.
Our class A share price may decline because of future sales of our shares by El.En.
El.En. may sell all or part of the shares of our class B common stock that it owns, at which time those shares would automatically convert into shares of our class A common stock. El.En. is not subject to any contractual obligation to maintain its ownership position in our shares, except that it has agreed with the lead-managing underwriter of our December 2005 initial public offering, Citigroup Global Markets Inc., that it will not, without Citigroup’s prior consent, sell or otherwise dispose of any shares of our common stock until December 9, 2007, other than:
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up to 33% of the shares of our common stock that it beneficially owned on December 8, 2005, the date of the prospectus relating to our initial public offering, until June 9, 2007; and
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up to an additional 33% of the shares of our common stock that it beneficially owned on December 8, 2005 during the period between June 9, 2007 and December 9, 2007.
Consequently, El.En. may not maintain its ownership of our common stock. Sales by El.En. of substantial amounts of our common stock in the public market could adversely affect prevailing market prices for our class A common stock.
If El.En. sells the shares of our stock held by it and no longer has control over us, our commercial relationship with El.En. may be adversely affected.
El.En. has advised us that it currently does not intend to sell its shares of our common stock in the foreseeable future. However, El.En.’s plans and intentions may change at any time and, other than El.En.’s agreement with the underwriters discussed above not to sell more than specified amounts of shares of our common stock before December 9, 2007, El.En. is not subject to any contractual obligation to maintain an ownership position in our shares.
If El.En. sells our shares and no longer has control over us, El.En. will cease to include our financial results in its consolidated financial statements, and El.En.’s interests may differ significantly from ours. If this occurs, our commercial relationship with El.En., from which we derived 6% of our revenues in 2006 and 7% of our revenues in 2005, may be adversely affected, which, in turn, could have a material adverse effect on our business. For example, if El.En. does not have a continuing interest in our financial success, it may be more inclined to compete with us in North America and in other markets, not to enter into future commercial agreements with us or to terminate or not renew our existing distribution agreements. If any of these events were to occur, it could harm our business.
Risks Related to Intellectual Property
If we infringe or are alleged to infringe intellectual property rights of third parties, our business could be adversely affected.
Our products may infringe or be claimed to infringe patents or patent applications under which we do not hold licenses or other rights. Third parties may own or control these patents and patent applications in the United States and abroad. These third parties could bring claims against us that would cause us to incur substantial expenses and, if successfully asserted against us, could cause us to pay substantial damages. Further, if a patent infringement suit were brought against us, we could be forced to stop or delay manufacturing or sales of the product that is the subject of the suit.
As a result of patent infringement claims, or in order to avoid potential claims, we may choose or be required to seek a license from the third party and be required to pay license fees or royalties or both. These licenses may not be available on acceptable terms, or at all. Even if we were able to obtain a license, the rights may be nonexclusive, which could result in our competitors gaining access to the same intellectual property. Ultimately, we could be forced to cease some aspect of our business operations if, as a result of actual or threatened patent infringement claims, we are unable to enter into licenses on acceptable terms. This could harm our business significantly.
There has been substantial litigation and other proceedings regarding patent and other intellectual property rights in our industry. In addition to infringement claims against us, we may become a party to other types of patent litigation and other proceedings, including interference proceedings declared by the United States Patent and Trademark Office and opposition proceedings in the European Patent Office, regarding intellectual property rights with respect to our products and technology. The cost to us of any patent litigation or other proceeding, even if resolved in our favor, could be substantial. Some of our competitors may be able to sustain the costs of such litigation or proceedings more effectively than we can because of their greater financial resources. Uncertainties resulting from the initiation and continuation of patent litigation or other proceedings could have a material adverse effect on our ability to compete in the marketplace. Patent litigation and other proceedings may also absorb significant management time.
If we are unable to obtain or maintain intellectual property rights relating to our technology and products, the commercial value of our technology and products will be adversely affected and our competitive position could be harmed.
Our success and ability to compete depends in part upon our ability to obtain protection in the United States and other countries for our products by establishing and maintaining intellectual property rights relating to or incorporated into our technology and products. We own a variety of patents and patent
applications in the United States and corresponding patents and patent applications in many foreign jurisdictions. To date, however, our patent estate has not stopped other companies from competing against us, and we do not know how successful we would be should we choose to assert our patents against suspected infringers. Our pending and future patent applications may not issue as patents or, if issued, may not issue in a form that will be advantageous to us. Even if issued, patents may be challenged, narrowed, invalidated or circumvented, which could limit our ability to stop competitors from marketing similar products or limit the length of term of patent protection we may have for our products. Changes in either patent laws or in interpretations of patent laws in the United States and other countries may diminish the value of our intellectual property or narrow the scope of our patent protection.
If we are unable to protect the confidentiality of our proprietary information and know-how, the value of our technology and products could be adversely affected.
In addition to patented technology, we rely upon unpatented proprietary technology, processes and know-how, particularly with respect to our Alexandrite and pulse dye lasers. We generally seek to protect this information in part by confidentiality agreements with our employees, consultants and third parties. These agreements may be breached, and we may not have adequate remedies for any such breach. In addition, our trade secrets may otherwise become known or be independently developed by competitors.
Risks Related to Government Regulation
If we fail to obtain and maintain necessary U.S. Food and Drug Administration clearances for our products and indications or if clearances for future products and indications are delayed or not issued, our business would be harmed.
Our products are classified as medical devices and are subject to extensive regulation in the United States by the Food and Drug Administration, or FDA, and other federal, state and local authorities. These regulations relate to manufacturing, labeling, sale, promotion, distribution, importing and exporting and shipping of our products. In the United States, before we can market a new medical device, or a new use of, or claim for, an existing product, we must first receive either 510(k) clearance or premarket approval from the FDA, unless an exemption applies. Both of these processes can be expensive and lengthy and entail significant user fees, unless exempt. The FDA’s 510(k) clearance process usually takes from three to 12 months, but it can last longer. The process of obtaining premarket approval is much more costly and uncertain than the 510(k) clearance process. It generally takes from one to three years, or even longer, from the time the premarket approval application is submitted to the FDA until an approval is obtained.
In order to obtain premarket approval and, in some cases, a 510(k) clearance, a product sponsor must conduct well controlled clinical trials designed to test the safety and effectiveness of the product. Conducting clinical trials generally entails a long, expensive and uncertain process that is subject to delays and failure at any stage. The data obtained from clinical trials may be inadequate to support approval or clearance of a submission. In addition, the occurrence of unexpected findings in connection with clinical trials may prevent or delay obtaining approval or clearance. If we conduct clinical trials, they may be delayed or halted, or be inadequate to support approval or clearance, for numerous reasons, including:
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FDA, other regulatory authorities or an institutional review board may place a clinical trial on hold;
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patients may not enroll in clinical trials, or patient follow-up may not occur, at the rate we expect;
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patients may not comply with trial protocols;
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institutional review boards and third party clinical investigators may delay or reject our trial protocol;
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third party clinical investigators may decline to participate in a trial or may not perform a trial on our anticipated schedule or consistent with the clinical trial protocol, good clinical practices, or other FDA requirements;
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third party organizations may not perform data collection and analysis in a timely or accurate manner;
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regulatory inspections of our clinical trials or manufacturing facilities may, among other things, require us to undertake corrective action or suspend or terminate our clinical trials, or invalidate our clinical trials;
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changes in governmental regulations or administrative actions; and
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the interim or final results of the clinical trials may be inconclusive or unfavorable as to safety or effectiveness.
Medical devices may be marketed only for the indications for which they are approved or cleared. The FDA may not approve or clear indications that are necessary or desirable for successful commercialization. Indeed, the FDA may refuse our requests for 510(k) clearance or premarket approval of new products, new intended uses or modifications to existing products. Our clearances can be revoked if safety or effectiveness problems develop.
After clearance or approval of our products, we are subject to continuing regulation by the FDA, and if we fail to comply with FDA regulations, our business could suffer.
Even after clearance or approval of a product, we are subject to continuing regulation by the FDA, including the requirements that our facility be registered and our devices listed with the agency. We are subject to Medical Device Reporting regulations, which require us to report to the FDA if our products may have caused or contributed to a death or serious injury or malfunction in a way that would likely cause or contribute to a death or serious injury if the malfunction were to recur. We must report corrections and removals to the FDA where the correction or removal was initiated to reduce a risk to health posed by the device or to remedy a violation of the Federal Food, Drug, and Cosmetic Act caused by the device that may present a risk to health, and maintain records of other corrections or removals. The FDA closely regulates promotion and advertising and our promotional and advertising activities could come under scrutiny. Since 1994, we have received five untitled letters from the FDA regarding alleged violations caused by our promotional activities. We have responded to these letters and the FDA has found our responses acceptable. If the FDA objects to our promotional and advertising activities or finds that we failed to submit reports under the Medical Device Reporting regulations, for example, the FDA may allege our activities resulted in violations.
The FDA and state authorities have broad enforcement powers. Our failure to comply with applicable regulatory requirements could result in enforcement action by the FDA or state agencies, which may include any of the following sanctions:
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untitled letters, warning letters, fines, injunctions, consent decrees and civil penalties;
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repair, replacement, refunds, recall or seizure of our products;
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operating restrictions or partial suspension or total shutdown of production;
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refusing or delaying our requests for 510(k) clearance or premarket approval of new products or new intended uses;
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withdrawing 510(k) clearance or premarket approvals that have already been granted; and
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criminal prosecution.
If any of these events were to occur, they could harm our business.
Federal regulatory reforms may adversely affect our ability to sell our products profitably.
From time to time, legislation is drafted and introduced in Congress that could significantly change the statutory provisions governing the clearance or approval, manufacture and marketing of a device. In addition, FDA regulations and guidance are often revised or reinterpreted by the agency in ways that may significantly affect our business and our products. It is impossible to predict whether legislative changes will be enacted or FDA regulations, guidance or interpretations changed, and what the impact of such changes, if any, may be.
We have modified some of our products without FDA clearance. The FDA could retroactively determine that the modifications were improper and require us to stop marketing and recall the modified products.
Any modifications to one of our FDA-cleared devices that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new 510(k) clearance or a premarket approval. We may be required to submit extensive pre-clinical and clinical data depending on the nature of the changes. We may not be able to obtain additional 510(k) clearances or premarket approvals for modifications to, or additional indications for, our existing products in a timely fashion, or at all. Delays in obtaining future clearances or approvals would adversely affect our ability to introduce new or enhanced products in a timely manner, which in turn would harm our revenue and operating results. We have made modifications to our devices in the past and may make additional modifications in the future that we believe do not or will not require additional clearances or approvals. If the FDA disagrees, and requires new clearances or approvals for the modifications, we may be required to recall and to stop marketing the modified devices, which could harm our operating results and require us to redesign our products.
If we fail to comply with the FDA’s Quality System Regulation and laser performance standards, our manufacturing operations could be halted, and our business would suffer.
We are currently required to demonstrate and maintain compliance with the FDA’s Quality System Regulation, or QSR. The QSR is a complex regulatory scheme that covers the methods and documentation of the design, testing, control, manufacturing, labeling, quality assurance, packaging, storage and shipping of our products. Because our products involve the use of lasers, our products also are covered by a performance standard for lasers set forth in FDA regulations. The laser performance standard imposes specific record keeping, reporting, product testing and product labeling requirements. These requirements include affixing warning labels to laser products as well as incorporating certain safety features in the design of laser products. The FDA enforces the QSR and laser performance standards through periodic unannounced inspections. We have been, and anticipate in the future being, subject to such inspections. Our failure to comply with the QSR or to take satisfactory corrective action in response to an adverse QSR inspection or our failure to comply with applicable laser performance standards could result in enforcement actions, including a public warning letter, a shutdown of or restrictions on our manufacturing operations, delays in approving or clearing a product, refusal to permit the import or export of our products, a recall or seizure of our products, fines, injunctions, civil or criminal penalties, or other sanctions, such as those described in the preceding paragraphs, any of which could cause our business and operating results to suffer.
If we fail to comply with state laws and regulations, or if state laws or regulations change, our business could suffer.
In addition to FDA regulations, most of our products are also subject to state regulations relating to their sale and use. These regulations are complex and vary from state to state, which complicates monitoring compliance. In addition, these regulations are in many instances in flux. For example, federal regulations allow our prescription products to be sold to or on the order of “licensed practitioners,” that is, practitioners licensed by law to use or order the use of a prescription device. Licensed practitioners are defined on a state-by-state basis. As a result, some states permit non-physicians to purchase and operate our products, while other states do not. Additionally, a state could change its regulations at any time to prohibit sales to particular types of customers. We believe that, to date, we have sold our prescription products only to licensed practitioners. However, our failure to comply with state laws or regulations and changes in state laws or regulations may adversely affect our business.
We or our distributors may be unable to obtain or maintain international regulatory qualifications or approvals for our current or future products and indications, which could harm our business.
Sales of our products outside the United States are subject to foreign regulatory requirements that vary widely from country to country. In many countries, our third party distributors are responsible for obtaining and maintaining regulatory approvals for our products. We do not control our third party distributors, and they
may not be successful in obtaining or maintaining these regulatory approvals. In addition, the FDA regulates exports of medical devices from the United States.
Complying with international regulatory requirements can be an expensive and time consuming process, and approval is not certain. The time required to obtain foreign clearances or approvals may be longer than that required for FDA clearance or approval, and requirements for such clearances or approvals may differ significantly from FDA requirements. Foreign regulatory authorities may not clear or approve our products for the same indications cleared or approved by the FDA. The foreign regulatory approval process may include all of the risks associated with obtaining FDA clearance or approval in addition to other risks. Although we or our distributors have obtained regulatory approvals in the European Union and other countries outside the United States for many of our products, we or our distributors may be unable to maintain regulatory qualifications, clearances or approvals in these countries or obtain qualifications, clearances or approvals in other countries. For example, we are in the process of seeking regulatory approvals from the Japanese Ministry of Health, Labour and Welfare for the direct sale of our products into that country. If we are not successful in doing so, our business will be harmed. We may also incur significant costs in attempting to obtain and in maintaining foreign regulatory clearances, approvals or qualifications.
Foreign regulatory agencies, as well as the FDA, periodically inspect manufacturing facilities both in the United States and abroad. If we experience delays in receiving necessary qualifications, clearances or approvals to market our products outside the United States, or if we fail to receive those qualifications, clearances or approvals, or if we fail to comply with other foreign regulatory requirements, we and our distributors may be unable to market our products or enhancements in international markets effectively, or at all. Additionally, the imposition of new requirements may significantly affect our business and our products. We may not be able to adjust to such new requirements.
New regulations may limit our ability to sell to non-physicians, which could harm our business.
Currently, we sell our products primarily to physicians and, outside the United States, to aestheticians. In addition, we recently began marketing our products to the growing aesthetic spa market, where non-physicians under physician supervision perform aesthetic procedures at dedicated facilities. However, federal, state and international regulations could change at any time, disallowing sales of our products to aestheticians, and limiting the ability of aestheticians and non-physicians to operate our products. Any limitations on our ability to sell our products to non-physicians or on the ability of aestheticians and non-physicians to operate our products could cause our business and operating results to suffer.
Item 1B.
Item 1B.
Unresolved Staff Comments
None.
Item 2.
Item 2.
Properties
In July 2005, we moved our executive offices and our manufacturing, research and development and warehouse operations to a new 55,000 square foot facility that we lease in Westford, Massachusetts. The lease on this facility expires in March 2012. In addition, we lease an aggregate of approximately 5,300 square feet of space at six other locations in Europe and the Asia/Pacific region that we use for sales and service purposes.
Item 3.
Item 3.
Legal Proceedings
In May 2005, Dr. Ari Weitzner, individually and as putative representative of a purported class, filed a complaint against us under the federal Telephone Consumer Protection Act, or TCPA, in Massachusetts Superior Court in Middlesex County seeking monetary damages, injunctive relief, costs and attorneys fees. The complaint alleges that we violated the TCPA by sending unsolicited advertisements by facsimile to the plaintiff and other recipients without the prior express invitation or permission of the recipients. Under the TCPA, recipients of unsolicited facsimile advertisements are entitled to damages of up to $500 per facsimile for inadvertent violations and up to $1,500 per facsimile for knowing or willful violations. Although we are
continuing to investigate the number of facsimiles transmitted during the period for which the plaintiff in the lawsuit seeks class certification and the number of these facsimiles that were “unsolicited” within the meaning of the TCPA, we expect the number of unsolicited facsimiles to be very large. We are vigorously defending the lawsuit and has filed initial briefs and motions with the court. We are not able to estimate the amount or range of loss that could result from an unfavorable outcome of the lawsuit as the matter is still in the early stages of the proceedings.
In December 2005, certain individuals commenced an arbitration against us along with Sona International Inc., Sona Med Spa Inc., Carousel Capital, Inc. and various individuals. The arbitration demand alleges fraud, violations of various state consumer protection laws and other causes of action in connection with the plaintiffs’ acquisition of franchises from the Sona entities. We declined to participate in the arbitration because we had not agreed contractually to do so, and in 2006 we were dismissed from the arbitration by agreement of the parties.
In January 2006, Gentle Laser Solutions, Inc., Liberty Bell Med Spa, Inc. and Kevin T. Campbell filed suit against us and one of our former directors, along with Sona International Inc., Sona Lasers Centers, Inc. and various other individuals, in the Superior Court of New Jersey. The matter was later removed to the U.S. District Court in the District of New Jersey. The suit alleges fraud, breach of contract and other causes of action in connection with the plaintiffs’ acquisition of franchises from the Sona entities. Court ordered conferences scheduled for December 1, 2006 and January 29, 2007 were postponed due to a pending motion to dismiss by Sona. We are not able to estimate the amount or range of loss that could result from an unfavorable outcome of the lawsuit as the matter is still in the early stages of the proceedings.
In June 2006, Baltimore Laser Solutions, Inc. and Kevin T. Campbell, filed suit against us and one of our former directors, along with Sona International Inc., Sona Lasers Centers, Inc. and various other individuals, in the U.S. District Court in the District of Maryland. The suit alleges fraud, breach of contract and other causes of action in connection with the plaintiffs’ acquisition of franchises from the Sona entities. We are not able to estimate the amount or range of loss that could result from an unfavorable outcome of the lawsuit as the matter is still in the early stages of the proceedings.
In September 2006, five groups of plaintiffs, all of whom are former Sona franchisees or franchises, filed suit against us in the U.S. District Court in the District of Minnesota. On January 18, 2007, we received a copy of an amended complaint, adding two groups of plaintiffs. The suit alleges fraud, negligent misrepresentation and other causes of action in connection with our relationship with Sona. On February 13, 2007, we filed a motion to dismiss the amended complaint in its entirety. We are not able to estimate the amount or range of loss that could result from an unfavorable outcome of the lawsuit as the matter is still in the early stages of the proceedings.
In addition to the matters discussed above, from time to time, we are subject to various claims, lawsuits, disputes with third parties, investigations and pending actions involving various allegations against us incident to the operation of its business, principally product liability. Each of these other matters is subject to various uncertainties, and it is possible that some of these other matters may be resolved unfavorably to us. We establish accruals for losses that management deems to be probable and subject to reasonable estimate. We believe that the ultimate outcome of these matters will not have a material adverse impact on our consolidated financial position, results of operations or cash flows.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders.
None.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuers Purchases of Equity Securities
Market Price of and Dividends on Our Common Stock and Related Stockholder Matters.
Our class A common stock began trading on The Nasdaq National Market under the symbol “CYNO” on December 9, 2005. The following table sets forth, for the periods indicated, the high and low sales prices of our class A common stock on The Nasdaq Global Market.
There is no established public trading market for our class B common stock because, under the terms of our restated certificate of incorporation, shares of our class B common stock will convert automatically into class A common stock upon any transfer of such shares, whether or not for value. Additionally, shares of our class B common stock are also convertible into class A common stock upon the occurrence of events specified in our restated certificate of incorporation. Each share of our class B common stock is convertible into one share of class A common stock.
On March 6, 2007, the closing price per share of our class A common stock was $21.66, as reported on The Nasdaq Global Market. The number of record holders of our class A common stock as of March 6, 2007 was 18. The number of record holders of our class B common stock as of March 6, 2007 was 12.
We have never paid or declared any cash dividends on our common stock. We currently intend to retain earnings, if any, to finance the growth and development of our business. Payment of future dividends, if any, will be at the discretion of our board of directors.
On December 13, 2005, we completed an initial public offering of 5,750,000 shares of our class A common stock at a price to the public of $15.00 per share. We sold 4,750,000 shares of the class A common stock, including an over-allotment option of 750,000 shares, and El.En., the selling shareholder in the offering, sold 1,000,000 of the shares. The offer and sale of all of the shares in the initial public offering were registered under the Securities Act of 1933, as amended, pursuant to a registration statement on Form S-1 (File No. 333-127463), which was declared effective by the Securities and Exchange Commission on November 8, 2005. We received aggregate net proceeds of approximately $64.0 million, after deducting underwriting discounts and commission of approximately $5.0 million and expenses of the offering of approximately $2.3 million. None of the underwriting discounts and commissions or offering expenses were incurred or paid to directors or officers of ours or their associates or to persons owning 10 percent or more of our common stock or to any affiliates of ours. From the effective date of the registration statement through December 31, 2006, we used approximately $10.4 million for general corporate purposes, with the remaining $53.6 million in proceeds invested in cash and cash equivalents and marketable securities.
Item 6.
Item 6.
Selected Financial Data
You should read the following selected consolidated financial data in conjunction with our consolidated financial statements and the related notes which are included elsewhere in this Annual Report and the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of this Annual Report. We have derived the consolidated statement of operations data for the years ended December 31, 2006, 2005, and 2004 and the consolidated balance sheet data as of December 31, 2006 and 2005 from our audited consolidated financial statements, which are included elsewhere in this Annual Report. We have derived the consolidated statement of operations data for the years ended December 31, 2003 and 2002 and the consolidated balance sheet data as of December 31, 2004, 2003 and 2002 from our audited consolidated financial statements, which are not included in this Annual Report. Our historical results for any prior period are not necessarily indicative of results to be expected for any future period.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Company Overview
You should read the following discussion and analysis of our financial condition and results of operations together with our financial statements and the related notes and other financial data included elsewhere in this Annual Report. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. You should review Item 1A of this Annual Report for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis.
Company Overview
We develop and market aesthetic treatment systems used by physicians and other practitioners that incorporate laser and light-based energy sources. As of December 31, 2006, we had sold more than 5,900 aesthetic treatment systems worldwide.
We were incorporated in July 1991. In 2002, El.En. S.p.A., an Italian company that itself and through subsidiaries develops and markets laser systems for medical and industrial applications, acquired a majority of our capital stock. In September 2003, we recruited a new management team that has implemented a comprehensive reorganization of our company, including:
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redesigning many of our existing products;
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introducing innovative new products and technologies;
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streamlining and rationalizing our manufacturing processes;
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reorganizing and expanding our research and development, sales and marketing and distribution capabilities; and
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enhancing our customer service network.
Since the beginning of 2004, we have introduced 12 new aesthetic treatment systems, including our five flagship products:
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the Apogee Elite system, our flagship product for hair removal, in March 2004;
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the Cynergy system, our flagship product for the treatment of vascular lesions, in February 2005;
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the TriActive LaserDermology system, our flagship product for the temporary reduction of the appearance of cellulite, in February 2004.
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the Affirm system, our flagship product for anti-aging in April 2006.
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the Smartlipo system, our flagship product for LaserBodySculptingsm and for the removal of unwanted fat, in November 2006.
As a result of our product development efforts, we incurred increased research and development expenses in absolute dollars, although not as a percentage of revenues, during each of 2006 and 2005.
We have expanded our direct sales and marketing organization from 22 employees as of December 31, 2003 to 72 employees as of December 31, 2006. In addition, we have expanded our distribution relationships and had 19 distributors covering 51 countries as of December 31, 2006.
We recently redesigned or introduced a number of our products, including our Apogee, Cynergy, Acclaim and Affirm product families, so that they are built in a modular fashion using fewer components. We began shipping these redesigned products in the second quarter of 2005. We believe that this new approach allows our platform technology to be easily upgradeable, increases the scalability and efficiency of our production process and facilitates improvements in field service diagnosis and repair. We expect that the new modular design of these products will reduce our direct labor and inventory costs and result in lower cost of revenues as a percentage of revenues.
On August 31, 2006, we acquired the remaining 48% minority interest in Suzhou Cynosure Medical Devices Company, Ltd.’s, which we refer to as Suzhou, outstanding common stock for a purchase price of $640,000 in cash. We acquired the minority interest to gain complete control over Suzhou while extending the business license of Suzhou. The purchase of the minority interest was contingent upon Chinese government approval of the shareholder transfer from the seller to us for the shares acquired and approval of extension of the business license of Suzhou for a period of 20 years. The existing business license was set to expire on October 12, 2007. On November 10, 2006, Suzhou received approval from the Chinese government, evidenced by the issuance of a new business license allowing operations in China until October 12, 2027.
The aggregate purchase price of $640,000 was allocated to fair value of the minority interest in Suzhou, valued at approximately $357,000 as of August 31, 2006, with the residual of $283,000 allocated to the business license, which is subject to amortization due to its limited useful life. This acquired intangible asset is included in other assets and is being amortized on a straight-line basis over 20 years, which approximates the expected cash flows resulting from the underlying asset.
In November 2000, we purchased a 20% equity interest, which we subsequently increased to 40%, in Sona MedSpa International, Inc., formerly known as Sona International Corporation, an operator and franchisor of spa franchises. Also in November 2000, we entered into a supply and revenue sharing arrangement with Sona MedSpa pursuant to which we provided our aesthetic treatment systems to Sona MedSpa and its franchisees and received a share of their revenues from procedures using our products. We also guaranteed the lease obligations for two facilities operated by Sona MedSpa. In May 2004, we sold our equity interest in Sona MedSpa to third parties and also sold to Sona MedSpa a portion of the aesthetic treatment systems previously provided by us under the supply and revenue sharing arrangement. We recognized a gain of $3.0 million from the sale of our equity interest and an additional $1.2 million in revenue from the sale of the systems to Sona MedSpa in connection with the transaction. Also in May 2004, we entered into an amended supply and revenue sharing arrangement with Sona MedSpa pursuant to which we continue to sell systems to Sona MedSpa and its franchisees and receive a share of their revenues from procedures using our systems. In October 2005, we entered into a preferred vendor agreement with Sona MedSpa whereby we sold certain of these systems to Sona for approximately $1.3 million which we recorded as deferred revenue in 2005 as the fee was not deemed to be fixed or determinable at the time of sale.
In March 2006, Sona MedSpa notified us that it was uncertain that it had the financial resources to honor its commitments to us and we determined that the collectibility of the fee was not probable and, as a result, reversed the related deferred revenue. We expensed as cost of goods sold approximately $667,000 of inventory delivered under the agreement. Additionally, we provided an allowance for doubtful accounts of $463,000 for accounts receivable associated with services provided prior to the October 2005 preferred vendor agreement. On May 2, 2006, we sent Sona MedSpa a notice of default with respect to Sona MedSpa’s failure to pay Cynosure amounts payable under two agreements between the parties. On June 2, 2006, we terminated the agreement with Sona MedSpa as the defaults under the agreements were not cured.
On November 27, 2006, we settled our arbitration with Sona MedSpa and released the claims against each other in exchange for consideration of $250,000 in cash. The settlement payment we received has been recorded within accrued expenses in the accompanying consolidated balance sheet as of December 31, 2006 as
this payment may be subject to certain avoidance action by a third party and, if successful, could be subject to forfeiture.
Financial Operations Overview
Revenues
We generate revenues primarily from sales of our products and parts and accessories and, to a lesser extent, from services, including product warranty revenues. In 2006, we derived approximately 95% of our revenues from sales of our products and 5% of our revenues from service. In 2005, we derived approximately 92% of our revenues from sales of our products, 6% of our revenues from service and 2% of our revenues from a revenue sharing arrangement with Sona MedSpa, which was terminated during 2006. In 2004, we derived approximately 87% of our revenues from sales of our products, 6% of our revenues from service and 7% of our revenues from a revenue sharing arrangement with Sona MedSpa, which was terminated during 2006. Generally, we recognize revenues from the sales of our products upon delivery to our customers, revenues from service contracts and extended product warranties ratably over the coverage period, revenues from service in the period in which the service occurs and revenues from our revenue sharing arrangement in the period the procedures are performed.
We sell our products directly in North America, four European countries, Japan and China and use distributors to sell our products in other countries where we do not have a direct presence. In 2006, we derived 42% and in 2005 we derived 41% of our product revenues from sales of our products outside North America. As of December 31, 2006, we had 43 sales employees in North America, 9 sales employees in four European countries, Japan and China and distributors in 51 countries. The following table provides revenue data by geographical region for the years ended December 31, 2006, 2005 and 2004:
See Note 6 to our consolidated financial statements included in this Annual Report for revenues and asset data by geographic region.
Cost of Revenues
Our cost of revenues consists primarily of material, labor and manufacturing overhead expenses and includes the cost of components and subassemblies supplied by third party suppliers. Cost of revenues also includes royalties incurred on products sold, service and warranty expenses, as well as salaries and personnel-related expenses, including stock-based compensation, for our operations management team, purchasing and quality control.
Sales and Marketing Expenses
Our sales and marketing expenses consist primarily of salaries, commissions and other personnel-related expenses, including stock-based compensation, for employees engaged in sales, marketing and support of our products, trade show, promotional and public relations expenses and management and administration expenses in support of sales and marketing. We expect our sales and marketing expenses to increase in absolute dollars,
though we do not expect them to increase significantly as a percentage of revenues, as we expand our sales, marketing and distribution capabilities.
Research and Development Expenses
Our research and development expenses consist of salaries and other personnel-related expenses, including stock-based compensation, for employees primarily engaged in research, development and engineering activities and materials used and other overhead expenses incurred in connection with the design and development of our products. We expense all of our research and development costs as incurred. We expect our research and development expenditures to increase in absolute dollars, though we do not expect them to increase significantly as a percentage of revenues, as we continue to devote resources to research and develop new products and technologies.
General and Administrative Expenses
Our general and administrative expenses consist primarily of salaries and other personnel-related expenses, including stock-based compensation, for executive, accounting and administrative personnel, professional fees and other general corporate expenses. We expect our general and administrative expenses to increase in absolute dollars, though we do not expect them to increase significantly as a percentage of revenues.
Interest Income (Expense), net
Interest income consists primarily of interest earned on our marketable securities portfolio consisting mainly of state and municipal bonds, corporate bonds and certificates of deposit. Interest expense consists primarily of interest due on capitalized leases.
Benefit from Income Taxes
As of December 31, 2006, we had state tax credit carryforwards of approximately $209,000 to offset future tax liability, and state net operating loss carryforwards of approximately $561,000 to offset future taxable income. If not utilized, these credit and operating loss carryforwards will expire at various dates through 2019, and the losses will expire through 2026. In addition, the future utilization of our net operating loss carryforwards may be limited based upon changes in ownership pursuant to regulations promulgated under the Internal Revenue Code. We also had foreign net operating loss carryforwards of approximately $2,067,000 available to reduce future foreign taxable income which will expire at various times through 2024. Foreign net operating loss carryforwards include $1,875,000 in Germany and France, which do not expire.
Results of Operations
Year Ended December 31, 2006 and 2005
The following table contains selected statement of operations data, which serves as the basis of the discussion of our results of operations for the years ended December 31, 2006 and 2005:
Revenues
Revenues in the year ended December 31, 2006 exceeded revenues in 2005 by $22.1 million, or 39 %. The increase in revenues was attributable to a number of factors (in thousands, except for percentages):
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Revenues from the sale of products in North America increased $12.0 million, or 43%, to $39.8 million in 2006 as compared to $27.8 million in 2005. The increase was attributable to an increase in the number of product units sold and a higher average selling price due to a favorable change in product
mix. The increase in North American revenues resulted in part from the reorganization and expansion of our North American sales organization, including the hiring of 21 additional direct sales employees between December 31, 2005 and 2006. The increase also resulted from the introduction of new products, particularly our Affirm system at the end of the third quarter of 2006. Revenues from sales of products introduced since 2004 totaled $38.4 million, or 97%, of total North American product revenues in 2006.
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Revenues from sales of products outside of North America increased $10.7 million, or 61%, to $28.4 million in 2006 as compared to $17.7 million in 2005. The increase was mainly attributable to an increase in sales in Europe of $6.6 million, or 62%, over 2005, and an increase in sales in Asia/Pacific of $3.1 million, or 74%, over 2005, resulting from a favorable change in product mix and our increased focus on direct selling, for which we receive higher average selling prices as compared to sales through distributors.
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Revenues from original equipment manufacturer and other relationships and our revenue sharing arrangement decreased $2.6 million, or 69%, to $1.2 million in 2006 as compared to $3.8 million in 2005. The decrease was mainly attributable to approximately $2.5 million of revenue generated during 2005 under a revenue sharing arrangement with Sona MedSpa for which there was no corresponding revenue generated during 2006, as the agreement was terminated in June 2006.
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Revenues from the sale of parts and accessories and services increased $2.1 million, or 30%, to $9.1 million in 2006 as compared to $7.0 million in 2005. The increase was primarily attributable to an increase of approximately $1.3 million in revenues generated from the sale of parts and an increase of approximately $0.7 million in revenues generated from service contracts year over year, both of which are related to the overall increase in volume of sales during the past three years.
Cost of Revenues
Cost of revenues increased $7.1 million, or 27%, to $32.9 million in 2006, as compared to $25.8 million in 2005. The increase in the cost of revenues was primarily attributable to an increase in direct labor, overhead and material costs associated with increased sales of our products and royalties incurred on the sale of hair-removal systems. Included in cost of revenues for 2006 was a write off of $0.7 million related to inventory delivered under our agreement with Sona MedSpa, which was terminated in June 2006, as previously discussed, for which there was no related expense in 2005. Our cost of revenues decreased as a percentage of revenues to 42% in 2006 from 46% in 2005, resulting in an increase in our gross margin of 4% between the two years. The improved margin resulted primarily from higher average selling prices of our products due to a favorable change in product mix, in part as a result of the introduction of our Affirm system at the end of the third quarter of 2006, as well as increased direct sales in North America. We derived all of our North American product revenues from direct sales.
Sales and Marketing
Sales and marketing expenses increased $8.7 million, or 50%, to $26.2 million in 2006, as compared to $17.5 million in 2005. The increase was primarily attributable to an increase of $4.4 million in personnel costs and travel expenses associated with the expansion of our North American direct sales organization, which
includes an increase of $2.1 million in commissions expense, an increase of $0.4 million in non-cash stock-based compensation expense related to the adoption of SFAS No. 123(R), and an increase of $0.5 million in personnel costs and travel expenses associated with our international subsidiaries. Promotional costs increased $1.9 million, primarily due to our increased number of clinical workshops and trade shows, as well as an increase in clinical studies costs and promotional efforts. Consulting and outside services expenses have increased by $1.5 million. As a percentage of revenues, sales and marketing expenses increased to 33% in 2006 from 31% in 2005.
Research and Development
Research and development expenses increased $1.5 million or 46%, to $4.7 million in 2006, as compared to $3.2 million in 2005. In 2006, our research and development expenses were attributable to project research costs and product engineering expenses related to the introduction of our new Affirm system in the third quarter of 2006 and ongoing development of new products. In 2005, our research and development expenses were attributable to project research costs and product engineering expenses related to the introduction of our new Cynergy system in the first quarter of 2005 and ongoing development of new products. The increase is also attributable to an increase of $0.6 million in non-cash stock-based compensation expense related to the adoption of SFAS No. 123(R). As a percentage of revenues, research and development expenses remained relatively flat at 6% in 2006 and 2005.
General and Administrative
General and administrative expenses increased $3.9 million, or 76%, to $9.0 million in 2006 from $5.1 million in 2005. The increase was primarily attributable to costs associated with being a public company, which included a $1.7 million increase in consulting, legal and professional service fees, related to legal, audit and tax service fees, as well as consulting service fees related to the implementation of the internal control compliance and reporting requirements of Section 404 of the Sarbanes-Oxley Act of 2002, and a $0.7 million increase in personnel-related costs. The increase is also attributable to an increase of $0.9 million in stock-based compensation expense related to the adoption of SFAS No. 123(R). Bad debt expense has increased by $0.6 million due to the settlement of arbitration with Sona MedSpa and the write off of certain receivable balances related to the preferred vendor and revenue sharing agreements with this party, which were terminated in June 2006. As a percentage of revenues, general and administrative expenses increased to 11% in 2006 from 9% in 2005.
Royalty Settlement
On November 6, 2006, we entered into a patent cross-license agreement with Palomar Medical Technologies, Inc. Under the cross-license agreement, we obtained a non-exclusive license to integrate into our products certain hair removal technology covered by specified U.S. and foreign patents held by Palomar and Palomar obtained certain specified U.S. and foreign patents held by us. In November 2006, we made a payment to Palomar of $10 million for royalties related to sales prior to October 1, 2006 of hair removal-only systems including our Apogee family of products, PhotoLight, Acclaim 7000 and the PhotoSilk Plus. This was recorded as a royalty settlement within our operating expenses for the year ended December 31, 2006. In
connection with this agreement, we also agreed to pay royalties to Palomar on our sales of certain hair-removal products beginning October 1, 2006. The royalty rate for sales of hair-removal products ranges from 3.75% to 7.5% of net sales, depending upon product configuration and the number of energy sources. Royalty expense associated with such sales is recorded as cost of revenues.
Interest Income (Expense), net; Gain on Sale of Investment and Other Income (Expense), net
Interest income (expense), net increased to $2.6 million in income in 2006 from $89,000 in income in 2005. The increase resulted from interest earned on increased cash balances available for investment due to our initial public offering in December 2005. In 2006, we recorded a gain of $0.1 million on the sale of our equity interest in Solx, Inc. to a public company in exchange for consideration in cash and shares of common stock in the acquiring company. We had no similar gain in 2005. Other income (expense) increased to $0.8 million in income in 2006 from $0.4 million in expense in 2005. The increase was partially attributable to an increase in foreign currency remeasurement gains during 2006, as compared to foreign currency remeasurement losses during 2005.
(Benefit from) Provision for Income Taxes
In 2006, we recorded an income tax benefit of $0.3 million, representing an effective tax rate of 31%. In 2005, we recorded an income tax provision of $0.1 million, representing an effective tax rate of 2%. In 2006, we recorded a benefit related to net operating loss carryforwards generated in 2006, which offsets the provision for current taxable income. In 2005, we reduced the valuation allowance related to certain temporary differences and recorded a deferred tax asset of approximately $1.3 million as realization of these assets became probably in 2005 based on our future projections of our taxable income.
Years Ended December 31, 2005 and 2004
The following table contains selected statement of operations data, which serves as the basis of the discussion of our results of operations for the years ended December 31, 2005 and 2004 (in thousands, except for percentages):
Revenues
Total revenues for the year ended December 31, 2004 included $1.3 million of revenues from related party. There was no revenue from related parties for the year ended December 31, 2005. For purposes of the following discussion, we refer to revenues and revenues from related party on a combined basis. Revenues in 2005 exceeded revenues in 2004 by $14.6 million, or 35%. The increase in revenues was attributable to a number of factors (in thousands, except for percentages):
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Revenues from the sale of products in North America increased $14.5 million, or 108%, to $27.8 million in 2005 as compared to $13.3 million in 2004. The increase was attributable to an increase in the number of products sold and a higher average selling price due to a favorable change in product mix. The increase in North American revenues resulted in part from the reorganization and expansion of our
North American sales organization, including the hiring of 14 additional direct sales employees between December 31, 2004 and 2005. The increase also resulted from the introduction of new products, particularly our Apogee Elite system at the end of the first quarter of 2004. Revenues from sales of products introduced in 2004 totaled $24.5 million, or 88%, of total North American product revenues in 2005.
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Revenues from sales of products outside of North America increased $3.7 million, or 26%, to $17.7 million in 2005 as compared to $14.0 million in 2004. The increase was primarily attributable to an increase in sales in Europe of $2.2 million, or 26%, over 2004, resulting from a favorable change in product mix and our increased focus on direct selling, for which we receive higher average selling prices as compared to sales through distributors, including the opening of our direct sales office in Spain in the second half of 2004.
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Revenues from original equipment manufacturer and other relationships and our revenue sharing arrangement decreased $3.7 million, or 49%, to $3.8 million in 2005 as compared to $7.5 million in 2004. The decrease was mainly attributable to non-recurring revenues of $1.2 million from the purchase of aesthetic treatment systems by Sona MedSpa in May 2004 in connection with the sale of our equity interest in Sona MedSpa, a $1.5 million decrease in our revenue sharing arrangement and a $1.1 million decrease in sales of a product we distributed that was supplied by El.En. in 2004 but that we did not distribute in 2005.
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Revenues from the sale of parts and accessories and services increased $0.2 million, or 3%, to $7.0 million in 2005 as compared to $6.8 million in 2004. The increase was primarily attributable to an increase in revenues generated from service contracts.
Cost of Revenues
Cost of revenues increased $5.4 million, or 26%, to $25.8 million in 2005, as compared to $20.5 million in 2004. The increase in cost of revenues was primarily attributable to an increase in direct labor, overhead and material costs associated with increased sales of our products. Our cost of revenues decreased as a percentage of revenues to 46% in 2005 from 49% in 2004, resulting in an increase in our gross margin of 3% between the two years. The improved margin resulted from higher average selling prices of our products due to a favorable change in product mix, in part as a result of the introduction of our Apogee Elite system in the first quarter of 2004, as well as increased direct sales in North America. We derived all of our North American product revenues from direct sales.
Sales and Marketing
Sales and marketing expenses increased $4.9 million, or 39%, to $17.5 million in 2005, as compared to $12.6 million in 2004. The increase was attributable to an increase of $2.8 million in personnel costs and travel expenses associated with the expansion of our North American direct sales organization, $0.2 million in non-cash stock-based compensation expense and $0.6 million in personnel costs and travel expenses associated with our international subsidiaries. Promotional costs increased $1.1 million, primarily due to our increased number of clinical workshops, trade shows and promotional efforts. As a percentage of revenues, sales and marketing expenses increased to 31% in 2005 from 30% in 2004.
Research and Development
Research and development expenses remained relatively flat at $3.2 million in 2005 and 2004. In 2005, our research and development expenses were attributable to project research costs and product engineering expenses related to the introduction of our new Cynergy system in the first quarter of 2005 and ongoing development of new products. In 2004, our research and development expenses were attributable to project research costs and product engineering expenses related to the introduction of our new Apogee Elite, Apogee 5500 NL and Acclaim 7000 NL products in the first quarter of 2004 and our ongoing development of new products. As a percentage of revenues, research and development expenses decreased to 6% in 2005 from 8% in 2004.
General and Administrative
General and administrative expenses increased $1.0 million, or 24%, to $5.1 million in 2005 as compared to $4.1 million in 2004. The increase was primarily attributable to a $0.4 million increase in our international subsidiaries’ administrative expenses, primarily in connection with our opening an office in Spain in the second half of 2004, as well as a $0.2 million increase in personnel expenses associated with becoming a public company, $0.1 million increase in non-cash stock-based compensation expense and $0.2 million increase in legal expenses associated with patent filing costs. As a percentage of revenues, general and administrative expenses decreased to 9% in 2005 from 10% in 2004.
Interest Income (Expense), net; Gain on Sale of Investment and Other (Expense) Income, net
Interest income (expense), net increased to $89,000 in 2005 from $0.1 million in expense in 2004. The increase resulted from interest income earned on higher cash balances available for investment due to our initial public offering in December 2005. In 2004, we recorded a gain of $3.0 million on the sale of our 40% equity interest in Sona MedSpa. We had no similar gains in 2005. Other (expense) income, net decreased to $0.4 million in expense in 2005 from $1.0 million in income in 2004. The decrease was partially attributable to an increase in foreign currency transaction losses of $0.8 million and to a $0.2 million decrease in our equity interest in Sona MedSpa for 2005, as compared to 2004, as a result of the sale of such interest. The decrease in other (expense) income, net is also attributable to $0.3 million in other income that we realized in 2004 in connection with a settlement with an insurer.
Provision (Benefit) for Income Taxes
In 2005, we recorded an income tax provision of $0.1 million. In 2004, we recorded an income tax benefit of $0.3 million. In 2005, we reduced the valuation allowance related to certain temporary differences and recorded a deferred tax asset of approximately $1.3 million as realization of these assets became probable in 2005 based on our future projections of our taxable income. In the second half of 2004, we received $0.5 million of refund claims, which was recorded as an income tax benefit. In 2004, we utilized all of our available U.S. federal net operating loss carryforwards.
Liquidity and Capital Resources
We require cash to pay our operating expenses, make capital expenditures and pay our long-term liabilities. Since our inception, we have funded our operations through private placements of equity securities, short-term borrowings and funds generated from our operations. In December 2005, we completed our initial public offering of 5,750,000 shares of our class A common stock at a price to the public of $15.00 per share. We sold 5,750,000 shares of our class A common stock, including an over-allotment option of 750,000 shares, and El.En., the selling stockholder in the offering, sold 1,000,000 of the shares. We received aggregate net proceeds of approximately $64.0 million, after deducting underwriting discounts and commission of approximately $5.0 million and expenses of the offering of approximately $2.3 million.
At December 31, 2006, our cash, cash equivalents and marketable securities were $57.2 million as compared to $64.6 million at December 31, 2005. Our cash and cash equivalents of $13.7 million are highly liquid investments with maturity of 90 days or less at date of purchase and consist of time deposits and investments in money market funds with commercial banks and financial institutions. Our marketable securities of $43.5 million consist of investments in various state and municipal governments, certificates of deposit and corporate obligations, all of which mature by July 1, 2008. In November 2006, we paid Palomar $10 million for royalties related to sales prior to October 1, 2006 of hair removal-only systems, as discussed above.
We expect to generate positive cash flows from operations in the future. Our future capital requirements depend on a number of factors, including the rate of market acceptance of our current and future products, the resources we devote to developing and supporting our products and continued progress of our research and development of new products. We expect our capital expenditures over the next 12 months generally to be consistent with our capital expenditures during the prior 12 months.
We believe that our current cash, cash equivalents and marketable securities, as well as cash generated from operations, will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for the foreseeable future.
Cash Flows
Net cash used in operating activities was $4.1 million for the year ended December 31, 2006. This resulted primarily from net loss for the period of $0.7 million, increased by approximately $4.9 million in depreciation and stock-based compensation expense and decreased by approximately $1.1 million in deferred income tax benefits and $0.6 million in accretion of discounts on marketable securities. Net changes in working capital items decreased cash from operating activities by approximately $6.7 million related to an increase in inventory for anticipated future sales and an increase in accounts receivable reflecting the record sales during the fourth quarter of 2006. Net cash used in investing activities was $46.6 million for the year ended December 31, 2006, which consisted primarily of $188.9 million used to purchase marketable securities, offset by $145.9 million in proceeds generated from sales and maturities of securities, $3.2 million used for
fixed asset purchases and $0.6 million used to purchase the remaining minority interest in Suzhou Cynosure Medical Devices, Co. Net cash provided by financing activities during the year ended December 31, 2006 was $0.5 million, principally relating to proceeds from option exercises of $0.5 million, tax benefits related to stock options of $0.4 million and offset by $0.4 million in payments on capital lease obligations.
Net cash used in operating activities was $1.0 million for the year ended December 31, 2005. This resulted primarily from net income for the period of $4.2 million increased by approximately $2.2 million in depreciation and stock-based compensation expense and decreased by approximately $1.9 million in deferred income tax benefits. Net changes in working capital items decreased cash from operating activities by approximately $5.5 million principally related to an increase in inventory for anticipated future sales and in preparation for our transition to modular assembly and contract manufacturing. Net cash used in investing activities was $2.4 million for the year ended December 31, 2005 resulting primarily from $2.8 million used for fixed asset purchases and the payment of a $0.2 million security deposit relating to the lease for our new corporate headquarters offset by the receipt of $0.5 million released from escrow as part of the sale of our investment in Sona MedSpa. Net cash provided by financing activities was $63.6 million for the year ended December 31, 2005 resulting primarily from net proceeds of $64.0 million from our initial public offering offset by repayment of $0.3 million of a note payable to a related party.
Net cash provided by operating activities was $1.3 million for the year ended December 31, 2004. This primarily resulted from net income of $5.3 million increased by $1.3 million of depreciation and amortization, reduced by a $3.0 million gain from the sale of our equity interest in Sona MedSpa and a $2.3 million decrease in working capital primarily attributable to an increase in accounts receivables from increased sales and inventory for anticipated future sales. Net cash provided by investing activities was $0.3 million for the year ended December 31, 2004, resulting primarily from $3.1 million in net proceeds from the sale of our investment in Sona MedSpa, offset in large part by $2.8 million in capital expenditures. Net cash provided in financing activities was $0.1 million for the year ended December 31, 2004 resulting primarily from proceeds of $2.1 million from the sale of common stock and $0.5 million of proceeds from a note payable to El.En., offset by payments of $2.0 million on short-term loans payments of $0.2 million on capital lease obligations.
Contractual Obligations
Our major outstanding contractual obligations relate to our capital leases from equipment financings and our facilities leases. In addition, we guaranteed the lease obligations for two facilities that are operated by Sona MedSpa and will be obligated to pay these leases if Sona MedSpa can not or does not make the required lease payments. We have summarized in the table below our fixed contractual cash obligations as of December 31, 2006.
Off Balance Sheet Arrangements
Since inception, we have not engaged in any off balance sheet financing activities.
Critical Accounting Policies and Estimates
The discussion and analysis of our financial condition and results of operations set forth above are based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our estimates and judgments, including those described below. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances. These estimates and assumptions form the basis for making judgments about the carrying values of assets and liabilities, and the reported amounts of revenues and expenses, that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We believe the following critical accounting policies require significant judgment and estimates by us in the preparation of our financial statements.
Revenue Recognition and Deferred Revenue
In accordance with Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements, we recognize revenue from sales of aesthetic treatment systems and accessories when each of the following four criteria are met:
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delivery has occurred;
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there is persuasive evidence of an agreement;
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the fee is fixed or determinable; and
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collection is reasonably assured.
Revenue from the sale of service contracts is deferred and recognized on a straight-line basis over the contract period as services are provided. We are party to a revenue sharing arrangement with an operator and franchisor of spa franchises and recognize revenue from this arrangement in the period in which the procedures are performed.
We defer, until earned, payments that we receive in advance of product delivery or performance of services. When we enter into arrangements with multiple elements, which may include sales of products together with service contracts and warranties, we allocate revenue among the elements based on each element’s fair value in accordance with the principles of Emerging Issues Task Force Issue Number 00-21, Revenue Arrangements with Multiple Deliverables. This allocation requires us to make estimates of fair value for each element.
Accounts Receivable and Concentration of Credit Risk
Our accounts receivable balance, net of allowance for doubtful accounts, was $19.9 million as of December 31, 2006, compared with $13.6 million as of December 31, 2005. The allowance for doubtful accounts as of December 31, 2006 was $1.0 million and as of December 31, 2005 was $0.7 million. We maintain an allowance for doubtful accounts based upon the aging of our receivable balances, known collectibility issues and our historical experience with losses. While our credit losses have historically been within our expectations and the allowances established, we may not continue to experience the same credit losses that we have in the past, which could cause our provisions for doubtful accounts to increase. We work to mitigate bad debt exposure through our credit evaluation policies, reasonably short payment terms and geographical dispersion of sales. Our revenues include export sales to foreign companies located principally in Europe, the Asia/Pacific region and the Middle East. We obtain letters of credit for foreign sales that we consider to be at risk.
Inventories and Allowance for Obsolescence
We state all inventories at the lower of cost or market value, determined on a first-in, first-out method. We monitor standard costs on a monthly basis and update them annually and as necessary to reflect changes in raw material costs and labor and overhead rates. Our inventory balance was $17.6 million as of December 31, 2006 compared to $14.1 million as of December 31, 2005. Our inventory allowance as of December 31, 2006 and 2005 was $1.0 million. We provide inventory allowances when conditions indicate that the selling price could be less than cost due to physical deterioration, usage, obsolescence, reductions in estimated future demand and reductions in selling prices. We balance the need to maintain strategic inventory levels with the risk of obsolescence due to changing technology and customer demand levels. Unfavorable changes in market conditions may result in a need for additional inventory reserves that could adversely impact our gross margins. Conversely, favorable changes in demand could result in higher gross margins when we sell products.
Product Warranty Costs and Provisions
We provide a one-year parts and labor warranty on end-user sales of our aesthetic treatment systems. Distributor sales generally include a warranty on parts only. We estimate and provide for future costs for initial product warranties at the time revenue is recognized. We base product warranty costs on related material costs, technical support labor costs and overhead. We provide for the estimated cost of product warranties by considering historical material, labor and overhead expenses and applying the experience rates to the outstanding warranty period for products sold. As we sell new products to our customers, we must exercise considerable judgment in estimating the expected failure rates and warranty costs. If actual product failure rates, material usage, service delivery costs or overhead costs differ from our estimates, we would be required to revise our estimated warranty liability.
Stock-Based Compensation
Prior to January 1, 2006, we accounted for stock-based awards under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations, as permitted by Financial Accounting Standards Board Statement No. 123, Accounting for Stock-Based Compensation, or SFAS 123. Effective January 1, 2006, we adopted the fair value recognition provisions of FASB Statement No. 123(R), Share-Based Payment, or SFAS 123(R), using the modified-prospective-transition method. The modified-prospective-transition method is one in which compensation cost is recognized beginning with the effective date (1) for all share-based payments granted after the effective date and (2) for all awards granted to employees prior to the effective date of SFAS 123(R) that remain unvested on the effective date. In addition, SFAS 123(R) requires companies to utilize an estimated forfeiture rate when calculating the expense for the period, whereas, SFAS 123 permitted companies to record forfeitures based on actual forfeitures, which was our historical policy under SFAS 123. As a result, we have applied an estimated annual forfeiture rate of 1.0% in determining the expense recorded in the consolidated statements of income.
Effective with the adoption of SFAS 123(R), we have elected to use the Black-Scholes option pricing model to determine the weighted average fair value of options, rather than a binomial model. The weighted-average fair values of the options granted during the year ended December 31, 2006 were $11.52 using the following assumptions:
Option-pricing models require the input of various subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. Due to our initial public offering in December 2005, we believe there is not adequate information on the volatility of our own shares. As such, we estimated expected
stock price volatility is based on an average of the volatility of other similar companies in the same industry. We believe this is more reflective and a better indicator of the expected future volatility, than using an average of a comparable market index or of a comparable company in the same industry. Our expected term of options granted in the year ended December 31, 2006 was derived from the short-cut method described in SEC’s Staff Accounting Bulletin No. 107. The risk-free rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend yield of zero is based on the fact that we have never paid cash dividends and have no present intention to pay cash dividends.
SFAS 123(R) is a new and very complex accounting standard, the application of which requires significant judgment and the use of estimates, particularly surrounding Black-Scholes assumptions such as stock price volatility, expected option lives, and expected option forfeiture rates, to value equity-based compensation. There is little experience or guidance available with respect to developing these assumptions and models. In addition, given our initial public offering in December 2005, we have a very limited data in terms of historical forfeiture rates, volatilities and expected terms as a public company and, as such, we are developing our estimates for our volatilities and expected terms based on guideline companies within our industry. If actual forfeiture rates, volatilities and expected terms differ from our estimates, we would be required to revise our estimated stock-based compensation expense in future periods.
We account for transactions in which services are received from non-employees in exchange for equity instruments based on the fair value of such services received or of the equity instruments issued, whichever is more reliably measured, in accordance with SFAS No. 123 and the Emerging Issues Task Force Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, or EITF Issue No. 96-18.
Income Taxes
We account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. Under this method, we determine deferred tax assets and liabilities based upon the differences between the financial statement carrying amounts and the tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. The tax consequences of most events recognized in the current year’s financial statements are included in determining income taxes currently payable. However, because tax laws and financial accounting standards differ in their recognition and measurement of assets, liabilities, equity, revenues, expenses, gains and losses, differences arise between the amount of taxable income and pretax financial income for a year and between the tax bases of assets or liabilities and their reported amounts in the financial statements. Because we assume that the reported amounts of assets and liabilities will be recovered and settled, respectively, a difference between the tax basis of an asset or a liability and its reported amount in the balance sheet will result in a taxable or a deductible amount in some future years when the related liabilities are settled or the reported amounts of the assets are recovered, giving rise to a deferred tax asset. We then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we establish a valuation allowance. We consider the undistributed earnings of our foreign subsidiaries to be indefinitely reinvested and, as such, we do not provide U.S. income tax on such undistributed earnings.
Recent Accounting Pronouncements
In June 2006, the Financial Accounting Standards Board issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of SFAS 109, Accounting for Income Taxes, or FIN 48, to create a single model to address accounting for uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes, by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We will adopt FIN 48 as of January 1, 2007, as required. Based on our evaluation as of December 31, 2006, we do not believe that FIN 48 will have a material impact on our financial position or results of operations.
In September 2006, the FASB issued Statement No. 157, Fair Value Measurements, or SFAS 157. SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. This Statement does not require any new fair value measurements; rather, it applies under other accounting pronouncements that require or permit fair value measurements. The provisions of this Statement are to be applied prospectively as of January 1, 2008, with any transition adjustment recognized as a cumulative-effect adjustment to the opening balance of retained earnings. We do not expect that the adoption of SFAS 157 will have a material impact on our financial position or results of operations.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
The following discussion about our market risk disclosures involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. We are exposed to market risk related to changes in interest rates and foreign currency exchange rates. We do not use derivative financial instruments.
Interest Rate Sensitivity. We maintain an investment portfolio consisting mainly of state and municipal government obligations, corporate obligations and certificates of deposit. Each security matures by July 1, 2008. These available-for-sale securities are subject to interest rate risk and will fall in value if market interest rates increase. We have the ability to hold our fixed income investments until maturity (excluding acquisitions or mergers). Therefore, we do not expect our operating results or cash flows to be affected to any significant degree by any sudden change in market interest rates on our securities portfolio. The following table provides information about our investment portfolio. For investment securities, the table presents principal cash flows (in thousands) and weighted average interest rates by expected maturity dates.
Foreign Currency Exchange. A significant portion of our operations is conducted through operations in countries other than the United States. Revenues from our international operations that were recorded in U.S. dollars represented approximately 48% of our total international revenues during the year ended December 31, 2006. Substantially all of the remainder of our revenues was from sales in euros, British pounds and Japanese yen. Since we conduct our business in U.S. dollars, our main exposure, if any, results from changes in the exchange rate between these currencies and the U.S. dollar. Our functional currency is the U.S. dollar. Our policy is to reduce exposure to exchange rate fluctuations by having most of our assets and liabilities, as well as most of our revenues and expenditures, in U.S. dollars, or U.S. dollar linked. Therefore, we believe that the potential loss that would result from an increase or decrease in the exchange rate is immaterial to our business and net assets.
Item 8.
Item 8.
Financial Statements and Supplementary Data
Refer to page.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2006. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a
company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of December 31, 2006, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.
Changes in Internal Control over Financial Reporting
No change in our internal control over financial reporting occurred during the fiscal quarter ended December 31, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Management’s Annual Report on Internal Control over Financial Reporting
Management is responsible for establishing and maintaining adequate control over financial reporting as defined in Rule 13(a)-15(f) and 15(d)-15(f) under the Securities and Exchange Act of 1934. Internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. Internal control over financial reporting includes those policies and procedures that: 1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; 2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and 3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, a system of internal control over financial reporting can provide only reasonable assurance and may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2006. In making its assessment, management used the criteria set forth in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission. A “material weakness” is a control deficiency (within the meaning of Public Company Accounting Oversight Board Auditing Standard No. 2), or combination of control deficiencies, that result in there being more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis by employees in the normal course of their assigned functions. Based on management’s assessment, management determined that the Company maintained effective internal control over financial reporting as of December 31, 2006 based on the COSO criteria.
Management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by Ernst & Young, LLP, an independent registered public accounting firm, as stated in its report below.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of
Cynosure, Inc.
We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting, that Cynosure, Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Cynosure, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Cynosure, Inc. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Cynosure, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Cynosure, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss) and cash flows for each of the three years in the period ended December 31, 2006, and our report dated March 7, 2007 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Boston, Massachusetts
March 7, 2007
Item 9B.
Item 9B.
Other Information
None.
PART III
Item 10.
Item 10.
Directors, Executive Officers and Corporate Governance
Incorporated by reference from the information in our proxy statement for the 2007 Annual Meeting of Stockholders, which we will file with the Securities and Exchange Commission within 120 days of the end of the fiscal year to which this report relates.
Item 11.
Item 11.
Executive Compensation
Incorporated by reference from the information in our proxy statement for the 2007 Annual Meeting of Stockholders, which we will file with the Securities and Exchange Commission within 120 days of the end of the fiscal year to which this report relates.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Incorporated by reference from the information in our proxy statement for the 2007 Annual Meeting of Stockholders, which we will file with the Securities and Exchange Commission within 120 days of the end of the fiscal year to which this report relates.
Item 13.
Item 13.
Certain Relationships and Related Transactions, and Director Independence
Incorporated by reference from the information in our proxy statement for the 2007 Annual Meeting of Stockholders, which we will file with the Securities and Exchange Commission within 120 days of the end of the fiscal year to which this report relates.
Item 14.
Item 14.
Principal Accountant Fees and Services
Incorporated by reference from the information in our proxy statement for the 2007 Annual Meeting of Stockholders, which we will file with the Securities and Exchange Commission within 120 days of the end of the fiscal year to which this report relates.
PART IV
Item 15.
Item 15.
Exhibits and Financial Statement Schedules
(a) 1. Financial Statements. The financial statements annexed to this report begin on page.
2. Financial Statement Schedules. The financial statement schedules annexed to this report beginning on page are incorporated by reference.
3. Exhibits. The Exhibit Index annexed to this report is incorporated by reference.
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.
CYNOSURE, INC.
By:
/s/ Michael R. Davin
Michael R. Davin
President, Chief Executive Officer and
Chairman of the Board of Directors
Pursuant to the requirements of the Securities Act of 1934, this report has been signed by the following persons on behalf of the registrant in the capacities and on the dates indicated.
CYNOSURE, INC.
(1)
From November 2000 until May 2004, Cynosure, Inc. held an equity investment in Sona MedSpa International Inc., an operator and franchisor of spa franchises formerly known as Sona International Corporation and Sona International, Inc. Cynosure accounted for the investment using the equity method of accounting. The consolidated financial statements of Sona International, Inc. have been included pursuant to Rule 3-09 of Regulation S-X under the Securities Act of 1933, as amended.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Cynosure, Inc.
We have audited the accompanying consolidated balance sheets of Cynosure, Inc. as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss) and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Cynosure, Inc. at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 2 to the consolidated financial statements, on January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R), Share-Based Payment, using the modified-prospective-transition method.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Cynosure, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 7, 2007 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Boston, Massachusetts
March 7, 2007
CYNOSURE, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
CYNOSURE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(1) Stock-based compensation is attributable to the following categories:
The accompanying notes are an integral part of these consolidated financial statements.
CYNOSURE, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE (LOSS) INCOME
(In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
CYNOSURE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
CYNOSURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.
Nature of the Business
Cynosure, Inc. (Cynosure or the Company) develops, manufactures and markets aesthetic treatment systems that are used by physicians and other practitioners to perform non-invasive or minimally invasive procedures to remove hair, treat vascular lesions, rejuvenate skin through the treatment of shallow vascular lesions and pigmented lesions, temporarily reduce the appearance of cellulite, provide treatments for wrinkles, skin texture and skin discoloration and remove unwanted fat. Cynosure markets and sells its products primarily to the dermatology, plastic surgery and general medical markets, both domestically and internationally. Cynosure is a Delaware corporation, incorporated on July 10, 1991, located in Westford, Massachusetts.
In May 2002, Cynosure sold 3,327,960 shares of common stock (representing a 60% ownership interest) to El.En. S.p.A. (El.En.) for approximately $9.8 million in cash. Final consideration of $1.5 million from the sale was received in May 2003 (see Note 12). During 2004, El.En. acquired 2,190,834 additional shares of Cynosure’s common stock from the Company and certain minority stockholders, increasing its ownership percentage of Cynosure to approximately 87%.
In December 2005, Cynosure completed it’s initial public offering (IPO) of class A common stock at a price to the public of $15.00 per share. Cynosure sold 5,750,000 shares of class A common stock, including an over-allotment option of 750,000 shares, and El.En., the selling stockholder in the offering, sold 1,000,000 of the shares. Cynosure received aggregate net proceeds of approximately $64.0 million, after deducting underwriting discounts and commission of approximately $5.0 million and expenses of the offering of approximately $2.3 million. El.En.’s ownership percentage of Cynosure as of December 31, 2006 is 35%.
2.
Summary of Significant Accounting Policies
Significant accounting policies followed in the preparation of these consolidated financial statements are as follows:
Management Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosures at the date of the financial statements and during the reporting period. Components particularly subject to estimation include the allowance for doubtful accounts, inventory reserves, fair value of stock options and accrued warranties. On an ongoing basis, management evaluates its estimates. Actual results could differ from these estimates.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of Cynosure, Inc. and its wholly owned subsidiaries: Cynosure GmbH, Cynosure S.A.R.L., Cynosure UK Limited and Cynosure KK. As of December 31, 2005, Cynosure had a 52% interest in Suzhou Cynosure Medical Devices, Co. (Suzhou), located in the People’s Republic of China, and the related financial statements have been consolidated. In November 2006, Cynosure completed the acquisition of the remaining 48% interest in Suzhou and, as a result it is now a wholly owned subsidiary as of December 31, 2006 (See Note 5). All significant intercompany balances and transactions have been eliminated.
Reclassification
Certain amounts in the prior year’s financial statements have been reclassified to conform to the current year’s presentation, specifically related to the presentation of stock-based compensation expense.
CYNOSURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Cash and Cash Equivalents and Marketable Investments
Cynosure considers all short-term, highly liquid investments with original maturities at the time of purchase of 90 days or less to be cash equivalents. Cynosure accounts for investments in marketable securities as available-for-sale securities in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. Under SFAS No. 115, securities purchased to be held for indefinite periods of time and not intended at the time of purchase to be held until maturity are classified as available-for-sale securities. Cynosure continually evaluates whether any marketable investments have been impaired and, if so, whether such impairment is temporary or other than temporary.
Accounts Receivable and Concentration of Credit Risk
Management works to mitigate its concentration of credit risk with respect to accounts receivable through its credit evaluation policies, reasonably short payment terms and geographical dispersion of sales. Revenue includes export sales to foreign companies located principally in Europe, the Asia/Pacific region and the Middle East. Cynosure obtains letters of credit for foreign sales considered by management to be at risk. Cynosure maintains reserves for potential credit losses based upon the aging of its receivable balances, known collectibility issues and its historical experience with losses. In the event that it is determined that the customer may not be able to meet its full obligation to Cynosure, Cynosure records a specific allowance to reduce the related receivable to the amount that Cynosure expects to recover given all information present. No customer accounted for 10% or greater of revenue during 2005 or 2006. No customer accounted for 10% or greater of accounts receivable as of December 31, 2006. One customer accounted for 13% of revenues in 2004 and 13% and 12% of accounts receivable as of December 31, 2005 and 2004, respectively. Accounts receivable allowance activity consisted of the following for the years ended December 31:
During 2006, Cynosure was notified by Sona MedSpa that it was uncertain that it had the financial resources to honor its commitments to Cynosure under its agreements with Cynosure. In connection with this notification, Cynosure provided an allowance for doubtful accounts totaling approximately $1.5 million for accounts receivable associated with amounts owed by Sona MedSpa. In May 2006, Cynosure sent Sona MedSpa a notice of default with respect to Sona MedSpa’s failure to pay Cynosure amounts payable under the agreements between the parties. In June 2006, Cynosure terminated the agreement with Sona MedSpa as the defaults under the agreements were not cured and initiated an arbitration claim pursuant to the terms of the agreement.. In November 2006, Cynosure settled its arbitration with Sona MedSpa and released the claims against each other in exchange for consideration of $250,000 in cash. The settlement payment received by Cynosure has been recorded within accrued expenses in the accompanying consolidated balance sheet as of December 31, 2006 as this payment may be subject to certain avoidance action by a third-party and, if successful, could be subject to forfeiture. As a result of this settlement, Cynosure wrote off approximately $1.9 million in accounts receivable from Sona MedSpa.
CYNOSURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Inventory
Cynosure states all inventories at the lower of cost or market, determined on a first-in, first-out method. Inventory includes material, labor and overhead and consists of the following:
Included in finished goods are lasers used for demonstration purposes. Cynosure’s policy is to include demonstration lasers as inventory for a period of up to one year after production at which time the demonstration lasers are either sold or transferred to fixed assets at the lower of cost or market and depreciated over their estimated useful life. Similar to any other finished goods in inventory, Cynosure accounts for such demonstration inventory in accordance with the policy for excess and obsolescence review of Cynosure’s entire inventory.
Cynosure’s policy is to establish inventory reserves when conditions exist that suggest that inventory may be in excess of anticipated demand or is obsolete based upon assumptions about future demand for products and market conditions. Cynosure regularly evaluates the ability to realize the value of inventory based on a combination of factors including the following: historical usage rates, forecasted sales or usage, product end of life dates, estimated current and future market values and new product introductions. Assumptions used in determining management’s estimates of future product demand may prove to be incorrect; in which case the provision required for excess and obsolete inventory would have to be adjusted in the future. If inventory is determined to be overvalued, Cynosure recognizes such costs as cost of goods sold at the time of such determination. Although Cynosure performs a detailed review of its forecasts of future product demand, any significant unanticipated changes in demand could have a significant impact on the value of Cynosure’s inventory and reported operating results. Inventory reserve activity consisted of the following for the years ended December 31:
Cynosure purchases a significant raw material component from one vendor, who is the sole manufacturer of this component. A delay in the production capabilities of this vendor could cause a delay in Cynosure’s manufacturing, and a possible loss of revenues, which would adversely affect operating results.
Property and Equipment
Property and equipment are recorded at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Assets under capital leases and leasehold improvements are amortized using the straight-line method over the shorter of the estimated useful life of the asset or the respective lease term. Included in property and equipment are certain lasers that are used for demonstration purposes, as well as lasers to which Cynosure continues to hold title that are placed at
CYNOSURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
customer locations under a revenue-sharing arrangement. Maintenance and repairs are charged to expense as incurred. Cynosure continually evaluates whether events or circumstances have occurred that indicate that the estimated remaining useful life of its long-lived assets may warrant revision or that the carrying value of these assets may be impaired. Cynosure evaluates the realizability of its long-lived assets based on profitability and cash flow expectations for the related asset. Any write-downs are treated as permanent reductions in the carrying amount of the assets. Based on this evaluation, Cynosure believes that, as of each of the balance sheet dates presented, none of Cynosure’s long-lived assets were impaired.
Revenue Recognition and Deferred Revenue
Cynosure generates revenue from the sale of aesthetic treatment systems that are used by physicians and other practitioners to perform various non-invasive and minimally invasive aesthetic procedures. These systems incorporate a broad range of laser and other light-based energy sources. Cynosure offers service and warranty contracts in connection with these sales.
Cynosure recognizes revenue in accordance with Securities and Exchange Commission (SEC) Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements (SAB 104). Cynosure recognizes revenue from sales of its treatment systems and accessories upon delivery, provided there are no uncertainties regarding customer acceptance there is persuasive evidence of an arrangement, the fee is fixed or determinable, and collectibility of the related receivable is reasonably assured. Revenues from the sales of service and warranty contracts are deferred and recognized on a straight-line basis over the contract period as services are provided. Payments received by Cynosure in advance of product delivery or performance of services are deferred until earned. Multiple-element arrangements are evaluated in accordance with the principles of Emerging Issues Task Force (EITF) Issue Number 00-21, Revenue Arrangements with Multiple Deliverables (EITF 00-21), and Cynosure allocates revenue among the elements based upon each element’s relative fair value.
Cynosure also had entered into a revenue sharing arrangement with Sona MedSpa whereby Cynosure received a percentage of the revenues related to the cosmetic procedures performed at Sona MedSpa locations. Cynosure recognized this revenue in the period the procedure was performed. During the years ended December 31, 2006, 2005 and 2004, Cynosure recognized approximately $9,000, $1,241,000 and $2,402,000, respectively, under this revenue sharing arrangement. In June 2006, Cynosure terminated this agreement with Sona MedSpa.
In accordance with the provisions of EITF Issue Number 00-10, Accounting for Shipping and Handling Costs (EITF 00-10), Cynosure records shipping and handling costs billed to its customers as a component of revenue, and the underlying expense as a component of cost of revenue. Shipping and handling costs included as a component of revenue totaled $417,000, $327,000 and $210,000 for the years ended December 31, 2006, 2005 and 2004, respectively. Shipping and handling costs included as a component of cost of revenue totaled $478,000, $445,000 and $210,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
Product Warranty Costs
Cynosure typically provides a one-year parts and labor warranty on end-user sales of lasers. Distributor sales generally include a warranty on parts only. Estimated future costs for initial product warranties are
CYNOSURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
provided for at the time of revenue recognition. The following table sets forth activity in the accrued warranty account:
Research and Development
Research and development costs consist of salaries and other personnel-related expenses, including stock-based compensation, of employees primarily engaged in research, development and engineering activities and materials used and other overhead expenses incurred in connection with the design and development of Cynosure’s products. These costs are expensed as incurred.
Advertising Costs
Cynosure expenses advertising costs as incurred. Advertising costs totaled $555,000, $405,000 and $252,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
Foreign Currency Translation
The financial statements of Cynosure’s foreign subsidiaries are translated from local currency into U.S. dollars using the current exchange rate at the balance sheet date for assets and liabilities, and the average exchange rate prevailing during the period for revenue and expenses. The functional currency for Cynosure’s foreign subsidiaries is considered to be the local currency for each entity and, accordingly, translation adjustments for these subsidiaries are included in accumulated other comprehensive income (loss) within stockholders’ equity. Certain intercompany and third party foreign currency-denominated transactions generated foreign currency remeasurement gains (losses) of approximately $812,000, ($278,000) and $558,000 during 2006, 2005 and 2004, respectively, which are included in other income (expense), net, in the consolidated statements of operations.
Comprehensive (Loss) Income and Accumulated Other Comprehensive (Loss) Income
Comprehensive (loss) income is the change in equity of a company during a period from transactions and other events and circumstances, excluding transactions resulting from investments by owners and distributions to owners.
The components of accumulated other comprehensive (loss) income as of December 31, 2006 and 2005 are as follows:
CYNOSURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Fair Value of Financial Instruments
The carrying value of Cynosure’s financial instruments, which include cash equivalents, marketable securities, accounts receivable, short-term loan and capital leases, approximates their fair value at December 31, 2006 and 2005.
Stock-Based Compensation
Effective January 1, 2006, Cynosure adopted the fair value recognition provisions of FASB Statement No. 123(R), Share-Based Payment, (SFAS 123(R)) using the modified-prospective-transition method. The modified-prospective-transition method is one in which compensation cost is recognized beginning with the effective date (a) for all share-based payments granted after the effective date and (b) for all awards granted to employees prior to the effective date of SFAS 123(R) that remain unvested on the effective date. In addition, SFAS 123(R) requires companies to utilize an estimated forfeiture rate when calculating the expense for the period, whereas, SFAS 123 permitted companies to record forfeitures based on actual forfeitures, which was Cynosure’s historical policy under SFAS 123. As a result, Cynosure has applied an estimated annual forfeiture rate of 1.0% in determining the expense recorded in the consolidated statements of income.
The stock-based compensation expense increased both basic and diluted net loss per share by $0.16 for the year period ended December 31, 2006. These results reflect stock-based compensation expense of $2.5 million and related tax benefits of $652,000 for the year ended December 31, 2006. In accordance with the modified-prospective-transition method of SFAS 123(R), Cynosure has not restated results for prior periods. Cynosure capitalized $65,000 of stock-based compensation expense as a part of inventory as of December 31, 2006. As of December 31, 2006, there was $7.4 million of unrecognized compensation expense related to non-vested share awards that is expected to be recognized on a straight-line basis over a weighted-average period of 2.4 years. Additionally, as a result of implementation of SFAS 123(R), as of January 1, 2006, Cynosure reversed approximately $1.4 million of remaining deferred stock-based compensation associated with the May 2005 option grants. Cash received from option exercises was $484,000 during the year ended December 31, 2006. Cynosure recognized $397,000 in tax benefits in excess of book deductions from these option exercises during the year period ended December 31, 2006.
Cynosure granted 522,150 stock options during the year period ended December 31, 2006. Effective with the adoption of SFAS 123(R), Cynosure has elected to use the Black-Scholes option pricing model to determine the weighted average fair value of options, rather than a binomial model. The weighted-average fair value of the options granted during the year ended December 31, 2006 was $11.52 using the following assumptions:
Option-pricing models require the input of various subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. Due to Cynosure’s initial public offering in December 2005, Cynosure believes there is not adequate information on the volatility of its own shares. As such, Cynosure’s estimated expected stock price volatility is based on an average of the volatility of other similar companies in the same industry. Cynosure believes this is more reflective and a better indicator of the expected future volatility, than using an average of a comparable market index or of a comparable company in the same industry. Cynosure’s expected term of options granted in the twelve months ended December 31, 2006 was derived from the short-cut method described in SEC’s Staff Accounting Bulletin (SAB) No. 107.
CYNOSURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The risk-free rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend yield of zero is based on the fact that Cynosure has never paid cash dividends and has no present intention to pay cash dividends.
Cynosure accounts for transactions in which services are received from non-employees in exchange for equity instruments based on the fair value of such services received or of the equity instruments issued, whichever is more reliably measured, in accordance with SFAS No. 123(R) and the Emerging Issues Task Force Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, or EITF Issue No. 96-18.
In July 2006, Cynosure entered into a consulting agreement with a former employee, who agreed to provide services to the Company after his employment terminates for a period of one year from the effective date of the agreement. This consulting agreement can be terminated at any time by either party. In connection with this agreement, all vested incentive stock options granted to this former employee were converted into an equivalent number of vested non-qualified stock options in order to avoid termination of such options and allow the former employee to exercise such options during the term of the consulting agreement. This agreement also provided for an additional year of vesting of all of the unvested options previously granted to the former employee, while he was employed by the Company, throughout the term of the consulting agreement. During the year ended December 31, 2006, Cynosure recorded approximately $363,000 of additional stock-based compensation expense related to this agreement.
Prior to January 1, 2006, Cynosure accounted for stock-based awards under the recognition and measurement provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations, as permitted by Financial Accounting Standards Board (FASB) Statement No. 123, Accounting for Stock-Based Compensation (SFAS 123). Under the intrinsic-value method, compensation expense is measured on the date of grant as the difference between the deemed fair market value of Cynosure’s common stock for accounting purposes and the option exercise price multiplied by the number of options granted. Generally, Cynosure granted stock options with exercise prices equal to the fair market value for accounting purposes of its common stock; however, to the extent that the deemed fair market value for accounting purposes of the common stock exceeded the exercise price, Cynosure recorded deferred stock-based compensation and amortized the expense over the vesting schedule of the options, generally four years. The fair value for accounting purposes of Cynosure’s common stock was determined by the Company’s board of directors. Prior to the completion of the Cynosure’s IPO, Cynosure’s board of directors considered objective and subjective factors in determining the fair value of Cynosure’s common stock for accounting purposes. During the year ended December 31, 2005, Cynosure granted stock options with exercise prices less than the deemed fair market value of common stock for accounting purposes and, as a result, recorded deferred stock-based compensation of approximately $1.7 million. During the year ended December 31, 2005, Cynosure recorded amortization of deferred stock-based compensation of $264,000.
CYNOSURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
If compensation cost had been determined for stock options granted to employees based on the fair value of the awards at the date of grant in accordance with the provisions of SFAS 123, Cynosure’s net income would have been the pro forma amount indicated below:
In computing this pro forma amount, the Company has used the Black-Scholes pricing model using the following assumptions for options granted in fiscal years 2005 and 2004:
Income Taxes
Cynosure provides for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes (SFAS 109). SFAS 109 recognizes tax assets and liabilities for the cumulative effect of all temporary differences between the financial statement carrying amounts and the tax basis of assets and liabilities, and are measured using the enacted tax rates that will be in effect when these differences are expected to reverse. Valuation allowances are provided if, based on the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. Cynosure considers the undistributed foreign earnings of its foreign subsidiaries to be indefinitely reinvested and, as such, Cynosure does not provide U.S. income tax on such undistributed earnings.
Net (Loss) Income per Common Share
Basic net (loss) income per share is determined by dividing net (loss) income by the weighted average common shares outstanding during the period. Diluted net income per share is determined by dividing net income by the diluted weighted average shares outstanding during the period. Diluted weighted average shares reflect the dilutive effect, if any, of common stock options based on the treasury stock method.
CYNOSURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
For the year ended December 31, 2006, the number of basic and diluted weighted average shares outstanding were the same. The Company had outstanding options to purchase approximately 2.2 million shares of the Company’s common stock that were potential dilutive securities outstanding as of December 31, 2006; however, any increase in the number of shares of common stock equivalents for the year ended December 31, 2006 would be antidilutive based on the net loss for that year and therefore were not included.
The reconciliation of basic and diluted weighted average shares outstanding for the years ended December 31, 2005 and 2004 is as follows:
There were no antidilutive shares for the year ended December 31, 2005. For the year ended December 31, 2004, options to purchase approximately 123,000 were excluded from the calculation of diluted weighted average common shares outstanding as their effect was antidilutive.
Recent Accounting Pronouncements
In June 2006, the Financial Accounting Standards Board issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of SFAS 109, Accounting for Income Taxes (FIN 48), to create a single model to address accounting for uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes, by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. Cynosure will adopt FIN 48 as of January 1, 2007, as required. Based on its evaluation as of December 31, 2006, Cynosure does not believe that FIN 48 will have a material impact on its financial position or results of operations.
In September 2006, the FASB issued Statement No. 157, Fair Value Measurements, (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. This Statement does not require any new fair value measurements; rather, it applies under other accounting pronouncements that require or permit fair value measurements. The provisions of this Statement are to be applied prospectively as of January 1, 2008, with any transition adjustment recognized as a cumulative-effect adjustment to the opening balance of retained earnings. Cynosure does not expect that the adoption of SFAS 157 will have a material impact on its financial position or results of operations.
3.
Royalty Settlement
In various communications that the Company received from Palomar Medical Technologies, Inc. (Palomar) prior to September 30, 2006, Palomar asserted that Cynosure required a license under specified U.S. and foreign patents owned or licensed by Palomar with respect to Cynosure’s hair removal-only systems. In the third quarter of 2006, Cynosure entered into negotiations with Palomar with respect to such a license. On November 6, 2006, Cynosure entered into a non-exclusive patent license with Palomar. Under the cross-license agreement, Cynosure obtained a non-exclusive license to integrate into its products certain hair removal technology covered by specified U.S. and foreign patents held by Palomar and Palomar obtained a non-exclusive license under certain U.S. and foreign patents held by Cynosure. In November 2006, Cynosure made a payment to Palomar of $10 million for royalties related to sales prior to October 1, 2006 of hair removal-
CYNOSURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
only systems including Cynosure’s Apogee family of products, PhotoLight, Acclaim 7000 and the PhotoSilk Plus. Cynosure recorded this amount as a royalty settlement within Cynosure’s operating expenses for the year ended December 31, 2006.
In connection with this agreement, Cynosure also agreed to pay royalties to Palomar on Cynosure’s future sales of certain hair removal products. The royalty rate for future sales of hair removal products ranges from 3.75% to 7.5% of net sales beginning October 1, 2006, depending upon product configuration and the number of energy sources. Royalty expense associated with such sales is recorded as cost of revenues. Cynosure’s revenue from systems that do not include hair removal capabilities and revenue from service is not subject to any past or future royalties under the Palomar agreement.
4.
Marketable Securities
Cynosure’s available-for-sale securities at December 31, 2006 consist of approximately $43.3 million of investments in debt securities consisting of state and municipal bonds, corporate bonds and certificates of deposit and approximately $210,000 in equity securities. As of December 31, 2006, Cynosure’s equity securities consist of 133,511 shares of common stock of a public company with a fair market value of approximately $210,000. These shares were acquired in connection with the sale of Cynosure’s investment in a private company during the year ended December 31, 2006 and are considered available-for-sale securities in accordance with SFAS No. 115. (See Note 9 for further discussion.) All investments are recorded at fair market value, with any unrealized gains and losses reported as a separate component of accumulated other comprehensive loss.
As of December 31, 2006, Cynosure’s marketable securities consist of the following (in thousands):
As of December 31, 2006, the Company had 19 securities that were in an unrealized loss position, all of which have been in such a position for less than twelve months. The unrealized losses in all investment types were caused by increasing market interest rates. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Because Cynosure has the ability and the intent to hold these investments until a recovery of market value, Cynosure does not consider these investments to be other-than-temporarily impaired at December 31, 2006.
As of December 31, 2006, Cynosure’s marketable securities mature as follows (in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
5.
Acquisition of Minority Interest
On August 31, 2006, Cynosure acquired the remaining 48% minority interest in Suzhou Cynosure Medical Devices Company, Ltd.’s (Suzhou) outstanding common stock for a purchase price of $640,000 in cash. Cynosure did not incur any material closing costs related to the purchase and, as such, the $640,000 cash consideration represents the entire purchase price. The business purpose of acquiring the minority interest was to gain complete control over Suzhou while extending the business license of Suzhou. The purchase of the minority interest was contingent upon Chinese government approval of the shareholder transfer from the seller to Cynosure for the shares acquired and approval of extension of the business license of Suzhou for a period of 20 years. The existing business license was set to expire on October 12, 2007. On November 10, 2006, Suzhou received such approval from the Chinese government, evidenced by the issuance of a new business license allowing operations in China until October 12, 2027.
In accordance with SFAS No. 141, Business Combinations, the acquisition of the minority interest was accounted for as a business combination, which required allocation of the purchase price to assets acquired and liabilities assumed. As such, the aggregate purchase price of $640,000 was allocated to the net assets acquired from the minority interest holders of Suzhou, which had a total value of $357,000 and consisted primarily of $263,000 of cash, $148,000 of accounts receivable, $487,000 of inventory, $36,000 of other assets, and $190,000 of other current liabilities as of August 31, 2006, with the residual of $283,000 allocated to the business license, which is subject to amortization due to its limited useful life. This acquired intangible asset is included in other assets in the accompanying consolidated balance sheet as of December 31, 2006 and is being amortized on a straight-line basis over a 20-year period, which approximates the expected cash flows resulting from the underlying asset.
6.
Segment and Geographic Information
In accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (SFAS 131), operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision maker, or decision-making group, in making decisions how to allocate resources and assess performance. Cynosure’s chief decision-maker, as defined under SFAS 131, is a combination of the Chief Executive Officer and the Chief Financial Officer. Cynosure views its operations and manages its business as one segment, aesthetic treatment products and services.
The following table represents total revenue by geographic destination:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Net assets by geographic area are as follows:
Long-lived assets by geographic area are as follows:
No individual country within Europe or Asia/Pacific represented greater than 10% of total revenue or net assets for any period presented.
7.
Balance Sheet Accounts
Property and Equipment
Property and equipment consists of the following at December 31:
Depreciation expense relating to property and equipment was $2,341,000, $1,733,000 and $1,275,000 for the years ended December 31, 2006, 2005 and 2004, respectively. As of December 31, 2006 and 2005, the cost of assets recorded under capitalized leases was approximately $2,472,000 and $1,676,000, and the related
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
accumulated amortization was approximately $993,000 and $581,000, respectively. Amortization expense of assets recorded under capitalized leases is included as a component of depreciation expense.
Accrued Expenses
Accrued expenses consist of the following at December 31:
8.
Investment in Sona MedSpa
In 2001, Cynosure invested $1,500,000 in the Series A preferred stock of Sona MedSpa International, Inc. (Sona MedSpa), a spa franchise or that owns and operates hair removal clinics in the United States. Cynosure’s equity investment represented a 40% equity ownership of Sona MedSpa, which Cynosure accounted for under the equity method of accounting, which required classification of Sona MedSpa as a related party. During 2000 and 2001, Cynosure agreed to guarantee certain Sona MedSpa lease commitments (see Note 16). The Company recognized $154,000 as the Company’s share of Sona MedSpa’s (loss) income as a component of other (expense) income for the year ended December 31, 2004. In May 2004, Cynosure sold its 40% equity interest in Sona MedSpa for $3.6 million, resulting in a $3.0 million gain. Of the sales price, $2.6 million was received in cash and $1.0 million was deposited in escrow to be received in three installments over the next 18 months. As of December 31, 2005, all amounts deposited in escrow were released to Cynosure.
In connection with the original investment in Sona MedSpa, Cynosure also entered into a revenue sharing arrangement with Sona MedSpa whereby Cynosure provided lasers to Sona MedSpa and, in return, received a percentage of the revenues related to the aesthetic procedures performed at Sona MedSpa locations. Simultaneous with the sale of Cynosure’s equity investment, Cynosure sold certain lasers previously placed in Sona MedSpa clinics to Sona MedSpa for $1.2 million, which is included in Cynosure revenues in 2004. Cynosure also entered into an amended laser placement and revenue sharing arrangement with the new owners of Sona MedSpa. Effective May 24, 2004, Cynosure had no ongoing ownership interest in Sona MedSpa and Sona MedSpa was no longer considered a related party. During the years ended December 31, 2005 and 2004, Cynosure recognized approximately $1,241,000 and $2,402,000, respectively, under the revenue sharing arrangement of which $1,269,000 is presented as related party revenues in the accompanying consolidated statement of operations for the year ended December 31, 2004, prior to the sale of the equity interest.
In October 2005, Cynosure entered into a preferred vendor agreement with Sona MedSpa whereby Cynosure sold certain laser systems to Sona Medspa for approximately $1.3 million, which was recorded as deferred revenue as of December 31, 2005 because the fee was not fixed or determinable at the time of sale.
In March 2006, Sona MedSpa notified Cynosure that Sona MedSpa was uncertain that it had the financial resources to honor its commitments to Cynosure and Cynosure determined that the collectibility of the fee was not probable and, as a result, reversed the related deferred revenue. Cynosure expensed as cost of goods sold approximately $667,000 of inventory delivered under the agreement. Additionally, Cynosure provided an
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
allowance for doubtful accounts of $463,000 for accounts receivable associated with services provided prior to the October 2005 preferred vendor agreement. On May 2, 2006, Cynosure sent Sona MedSpa a notice of default with respect to Sona MedSpa’s failure to pay Cynosure amounts payable under two agreements between the parties. On June 2, 2006, Cynosure terminated the agreement with Sona MedSpa as the defaults under the agreements were not cured.
On November 27, 2006, Cynosure settled its arbitration with Sona MedSpa and released the claims against each other in exchange for consideration of $250,000 in cash. The settlement payment received by Cynosure has been recorded within accrued expenses in the accompanying consolidated balance sheet as of December 31, 2006 as this payment may be subject to certain avoidance action by a third-party and, if successful, could be subject to forfeiture.
9. Investment in OccuLogix, Inc.
During 2003, Cynosure made an investment in Solx, Inc., a private company that represents an approximate 2% ownership interest in the entity. During the years ended December 31, 2005 and 2004, Cynosure recognized revenue of approximately $365,000 and $251,000, respectively, related to laser sales to this entity and did not recognize any revenue to this entity during the year ended December 31, 2006.
In August 2006, Cynosure sold its investment interest to OccuLogix, Inc., a public company, in exchange for consideration consisting of (1) approximately $379,000 in cash, and (2) 133,511 shares of common stock of the acquiring company with a fair market value of approximately $270,000 at the time of the sale. As a result of this sale, Cynosure recorded a gain of approximately $118,000, which is included in gain on sale of investment in the accompanying consolidated statements of operations for the year ended December 31, 2006. In connection with this sale, Cynosure received approximately $105,000 in cash, and the remaining cash consideration of approximately $274,000 is to be paid in the following installments: $64,000 in August 2007, $105,000 in August 2008 and $105,000 upon the achievement of a certain contingent event, as specified in the transaction agreement. Due to collection based on a contingent event and uncertainty regarding collection of the August 2007 and August 2008 payments, Cynosure deferred the gain related to the remaining cash consideration of $274,000 and will record this as a gain if and when it receives the remaining cash payments.
The value of the shares of the acquiring company’s common stock is included in Cynosure’s marketable securities on the accompanying consolidated balance sheet as they are considered available-for-sale securities in accordance with SFAS No. 115. In accordance with SFAS 115, Cynosure adjusted the value of this investment to its market value of approximately $210,000 as of December 31, 2006 and recorded the unrealized gain, net of related tax effects, as a separate component of accumulated other comprehensive income.
10.
Related Party Transactions
Purchases of inventory from El.En. during the years ended December 31, 2006, 2005 and 2004 were approximately $3,222,000, $2,423,000 and $2,142,000, respectively. As of December 31, 2006 and 2005, amounts due to related party for these purchases were approximately $1.1 million and $960,000, respectively. Cynosure had a note payable totaling $303,437, including accrued interest, at December 31, 2004 to El. En., which was paid in full in 2005. Amounts due from El.En. as of December 31, 2006 and 2005 were $335,000 and $72,000, respectively, which represent services performed by Cynosure.
11.
Short-term Loan
Cynosure’s short-term loan consists of a line of credit with a bank which expires on May 11, 2007 and bears interest at 5.11%. There are no amounts available for borrowing at December 31, 2006 and the note is due in full on May 11, 2007.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
12.
Stockholders’ Equity
Common Stock Authorized
In connection with the Cynosure IPO in December 2005, Cynosure restated it’s certificate of incorporation to create a dual class capital structure by authorizing $0.001 par value class A and class B common stock and reclassifying all of Cynosure’s shares of previously existing $0.01 par value common stock into shares of class B common stock. In addition, each outstanding option to purchase shares of common stock automatically became an option to purchase an equal number of shares of our class B common stock, with no other changes to the term of the option. Cynosure has authorized 61,500,000 shares of $0.001 par value class A common stock and 8,500,000 shares of $0.001 par value class B common stock. As of December 31, 2006, there were 7,101,765 shares of class A common stock issued and 4,109,188 shares of class B common stock issued.
The rights, preferences and privileges of each class of common stock are as follows:
Voting Rights
The holders of class A common stock and class B common stock have identical rights and will be entitled to one vote per share with respect to each matter presented to Cynosure stockholders on which the holders of common stock are entitled to vote, except for the approval rights of the holders of the class B common stock applicable to specified amendments to Cynosure’s certificate of incorporation and amendments of Cynosure’s bylaws by stockholders and except with respect to the election and removal of directors. El.En., Cynosure’s largest stockholder, is able to control the election of a majority of the members of Cynosure’s board of directors. El.En. owns 95% of Cynosure’s outstanding class B common stock, which comprises 35% of Cynosure’s aggregate outstanding common stock. Until El.En. beneficially owns less than 20% of the aggregate number of shares of Cynosure’s class A common stock and class B common stock outstanding or less than 50% of the number of shares of Cynosure’s class B common stock outstanding, El.En., as holder of a majority of the shares of Cynosure’s class B common stock, will have the right:
•
to elect a majority of the members of Cynosure’s board of directors;
•
to approve amendments to our bylaws adopted by Cynosure’s class A and class B stockholders, voting as a single class; and
•
to approve amendments to any provisions of Cynosure’s restated certificate of incorporation relating to the rights of holders of common stock, the powers, election and classification of the board of directors, corporate opportunities and the rights of holders of class A common stock and class B common stock to elect and remove directors, act by written consent and call special meetings of stockholders.
In addition, the holders of shares of Cynosure’s class B common stock will vote with Cynosure’s class A stockholders for the election of the remaining directors.
Conversion
Cynosure’s class A common stock is not convertible into any other shares of Cynosure’s capital stock.
Each share of class B common stock is convertible into one share of class A common stock at any time at the option of the holder. In addition, each share of class B common stock shall convert automatically into one share of class A common stock upon any transfer of such share of class B common stock, whether or not for value.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Dividends
Subject to preferences that may apply to any shares of preferred stock outstanding at the time, the holders of class A common stock and class B common stock shall be entitled to share equally, on a per share basis, in any dividends that Cynosure’s board of directors may determine to issue from time to time.
Liquidation Rights
In the event of our liquidation or dissolution, the holders of class A common stock and class B common stock shall be entitled to share equally, on a per share basis, in all assets remaining after the payment of all debts and other liabilities and subject to the prior rights of any outstanding preferred stock.
Issuances of Common Stock
In December 2005, Cynosure completed its IPO of 4,000,000 shares of common stock at $15.00 per share and sold an additional 750,000 shares of common stock at $15.00 per share as a result of the exercise of the over-allotment option by the underwriters of the IPO. The sale of the 4,750,000 shares of common stock in connection with the IPO resulted in net proceeds to Cynosure of approximately $64,024,000, after deducting underwriting discounts and offering-related expenses.
During October and November 2004, Cynosure entered into Stock Subscription Agreements (the Agreements) with certain accredited investors for the purchase of 575,000 shares of Cynosure common stock at $3.00 per share. The purchase price was payable in two installments, 50% upon execution of the subscription agreement and 50% due April 1, 2005. Certain of the subscription agreements required a single payment due April 15, 2005. The first installment payment of $413,000 is recorded as a stock purchase deposit included as a component of accrued expenses in the accompanying balance sheet. The common stock sold under the Agreements was issued in April 2005.
In connection with the signing of the stock subscription agreements, Cynosure entered into a Stock Purchase Agreement with El.En. to purchase 575,000 shares of Cynosure common stock at $3.00 per share to be delivered to the accredited investors pursuant to the subscription agreements. The payment terms of the Stock Purchase Agreement mirror those of the subscription agreement. The first installment payment of $413,000 is recorded as a stock purchase deposit in the other non-current assets section of the balance sheet. The common stock was purchased in April 2005 and recorded as a reduction of additional paid-in capital.
Preferred Stock
Cynosure has authorized 5,000,000 shares of $0.001 par value preferred stock. The Board of Directors has full authority to issue this stock and to fix the voting powers, preference rights, qualifications, limitations, or restrictions thereof, including dividend rights, conversion rights, redemption privileges and liquidation preferences and the number of shares constituting any series or designation of such series.
13.
Stock-Based Compensation
Stock Option Plan
In February 1992, the Board of Directors adopted, and the stockholders approved, the 1992 Stock Option Plan (the 1992 Plan). The 1992 Plan provided for the grant of incentive stock options (ISOs), as well as nonstatutory options. The Board of Directors administered the 1992 Plan and had sole discretion to grant options to purchase shares of the Company’s common stock.
The Board of Directors determined the term of each option, option price, number of shares for which each option was granted, whether restrictions would be imposed on the shares subject to options and the rate at which each option was exercisable. The exercise price for options granted was determined by the Board of Directors,
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
except that for ISOs, the exercise price could not be less than the fair market value per share of the underlying common stock on the date granted (110% of fair market value for ISOs granted to holders of more than 10% of the voting stock of the Cynosure). The term of the options were set forth in the applicable option agreements, except that in the case of ISOs, the option term was not to exceed ten years (five years for ISOs granted to holders of more than 10% of voting stock of the Cynosure). A maximum of 2,250,000 shares of common stock were reserved for issuance in accordance with the 1992 Plan. Options granted under the 1992 Plan vested either (i) over a 50-month period at the rate of 24% after the first year and 2% each month thereafter until fully vested or (ii) after eight years with acceleration of vesting if certain performance measures were met, as defined in the agreements. All options granted under the 1992 Plan to date were issued at fair market value as determined by the Board of Directors. The 1992 Plan expired on the tenth anniversary of the date of its adoption by the Board of Directors in February 2002. Options outstanding as of this date continue to have force and effect in accordance with the provisions of the instruments evidencing such options.
Stock Compensation Plan
In July 2003, the Board of Directors approved the 2003 Stock Compensation Plan (the 2003 Plan), which granted nine Cynosure executives the right to purchase up to a maximum of 550,000 shares of Cynosure’s common stock at an exercise price of $2.00 per share. The deemed fair value of Cynosure’s common stock for accounting purposes on the date of grant was $2.25. As a result, Cynosure recorded compensation expense for the difference between the purchase price and the deemed fair value over the period the rights vest. The number of shares each executive can purchase was determined by a service ratio, which is determined by the number of whole or partial months an executive is employed by Cynosure relative to a stated service period, determined on an individual participant basis. Once the right to purchase the shares is vested, the executives are obligated to purchase shares on the earlier of (1) an acquisition of Cynosure, (2) 180 days following an initial public offering of Cynosure’s common stock or (3) December 31, 2004. If neither of the first two events occurred, Cynosure or El.En. had the discretionary right to purchase the rights at the then-fair value of the common stock determined by a formula dependent upon operating results. Furthermore, one executive had a put right requiring either Cynosure or El.En. to purchase the common stock at a price determined by the formula previously noted.
For the year ended December 31, 2004, Cynosure recorded approximately $122,000 of cash and $182,000 of non-cash stock-based compensation expense, respectively, associated with the 2003 Plan. A portion of the 2004 stock-based compensation expense resulted from Cynosure issuing 75,855 shares of common stock to certain executives, in lieu of acquiring stock purchase rights from the executives, who were active employees of Cynosure as of October 1, 2004, effectively terminating the 2003 Plan. All vested rights for executives who were no longer employees of Cynosure as of October 1, 2004 expired unexercised.
Stock Option Plan
In October 2004, the Board of Directors adopted and the stockholders approved the 2004 Stock Option Plan (the 2004 Plan). The 2004 Plan provided for the grant of ISOs, as well as nonstatutory options. The Board of Directors administers the 2004 Plan and had sole discretion to grant options to purchase shares of Cynosure’s common stock.
The Board of Directors determines the term of each option, option price, number of shares for which each option is granted, whether restrictions would be imposed on the shares subject to options and the rate at which each option is exercisable. The exercise price for options granted is determined by the Board of Directors, except that for ISOs, the exercise price could not be less than the fair market value per share of the underlying common stock on the date granted (110% of fair market value for ISOs granted to holders of more than 10% of the voting stock of Cynosure). The term of the options is set forth in the applicable option agreement, except that in the case of ISOs, the option term cannot exceed ten years. As of December 31,
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
2005, a maximum of 1,791,001 shares of common stock are reserved for issuance in accordance with the 2004 Plan. Options granted under the Plan vested either (i) over a 48-month period at the rate of 25% after the first year and 6.25% each quarter thereafter until fully vested or (ii) over a vesting period determined by the Board of Directors. As of December 31, 2006, there are no shares available for future grant under the 2004 Plan.
In April and May 2005, Cynosure granted 10,000 and 358,200 options, respectively, to purchase common stock under the 2004 Plan. At the time of grant, these options were believed to have been issued at fair market value. Subsequently, the Board of Directors determined the April and May 2005 option grants were issued below the deemed fair market value for accounting purposes as supported by a retrospective valuation conducted by Cynosure and recorded approximately $1.7 million of deferred stock-based compensation expense which is being amortized over the vesting period of the options. During the year ended December 31, 2005, Cynosure recorded amortization of deferred stock-based compensation of $264,000. As a result of the implementation of SFAS 123(R), as of January 1, 2006, the Company reversed approximately $1.4 million of the remaining deferred stock-based compensation.
In May 2005, Cynosure granted approximately 18,000 options to non-employees under the 2004 Plan. In connection with this grant, Cynosure recorded $205,000 of stock-based compensation expense.
Stock Incentive Plan
In August 2005, the Board of Directors adopted the 2005 Stock Incentive Plan (the 2005 Plan) which was approved by our stockholders in December 2005. The 2005 Plan provided for the grant of ISOs, as well as nonstatutory options. The Board of Directors administers the 2005 Plan and had sole discretion to grant options to purchase shares of Cynosure’s common stock.
The Board of Directors determines the term of each option, option price, number of shares for which each option is granted, whether restrictions would be imposed on the shares subject to options and the rate at which each option is exercisable. The exercise price for options granted is determined by the Board of Directors, except that for ISOs, the exercise price could not be less than the fair market value per share of the underlying common stock on the date granted (110% of fair market value for ISOs granted to holders of more than 10% of the voting stock of Cynosure). The term of the options is set forth in the applicable option agreement, except that in the case of ISOs, the option term cannot exceed ten years. The number of shares of class A common stock reserved for issuance under the 2005 stock incentive plan is 558,999 shares. Options granted under the Plan vested either (i) over a 48-month period at the rate of 25% after the first year and 6.25% each quarter thereafter until fully vested or (ii) over a vesting period determined by the Board of Directors. As of December 31, 2006, there are 52,812 shares available for future grant under the 2005 Plan.Stock option activity under the 1992 Plan, the 2004 Plan and the 2005 Plan is as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
14.
Income Taxes
(Loss) income before income tax (benefit from) provision for income taxes and minority interest consists of the following:
The (benefit from) provision for income taxes consists of:
A reconciliation of the federal statutory rate to Cynosure’s effective tax rate is as follows for the years ended December 31:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Significant components of Cynosure’s net deferred tax assets as of December 31, 2006 and 2005 are as follows:
As of December 31, 2006, Cynosure had state tax credit carryforwards of approximately $209,000 to offset future tax liability, and state net operating loss carryforwards of approximately $561,000 to offset future taxable income. If not utilized, these credit carryforwards will expire at various dates through 2019, and the losses will expire through 2026. Cynosure also had foreign net operating loss carryforwards of approximately $2,067,000 available to reduce future foreign taxable income which will expire at various times through 2024. Foreign net operating losses related to Germany and France totaling $1,875,000, which do not expire. Cynosure has a net deferred tax asset before consideration of valuation allowances arising principally from foreign net operating loss carryforwards, accruals and other reserves, and state credit carryforwards. Based upon the weight of the available evidence, it is more likely than not that a portion of the deferred tax assets will not be realized and, accordingly, that amount has been fully reserved. During the year ended December 31, 2006, Cynosure reversed approximately $570,000 of valuation allowance primarily related to its foreign and state net operating losses and state tax credit carryforwards due to utilization of these carryforwards in 2006.
In 2006, Cynosure adopted SFAS 123(R) and recognized a benefit in excess of amount recorded per books of approximately $397,000 for stock-based compensation deductions recorded through additional paid in capital. This amount represents the cash benefit that Cynosure will receive through its current year federal loss carryback claim. The total state benefit of approximately $30,000 related to stock-based compensation deductions has not been recorded to additional paid in capital as no state cash benefit will be received in the current year. As of December 31, 2006, the Company has recorded an amount receivable related to its federal income taxes of approximately $2.7 million, which is included in prepaid expenses and other current assets in the accompanying consolidated balance sheet.
No amount for U.S. income tax has been provided on undistributed earnings of our foreign subsidiaries because the Company considers such earnings to be indefinitely reinvested. In the event of distribution of those earnings in the form of dividends or otherwise, the Company would be subject to both U.S. income taxes, subject to an adjustment, in any, for foreign tax credits, and foreign withholding taxes payable to certain foreign tax authorities. Determination of the amount of U.S. income tax liability that would be incurred is not practicable because of the complexities associated with this hypothetical calculation; however, unrecognized foreign tax credit carryforwards may be available to reduce some portion of the U.S. tax liability, if any.
15.
401(k) Plan
Cynosure sponsors the Cynosure 401(k) defined contribution plan. Participation in the plan is available to all employees of Cynosure who meet certain eligibility requirements. The Plan is qualified under
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Section 401(k) of the Internal Revenue Code, and is subject to contribution limitations as set annually by the Internal Revenue Service. Employer matching contributions are at Cynosure’s discretion. Cynosure’s contributions to this plan totaled approximately $42,000 for the year ended December 31, 2006. There were no employer matches for the years ended December 31, 2005 or 2004.
16.
Commitments and Contingencies
Lease Commitments
Cynosure leases its U.S. operating facility and certain foreign facilities under noncancelable operating lease agreements expiring through March 2012. Rent expense for the years ended December 31, 2006, 2005 and 2004 was approximately $1,042,000 $913,000 and $789,000, respectively.
Cynosure leases certain equipment and vehicles under operating and capital lease agreements with payments due through December 2011.
Commitments under Cynosure’s lease arrangements are as follows, in thousands:
Lease Guarantees
During 2000 and 2001, Cynosure guaranteed the lease obligations for two locations that are operated by Sona MedSpa, and will be obligated to pay these leases if Sona MedSpa cannot make the required lease payments. Minimum lease payments guaranteed by Cynosure as of December 31, 2006 are as follows, in thousands:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Litigation
In May 2005, Dr. Ari Weitzner, individually and as putative representative of a purported class, filed a complaint against Cynosure under the federal Telephone Consumer Protection Act, or TCPA, in Massachusetts Superior Court in Middlesex County seeking monetary damages, injunctive relief, costs and attorneys fees. The complaint alleges that Cynosure violated the TCPA by sending unsolicited advertisements by facsimile to the plaintiff and other recipients without the prior express invitation or permission of the recipients. Under the TCPA, recipients of unsolicited facsimile advertisements are entitled to damages of up to $500 per facsimile for inadvertent violations and up to $1,500 per facsimile for knowing or willful violations. Although Cynosure is continuing to investigate the number of facsimiles transmitted during the period for which the plaintiff in the lawsuit seeks class certification and the number of these facsimiles that were “unsolicited” within the meaning of the TCPA, Cynosure expects the number of unsolicited facsimiles to be very large. Cynosure is vigorously defending the lawsuit and has filed initial briefs and motions with the court. Cynosure is not able to estimate the amount or range of loss that could result from an unfavorable outcome of the lawsuit as the matter is still in the early stages of the proceedings.
In December 2005, certain individuals commenced an arbitration against Cynosure along with Sona International Inc. Sona Med Spa Inc., Carousel Capital, Inc. and various individuals. The arbitration demand alleges fraud, violations of various state consumer protection laws and other causes of action in connection with the plaintiff’s acquisition of franchises from the Sona entities. Cynosure declined to participate in the arbitration because Cynosure had not agreed contractually to do so, and in 2006 it was dismissed from the arbitration by agreement of the parties.
In January 2006, Gentle Laser Solutions, Inc., Liberty Bell Med Spa, Inc. and Kevin T. Campbell filed suit against Cynosure and one of its former directors, along with Sona International Inc. Sona Lasers Centers, Inc. and various other individuals, in the Superior Court of New Jersey. The matter was later removed to the United States District Court in the District of New Jersey. The suit alleges fraud, breach of contract and other causes of action in connection with the plaintiffs’ acquisition of franchises from the Sona entities. Court ordered conferences scheduled for December 1, 2006 and January 29, 2007 were postponed due to a pending motion to dismiss by Sona. Cynosure is not able to estimate the amount or range of loss that could result from an unfavorable outcome of the lawsuit as the matter is still in the early stages of the proceedings.
In June 2006, Baltimore Laser Solutions, Inc., and Kevin T. Campbell, filed suit against Cynosure and one of its former directors, along with Sona International Inc., Sona Lasers Centers, Inc. and various other individuals, in the United States District Court in the District of Maryland. The suit alleges fraud, breach of contract and other causes of action in connection with the plaintiffs’ acquisition of franchises from the Sona entities. Cynosure is not able to estimate the amount or range of loss that could result from an unfavorable outcome of the lawsuit as the matter is still in the early stages of the proceedings.
In September 2006, five groups of plaintiffs, all of whom are former Sona franchisees or franchises, filed suit against Cynosure in the United States District Court in the District of Minnesota. On January 18, 2007, Cynosure received a copy of an amended complaint, adding two more groups of plaintiffs. The suit alleges fraud, negligent misrepresentation and other causes of action in connection with our relationship with Sona. On February 13, 2007, Cynosure filed a motion to dismiss the amended complaint in its entirety. Cynosure is not able to estimate the amount or range of loss that could result from an unfavorable outcome of the lawsuit as the matter is still in the early stages of the proceedings.
In addition to the matters discussed above, from time to time, Cynosure is subject to various claims, lawsuits, disputes with third parties, investigations and pending actions involving various allegations against Cynosure incident to the operation of its business, principally product liability. Each of these other matters is subject to various uncertainties, and it is possible that some of these other matters may be resolved unfavorably to Cynosure. Cynosure establishes accruals for losses that management deems to be probable and
CYNOSURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
subject to reasonable estimate. Cynosure believes that the ultimate outcome of these matters will not have a material adverse impact on its consolidated financial position, results of operations or cash flows.
17.
Summary Selected Quarterly Financial Data (Unaudited)
The following table sets forth certain unaudited consolidated quarterly statement of operations data for the eight quarters ended December 31, 2006. This information is unaudited, but in the opinion of management, it has been prepared substantially on the same basis as the audited consolidated financial statements and all necessary adjustments, consisting only of normal recurring adjustments, have been included in the amounts stated below to state fairly the unaudited consolidated quarterly results of operations. The results of operations for any quarter are not necessarily indicative of the results of operations for any future period.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Stockholders of
Sona International, Inc. and subsidiaries:
We have audited the accompanying consolidated balance sheet of Sona International, Inc. and subsidiaries as of December 31, 2004, and the related consolidated statements of operations and accumulated deficit and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with the auditing 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 consolidated financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sona International, Inc. and subsidiaries as of December 31, 2004, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.
/s/ Lattimore Black Morgan & Cain, P.C.
Brentwood, Tennessee
June 2, 2005, except for Note 16, as to which the date is March 8, 2007
SONA INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
December 31,
See accompanying notes to the consolidated financial statements.
SONA INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS AND ACCUMULATED DEFICIT
Year Ended December 31, 2004
See accompanying notes to the consolidated financial statements.
SONA INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
Year Ended December 31, 2004
See accompanying notes to the consolidated financial statements.
SONA INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
December 31,
1.
Nature of operations
Sona International, Inc. and its wholly owned subsidiaries (Sona Laser Centers, Inc. and National Franchise Realty, Inc.), (collectively, the “Company”) develop, operate and franchise laser hair removal and skin rejuvenation centers, through out the United States of America.
2.
Summary of significant accounting policies
(a)
Principles of consolidation
These consolidated financial statements include the accounts of the Sona International, Inc. and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.
(b)
Marketable securities
Securities consist of a certificate of deposit and are classified as held to maturity.
(c)
Receivables and credit policies
Accounts receivable are uncollateralized customer obligations due under normal trade terms requiring payment within 30 days from invoice date. Notes receivable are generally collateralized by equipment sold to franchisees and are collectible monthly over various terms. Late or interest charges on delinquent accounts are not recorded until collected. The carrying amount of accounts and notes receivable is reduced by a valuation allowance, if necessary, which reflects management’s best estimate of the amounts that will not be collected. The allowance is estimated based on management’s knowledge of its customers, historical loss experience and existing economic conditions.
(d)
Inventories
Inventories consist of products used in the laser hair removal and skin rejuvenation process and are stated at the lower of cost, determined on a first-in, first-out (FIFO) basis, or market (net realizable value).
(e)
Property and equipment
Property and equipment is stated at cost. Depreciation is provided over the assets’ estimated useful lives using the straight-line method ranging from three to seven years. Leasehold improvements are amortized over the shorter of their estimated lives or the respective lease terms.
(f)
Income taxes
The amount provided for income taxes is based upon the amounts of current and deferred taxes payable or refundable at the date of the consolidated financial statements as a result of all events recognized in the consolidated financial statements as measured by the provisions of enacted tax laws.
Deferred income taxes are recognized for differences between the basis of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the expected amount to be realized.
SONA INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(g)
Revenue recognition
Company-owned centers - revenue includes the sale of laser hair removal or skin rejuvenation services and are recognized when the services are performed. Revenue from the sale of products are recognized at the time of product delivery.
Franchise operations - Revenue from franchising activities is recognized based on the terms of the underlying agreements and are included in franchise fee revenue.
Development agreements - In general, the Company’s development agreements provide for the development of a specified number of centers within a defined geographic territory in accordance with a schedule of opening dates. Development schedules cover specified periods of time and typically have benchmarks for the number of centers to opened at six to twelve month intervals. Development agreement fees are collected when the related agreements are executed, are nonrefundable and are included in franchise fee revenue.
Franchise fees - In general, the Company’s franchise agreements provide for the payment of a one-time fee associated with the opening of a new center and an ongoing royalty based on a percentage of center sales and are included in franchise fee revenue.
Development fees and franchise fees are recorded as deferred revenue when received and are recognized as revenue when the centers covered are opened or all material services or conditions relating to the fees have been substantially performed or satisfied by the Company. Royalties are recognized as income monthly when franchisees report their revenues.
The Company provides lasers to its franchisees and Company owned centers under a laser placement agreement whereby revenues from the use of the lasers are shared with the laser manufacturer.
(h)
Advertising and promotion costs
Advertising and promotion costs are expensed as incurred.
(i)
Realization of long-lived assets
Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. If such assets are considered impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.
(j)
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 certain 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.
(k)
New accounting pronouncement
In January 2003, the Financial Accounting Standards Board issued Financial Interpretation No. 46, Consolidation of Variable Interest Entities. This interpretation addresses consolidation by business enterprises of variable interest entities (“VIE”). In December 2003, the FASB issued FIN No. 46(R) , Consolidation of Variable Interest Entities - an interpretation of ARB 51 (revised December 2003), which replaced FIN No. 46.
SONA INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
FIN No. 46(R) was primarily issued to clarify the required accounting for interests in VIEs. FIN No. 46(R)will be effective January 1, 2005 for the Company. Management is currently assessing the impact of FIN No. 46(R) on the Company’s consolidated financial position and results of operations.
3.
Credit risk and other concentrations
The Company generally maintains cash and cash equivalents on deposit at banks in excess of federally insured amounts. The Company has not experienced any losses in such accounts and management believes the Company is not exposed to any significant credit risk related to cash and cash equivalents.
4.
Property and equipment
A summary of property and equipment as of December 31, 2004 is as follows:
5.
Income taxes
The provision for income taxes during 2004 is as follows:
The actual income tax expense differs from the expected income tax expense because Sona Laser Centers, Inc. has taxable income in the State of Tennessee and Tennessee does not allow reporting taxable income on a consolidated basis.
SONA INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Deferred income taxes as of December 31, 2004 include the following amounts of deferred income tax assets and liabilities:
The deferred income tax assets result primarily from the allowance for doubtful accounts, accrued severance and vacation costs and federal and state net operating loss carryforwards. The deferred tax liabilities result primarily from the use of accelerated methods of depreciation of property and equipment for income tax purposes.
The valuation allowance was established to reduce the deferred income tax asset to the amount that will more likely than not be realized. This reduction is provided due to the uncertainty of the Company’s ability to utilize the federal and state net operating loss carryforwards before they expire. The valuation allowance increased approximately $650,000 in 2004.
At December 31, 2004, the Company had federal and state net operating loss carryforwards of approximately $2,508,000 and $777,000, which will begin to expire in 2023 and 2018, respectively.
6.
Long-term debt
A summary of long-term debt as of December 31, 2004 is as follows:
SONA INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
A summary of future maturities of long-term debt as of December 31, 2004 is as follows:
The provisions of the note payable place certain restrictions and limitations upon the Company. These include restrictions or limitations on the payment of dividends, capital expenditures, advances to related parties and affiliates, investments, sales or rentals of property, and additional borrowings. The Company was in compliance with these provisions at December 31, 2004.
7.
Subordinated debt
The Company has entered into a subordinated debt agreement with SONA Holdings, LLC, the Company’s majority stockholder. The agreement requires a lump-sum payment of unpaid principal and interest due on May 24, 2007. Included in interest expense for the year ended December 31, 2004 is non-cash interest totaling approximately $342,000 related to the subordinated debt agreement.
8.
Stockholders agreement
Holders of the Company’s common stock are entitled to vote upon the election of directors and upon any other matter submitted to the stockholders for a vote. Each share of common stock issued and outstanding shall be entitled to one vote. Holders of the Company’s common stock are entitled to dividend and liquidation rights subject the rights of holders of the Company’s Series A Convertible Participating Redeemable Preferred Stock (as described in Note 9).
On May 24, 2004, SONA Holdings, LLC purchased 96% of the outstanding shares of common stock and 100% of the outstanding shares of the Series A Convertible Participating Redeemable Preferred Stock from stockholders in exchange for cash of approximately $6,219,000 and members interest valued at approximately $2,781,000 or a total of $9,000,000. This transaction did not affect the reporting period or the reporting entity. Two stockholders owning one share of common stock each (4% in total) dissented from the sale to SONA Holdings, LLC. This dissent is the subject of litigation between the Company and these two stockholders. Management does not believe this litigation will have a material impact on the Company’s financial position.
9.
Convertible participating redeemable preferred stock
The Company has authorized the issuance of 200 shares of preferred stock, all of which have been designated as Series A Convertible Participating Redeemable Preferred Stock (“Preferred Stock”). The Preferred Stock is entitled to the same voting rights as common stockholders, one vote per share. Holders of the Preferred Stock shall have the right, at their option and at any time, to convert shares of the Preferred Stock into an equal number of shares of the Company’s common stock. The Preferred Stock shall participate in any and all dividends declared by the Board of Directors and paid with respect to the common stock treating each share of Preferred Stock as being equal to the number of shares of common stock.
The Preferred Stock is also entitled to redemption rights. The Company upon receipt of written request for redemption from the holder of the Preferred Stock will redeem the shares of Preferred Stock in
SONA INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
immediately available, legal funds at the greater of the (1) Preferred Stock purchase price or (2) fair market value of the shares of Preferred Stock as determined in good faith by the Company’s board of directors.
In the event of liquidation, the Preferred Stock shall be first entitled, before any distribution or payment is made with respect to the common stock, an amount equal to the greater of, on a per share basis, (i) the original purchase price of the Preferred Stock, which the original purchase price shall be determined by dividing the full amount invested in the Company by the holders of the Preferred Stock or (ii) the amount of per share of Preferred Stock as would be payable had each share been converted to common stock prior to liquidation.
10.
Related party transactions
The Company has an exclusive laser placement agreement and a consulting agreement with Cynosure, Inc. (“Cynosure”), a former stockholder of the Company. The laser placement agreement requires Cynosure to place lasers of the latest available Cynosure technology in all franchisees and Company-owned laser centers. Cynosure must maintain the lasers in good working order. In return, the Company exclusively uses Cynosure lasers and pays Cynosure fees based on cash collected for laser hair removal services. The Company paid Cynosure $177,047 in 2004 for Company owned centers.
The Company has entered into an agreement to purchase two products from companies owned by former stockholders. The products enhance the laser treatments. The agreements are not exclusive and require the related companies to sell the products to the Company at preferred pricing and pay the Company a royalty for using its name in one of the products. The Company purchased $467,360 in 2004 of products from the related companies.
On May 24, 2004, the Company entered in a advisory services agreement with Carousel Capital Company, LLC, a related party, to provide consulting services through May 24, 2011 at an annual advisory fee of $150,000 per year. For the year ended December 31, 2004, the Company accrued and expensed approximately $91,000 related to this advisory agreement.
11.
Franchise agreements
The Company has entered into franchise agreements for 46 markets. At December 31, 2004, 31 centers were open for business and 15 centers were in various stages of development.
12.
Profit-sharing plan
The Company provides a qualified profit-sharing plan for all eligible employees. The Company contributed approximately $102,000 to the plan for 2004.
13.
Commitments and contingencies
The Company leases space for its main office and warehouse facilities and for each of the Company-owned clinics or centers under operating lease agreements that expire at various dates through 2011. Rent
SONA INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
expense under these leases was $391,465 in 2004. At December 31, 2004, the Company is obligated under operating lease agreements to make future minimum lease payments as follows:
The Company is subject to certain governmental regulations at the federal and state levels in relation to the performance of its laser hair removal and skin rejuvenation procedures.
The Company may be exposed to professional liability and other claims by providing laser hair removal procedures and skin rejuvenation to the public. The Company maintains professional liability insurance on each of its centers. Each center also has an independent contractor as medical director, who is a physician and these physicians are required to carry their own professional liability insurance. The Company also maintains professional liability coverage for its directors and officers and general liability insurance.
Four members of management are employed pursuant to long-term employment agreements. The agreements contain termination provisions both for cause and without cause and for a change in control. The agreements provide that the executives will not compete with the Company or induce any employee to leave the Company for periods ranging from 12 to 18 months following the expiration or earlier termination of the agreement. Approximate future minimum payments under these employment agreements are $561,000 in 2005 and 2006, $409,000 in 2007, and $161,000 from 2008 to 2010.
The Company has a letter of credit outstanding with a bank at December 31, 2004 totaling approximately $55,000.
14.
Advertising
Advertising costs of $1,687,985 were expensed during 2004.
15.
Accrued Expenses
Accrued expenses included the following items which exceeded 5% of current liabilities at December 31, 2004:
16.
Subsequent Event
During 2005 and 2006, ten franchisees of the Company filed lawsuits or arbitrations (collectively the “Actions”) in which they allege various claims, including violations of state franchise laws, fraud and negligent misrepresentation by the Company. These Actions seek rescission of their franchise agreements with the Company and also seek compensatory damages ranging from $600,000 to $4,500,000 per Action. The franchisees are also seeking treble and punitive damages. The Company is vigorously defending each Action. Of the ten Actions, six were originally filed as lawsuits and the Company has filed motions to dismiss or stay the litigation pending arbitration in each case. To date, the courts have granted two of these motions, two
SONA INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
motions are pending, one plaintiff has dismissed a lawsuit, and the last lawsuit was dismissed by stipulation of the parties. The remaining four original Actions were filed as arbitrations. The current status is therefore two pending lawsuits, six filed arbitrations, and two former lawsuits which may be refiled as arbitrations.
These franchisees have discontinued paying the Company the royalty fees due in accordance with their respective franchise agreements. While management of the Company believes these lawsuits are without merit and is vigorously defending them, an adverse outcome may have a material impact on the operating results and the financial position of the Company, which would raise substantial doubt about the ability of the Company to continue as a going concern.
EXHIBIT INDEX
*
Management contract or compensation plan or arrangement required to be filed as an exhibit pursuant to Item 15(c) of Form 10-K.

Confidential treatment granted as to certain portions, which portions have been omitted and filed separately with the Securities and Exchange Commission.