ITEM 1. BUSINESS
In addition to historical facts or statements of current conditions, our disclosure and analysis in this Form 10-K contain some forward-looking statements. See the discussion of forward-looking statements in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operation” included in this Form 10-K.
Unless the context indicates otherwise, the terms “Orthovita,” “Company,” “we,” “us” or “our” herein refers to Orthovita, Inc. and, where appropriate, one or more of our subsidiaries.
GENERAL DEVELOPMENT OF OUR BUSINESS
We are an orthobiologics and biosurgery company which develops and markets novel medical devices. The orthobiologics platform offers products for the fusion, regeneration, and fixation of human bone. The biosurgery platform offers products for controlling intra-operative bleeding, also known as hemostasis. Our current fusion and regeneration products are based on our proprietary VITOSS® Bone Graft Substitute technology and address the non-structural bone graft market with synthetic, bioactive alternatives to patient- and cadaver-derived bone tissue. Our proprietary CORTOSS® Bone Augmentation Material, an injectable, polymer composite which mimics the structural characteristics of human bone, provides the basis for our fixation portfolio. CORTOSS Bone Augmentation Material is approved for certain uses in certain countries outside the U.S. and is under review for regulatory clearance in the U.S. for vertebral augmentation. Our hemostasis portfolio includes VITAGEL® Surgical Hemostat, a proprietary, collagen-based matrix that controls bleeding and facilitates healing, and VITASURE™ Absorbable Hemostat, a proprietary plant-based product that can be deployed quickly throughout surgery. We also market accessories and delivery products which complement our orthobiologics and biosurgery platforms.
We seek to expand our product portfolio through internal product development efforts, co-development efforts with strategic partners and acquisition opportunities. We employ in-house research and development personnel in support of our technology platforms. We internally developed our VITOSS and CORTOSS materials and maintain an ongoing internal research and development program. In addition, we work jointly with Kensey Nash Corporation (Kensey) to develop and commercialize certain orthobiologics products, and we have acquired rights from third parties to market VITAGEL and VITASURE. We continue to pursue in-licensing, co-development and other opportunities to acquire complementary products and technologies to broaden our product offerings and further leverage our sales force.
Other Sales and Corporate Information
We market and sell our VITOSS products, the IMBIBE® Bone Marrow Aspiration and Delivery Devices (used with VITOSS), VITAGEL, CELLPAKER and VITASURE products through a U.S. field sales network of direct sales representatives and independent distributors. As of December 31, 2008, we had approximately 87 direct sales representatives and arrangements with approximately 30 independent distributors that we utilize to market and sell our products in the U.S. We continue to strengthen our field sales network through the addition of direct sales representatives in those U.S. sales territories where either we do not have independent distributor coverage or the territories are underserved. Outside the U.S., we primarily utilize a network of independent stocking distributors to market VITOSS, CORTOSS, the ALIQUOT® Delivery System (a system designed to facilitate effective delivery of our CORTOSS product), VITAGEL, CELLPAKER and VITASURE products.
Information regarding our product sales by geographic markets for 2008, 2007 and 2006 is included in Note 13 (Product Sales) to the consolidated financial statements included in this report.
We market our products for only the indication(s) or use(s) that have received regulatory approval or clearance.
We incorporated in Pennsylvania in 1992 and maintain a branch operation in Belgium, as well as wholly-owned subsidiaries in the United Kingdom and Pennsylvania for various non-U.S. sales activities, and a wholly-owned subsidiary incorporated in Delaware to hold certain intangible properties.
Our principal executive offices are located at 77 Great Valley Parkway, Malvern, Pennsylvania 19355, and our telephone number is (610) 640-1775. We maintain a website at www.orthovita.com and make available free of charge on this 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 these materials with, or furnish them to, the U.S. Securities and Exchange Commission. The reference to our website is intended to be an inactive textual reference only.
OUR PRODUCTS AND PRODUCT CANDIDATES
As further discussed below under the caption “GOVERNMENT REGULATION,” our products and product candidates are subject to extensive regulation as medical devices by the U.S. Food and Drug Administration (FDA), regulatory authorities in Europe and regulatory authorities in other jurisdictions. In the European Union (EU), we have selected KEMA as our notified body (Notified Body) under the Medical Devices Directive (“MDD”). Product approval or clearance applications for our products must be supported by valid scientific evidence, and may require clinical trial data, to demonstrate the safety and effectiveness of the products.
VITOSS Bone Graft Substitute
VITOSS is an ultra-porous resorbable beta-tricalcium phosphate bone void filler used to help the body guide the three-dimensional regeneration of the patient’s own bone. We launched VITOSS in the U.S. and the EU in 2001 and have sold approximately 275,000 units through December 31, 2008. VITOSS’s ultra-porosity allows it to soak and hold its own volume in blood and bone marrow aspirate and has been shown to perform well in an array of applications in the spine, extremities and pelvis, such as spinal grafting and the treatment of bone defects due to trauma, degenerative disease and tumors, including posterolateral spine fusion procedures. VITOSS integrates well into existing bone and allows for bone in-growth and maturation. VITOSS, the VITOSS FOAM products and the VITOSS Bioactive FOAM products are covered by issued and pending U.S. and non-U.S. patents.
Since the initial U.S. regulatory clearance and subsequent product launch in mid-2001, we have developed and are developing a number of new VITOSS-based products and related delivery devices that are designed to expand the market for our VITOSS products by broadening the range of surgical indications and by addressing additional
surgeon preferences and needs. In 2003, we entered into a development, manufacturing and supply agreement with Kensey, leading to the development and launch of the VITOSS FOAM product platform. The VITOSS FOAM products combine our base VITOSS technology with Kensey’s proprietary resorbable biomaterials to produce a wide array of pliant, flexible, flowable and compression resistant bone graft materials. The VITOSS FOAM products have the ability to soak and hold their own volume in blood and bone marrow aspirate while retaining these biological fluids in pliable and compression resistant forms. These forms can be designed into specific shapes and material characteristics to meet a surgeon’s need for handling and delivery in a variety of surgical approaches and applications. We launched our VITOSS Bioactive FOAM strip product as part of a controlled rollout in the first quarter of 2008, and fully launched the product during the second quarter of 2008. We launched our VITOSS Bioactive FOAM pack product during the end of the third quarter of 2008. In addition to our proprietary VITOSS beta-tricalcium phosphate bone graft substitute and Kensey’s proprietary resorbable biomaterials, VITOSS Bioactive FOAM products also contain our proprietary combeite bioactive glass.
Bone Defect Grafting. Injury or trauma to the bone, degenerative conditions, disease and aging all affect the health and viability of the human skeleton. These conditions often result in the need for the repair of bone defects through a bone grafting procedure. We estimate that approximately 1,000,000 bone grafting procedures on a worldwide basis are performed each year in the spine, extremities and pelvis. Bone grafting material is either (i) autograft material, which is often obtained or harvested from the iliac crest region of the patient’s own hip, (ii) allograft material, which is obtained from a cadaver, or (iii) synthetically derived materials that provide one or more components of either bone-like scaffold (such as VITOSS), cells or signals (such as bone morphogenic proteins). VITOSS has been used in bone grafting procedures as a bone graft substitute to provide a synthetic scaffold in a variety of applications, including those of the extremities, spine and pelvis. When used with the patient’s bone marrow, VITOSS provides all components of scaffold, cells and signals.
A harvest of autograft material involves an additional procedure that extends surgical time, adding to costs and increasing blood loss and patient risk of infection or adverse reaction from the additional time under anesthesia. In addition, harvesting bone for autograft sometimes causes protracted pain that may necessitate additional medical care after the surgical procedure. Using VITOSS instead of autograft material may avoid these potential complications.
Disadvantages of allograft bone include the possibility of disease transmission, antigenic response and quality variability from donor to donor. VITOSS is a synthetic beta-tricalcium phosphate material without these possible disadvantages.
Spinal Fusion and Grafting. Many patients affected by severe back pain due to degeneration of one or more discs are often treated with spinal surgical procedures. We estimate that each year approximately 500,000 spinal fusion procedures are performed in the United States. In cases where the patient has advanced disc degeneration or spinal instability, a fusion procedure can involve a surgical incision in the patient’s back or abdomen to access and remove the affected disc material. To provide initial stability and support of the surrounding vertebrae, the resulting defect is filled with a structural implant made of either titanium, shaped bone derived from a human cadaver, or a synthetic material known as polyetheretherketone (“PEEK”). Adjunctively, these procedures may require the use of bone grafting material repair defects and facilitate the fusion of two bony elements. We believe the use of VITOSS provides a clinically proven alternative to patient- or cadaver-derived tissues and may be preferable for both patients and their surgeons for its efficacy and safety.
Trauma. Physical trauma such as falls and accidents can result in bone fracture or damage. Fractures of broken bones are often realigned with hardware, such as plates, rods and screws. Once the hardware has been used to recreate the skeletal anatomy and to provide the stability of the bony structure, there are often defects or voids in the bone which remain. Those voids may require the use of bone graft material. The goal of bone grafting in trauma applications is to rapidly heal the damaged bone. Approximately 250,000 trauma related bone graft repairs are performed annually on a worldwide basis. Autograft, cadaver allograft, as well as synthetic scaffolds like VITOSS, are used for trauma related bone graft repairs. VITOSS has been used as a bone graft substitute in a variety of trauma applications, including those of the extremities, spine and pelvis.
Dental, Periodontal, Oral and Cranio-Maxillofacial. In August 2002, we entered into a supply agreement with BioMimetic Therapeutics, Inc. for our proprietary VITOMATRIX™ particulate synthetic scaffold biomaterial, which we produce in the same process used to manufacture VITOSS. In January 2008, in connection with the sale of its dental business to Luitpold Pharmaceuticals, Inc., BioMimetic assigned its rights and obligations under the supply agreement to Luitpold. Under the agreement, we supply our proprietary beta tricalcium phosphate biomaterial to Luitpold for its clinical and commercial use in combination with rhPDGF. Luitpold markets the combined product in the dental, periodontal, oral and cranio-maxillofacial bone grafting markets through its Osteohealth Company division.
Bone Marrow Aspiration System with IMBIBE Needles, Syringes and IMBIBE Disposable Delivery Instrumentation, used with VITOSS
The disposable IMBIBE devices provide spine and orthopedic surgeons with a simple method for harvesting a patient’s own bone marrow, mixing it with VITOSS, and delivering the mixture to the bone graft site. We believe IMBIBE, when used together with VITOSS, will provide greater flexibility and options for surgeons. IMBIBE is covered by a U.S. issued patent.
VITAGEL Surgical Hemostat and Accessories
VITAGEL is an FDA-approved, CE-marked composite liquid hemostat that combines the biomaterials bovine thrombin and bovine collagen with the patient’s autologous plasma. When applied to the surgical site, VITAGEL creates a safe adherent matrix and an impermeable barrier to blood flow. VITAGEL has been marketed to general surgeons and is applicable in the spine, hip and knee replacement surgery markets, where bleeding is a significant complication for many routine surgeries. After obtaining the right to sell CoStasis from Angiotech, we rebranded CoStasis as VITAGEL Surgical Hemostat in January 2005 with CELLPAKER accessories, and relaunched the product in the U.S. within our existing orthopedics and spine-based sales channel, utilizing the same marketing strategy that we use for all of our VITOSS-related products. This strategy provides our sales network additional functional biomaterial products to offer to customers. During the first half of 2006, we launched the VITAGEL Spray Set in the U.S. We obtained the CE Mark for VITAGEL, CELLPAKER and related accessories in July 2007 and launched these products in the European Union in the first quarter of 2008. VITAGEL and CELLPAKER are covered by U.S. and non-U.S. issued patents owned by Angiotech.
VITASURE Absorbable Hemostat
VITASURE Absorbable Hemostat
PMA approved, distribution rights initially obtained April 2008
Approved in European Union September 2002
(See GOVERNMENT REGULATION below)
VITASURE is an FDA-approved, CE-marked, plant-based hemostat product that can be deployed quickly throughout surgery. Through proprietary microporous polysaccharide hemosphere technology, VITASURE acts as a molecular sieve to quickly extract fluids from blood, creating an osmotic action that causes the VITASURE particles to swell and concentrates serum proteins, platelets, and other elements on the surface. The VITASURE particles and their coating of compacted cells then create a matrix for the formation of a tenacious fibrin clot. We obtained the right to distribute VITASURE in the U.S. and certain other territories for orthopedic and spine applications in 2008 from Medafor, Inc. We launched the VITASURE product in the U.S. in 2008 and in certain non-U.S. territories in January 2009. VITASURE is covered by U.S. and non-U.S. issued patents owned by Medafor and its licensor.
Near-Term Product Development
We have developed and are continuing to develop new products under our approved VITOSS, VITAGEL and IMBIBE product platforms. We may seek to bring VITOSS, VITAGEL and/or IMBIBE product line extensions to market in the U.S. through the 510(k) or PMA regulatory process (see GOVERNMENT REGULATION below). These product line extensions will be in addition to our U.S. CORTOSS investigational device exemption (“IDE”) clinical program, which is described below.
CORTOSS Bone Augmentation Material
CORTOSS is a self-setting glass ceramic polymeric composite engineered specifically to mimic the characteristics of human bone and to provide fixation for vertebral compression fractures (“VCFs”). Laboratory tests demonstrate that CORTOSS exhibits compressive strength similar to human bone. For patients with poor bone healing, as seen in osteoporotic patients, CORTOSS may be used in a variety of surgical procedures to quickly provide structural stability and reinforcement of the bones after surgery. The surgeon’s goal is to repair the patient’s bone and enhance the patient’s mobility as quickly as possible since prolonged bed rest or inactivity may result in decreased overall health for older or osteoporotic patients.
CORTOSS’s simple mix-on-demand delivery system design allows for minimum waste and maximum ease of use and flexibility for the surgeon. CORTOSS is an injectable material that is delivered through a pre-filled, unit dose, disposable cartridge. Delivery of CORTOSS to the surgical site may be started and stopped for a
prolonged period of time throughout the surgical procedure as polymerization is initiated only when CORTOSS is expressed through its static mix-tip. The polymerization is a self-setting reaction that causes CORTOSS to harden within minutes. CORTOSS provides two stages of fixation: immediate mechanical interlock into porous bone, followed by intimate bone apposition over time along the contours of its surface. CORTOSS is covered by several U.S. issued patents and other U.S. and non-U.S. patent applications are pending.
We received CE Certification for CORTOSS for use in screw augmentation procedures in October 2001 in the EU and regulatory approval in March 2001 in Australia, which enables us to sell CORTOSS in these territories as well as in other countries that have adopted the EU’s regulatory standards. Screw augmentation is a procedure for securing the fixation of bone screws used in patients with weak bone caused by osteoporosis. We initiated a limited launch of CORTOSS in Europe in December 2001. We successfully completed post-marketing human clinical studies in Europe for the use of CORTOSS in hip compression screw augmentation. In addition, during January 2003, we received CE Certification in the EU to market CORTOSS for vertebral augmentation of VCFs of the spine. Vertebral augmentation of VCFs is a procedure for repairing fractured vertebrae that can be performed on an outpatient or short-stay basis. We have sold approximately 12,000 units of CORTOSS through December 31, 2008. In 2007, we completed two FDA-approved IDE pilot clinical studies in the U.S. for the use of CORTOSS in vertebral augmentation of VCFs using the vertebroplasty and kyphoplasty surgical techniques, respectively. Both surgical techniques involve the injection of a self-setting material into the vertebral body to provide internal fixation of the VCF. Upon FDA review of the vertebroplasty pilot clinical data, we received approval from the FDA to begin patient enrollment in a prospective, randomized controlled pivotal phase of that clinical study. See “GOVERNMENT REGULATION-CORTOSS” below for more information about the design of the pivotal study. The pivotal study was fully enrolled in February 2007 with 162 CORTOSS patients and 94 polymethylmethacrylate (“PMMA”) control group patients. All 24-month post-procedure follow up for patients was completed in the first quarter of 2009. Our 510(k) application for the use of CORTOSS in vertebral augmentation is under review by the FDA (see GOVERNMENT REGULATION below). FDA clearance of CORTOSS would permit us to market and sell the material in the United States.
Vertebral Augmentation of VCFs. We estimate there are approximately 700,000 patients in the U.S. with VCFs caused by osteoporotic bone or bone cancer resulting in severe pain and immobility. Of these, we believe approximately 225,000 fractures are treated annually using vertebroplasty or kyphoplasty techniques. The traditional treatments, e.g., bed rest, bracing, narcotics or anesthetic injections, do not address the underlying fracture. Vertebral augmentation of VCFs has been reported to provide early pain relief in up to 90% of osteoporotic patients. Early relief of pain provided by vertebral augmentation of VCFs enables patients to maintain better functional capacity. Functional capacity, in turn, is believed to be directly related to the ability to live independently and unassisted. We are not aware of any product that has received FDA approval or CE Certification for use in this procedure on the basis of prospective, controlled clinical data. However, since 2004, several versions of PMMA bone cement have been 510(k) cleared by the FDA. We believe CORTOSS may have several advantages over PMMA in vertebral augmentation of VCFs, such as its lower temperature setting that reduces the risk of tissue necrosis associated with PMMA, its higher compression strength and its ability to be mixed on demand. In addition, unlike PMMA, CORTOSS does not release volatile free unreacted methylmethacrylate monomer into the patient’s body. Although documented complications of monomer released from PMMA may be rare, they are severe adverse events when they occur.
Screw Augmentation. Worldwide each year, we estimate approximately 1,500,000 orthopedic procedures are performed using internal fixation devices that involve screws, including pedicle, trauma and hip fracture screws. CORTOSS may be used in those procedures where the screws “strip” or fail to hold the integrity of the internal fixation construct due to poor bone quality, as is often the case with osteoporotic bone. Where screws fail to hold, current treatment options include: (i) replacing the screw with a screw of larger diameter, which may further weaken the bone and is not always possible because of the size of the screw holes and/or the bone, or (ii) augmenting the screws with PMMA bone cement, which is cumbersome and time consuming. PMMA must be manually mixed and transferred into a syringe for application. After mixing, there is only a small time window in which the PMMA can be used before it sets, making it difficult to augment more than one screw at a time.
Additionally, PMMA bone cement is not approved in either Europe or the U.S. for pedicle, trauma or hip fracture screw augmentation. We believe the use of CORTOSS to anchor the screw in a quick and efficient way enables the full function of the screw to be restored.
ALIQUOT Delivery System
Our ALIQUOT Delivery System facilitates delivery of materials to bony sites, including delivery of our CORTOSS product directly to the surgical site. A coaxial system of catheter and syringe dispenser is designed to assure effective delivery of material in vertebral augmentation of VCFs and screw augmentation procedures. During the second quarter of 2002, we received CE Certification from our Notified Body for certain ALIQUOT kit configurations. The ALIQUOT system was used as part of our European multi-center prospective clinical study for CORTOSS in vertebral augmentation of VCFs and was used in the U.S. clinical studies for CORTOSS in vertebral augmentation of VCFs. ALIQUOT is exempt from 510(k) clearance. ALIQUOT is covered by issued and pending U.S. and non-U.S. patents.
STRATEGIC PARTNERSHIPS
Kensey Agreement
In March 2003, we entered into an agreement with Kensey to jointly develop and commercialize certain orthobiologics products based upon our VITOSS platform. The new products developed under this agreement are based on our internally developed, proprietary VITOSS bone graft substitute material in combination with proprietary resorbable Kensey biomaterials. To date, the products covered by the Kensey agreement for which we have received 510(k) clearance from the FDA are our VITOSS FOAM and VITOSS Bioactive FOAM products.
Kensey has the exclusive right to manufacture any approved or cleared jointly developed products under the agreement, and we market and sell these products worldwide. Following the regulatory approval or clearance of each new product, we have obligations under the agreement to pay Kensey for manufacturing the product and make royalty payments to Kensey based on the net sales of the product. These rights and obligations extend until at least February 2024 for our VITOSS Bioactive FOAM product, and until February 2014 for our other products under the VITOSS FOAM product platform.
Approximately 63% of our product sales during 2008 was from products based upon our VITOSS FOAM platform which are covered by the agreement, including VITOSS Bioactive FOAM.
Angiotech Agreements
In June 2004, we entered into a distribution agreement with Angiotech Pharmaceuticals (U.S.), Inc. (collectively with its affiliates and parent company Angiotech Pharmaceuticals, Inc., “Angiotech”), to distribute to surgical customers throughout North America Angiotech’s CoStasis® composite liquid hemostat (which we re-branded as VITAGEL Surgical Hemostat) and the CELLPAKER® plasma collection system used in conjunction with VITAGEL. Under the distribution agreement, we purchased the products from Angiotech and paid royalties based on the net sales of such products. During the third quarter of 2005, the distribution agreement was amended to provide for the transition of product and accessory manufacturing responsibility from Angiotech to us, and we purchased all available existing VITAGEL and CELLPAKER products, accessories and work-in-process from Angiotech for $1,800,000. Effective January 1, 2006, we entered into a license agreement with Angiotech pursuant to which Angiotech licensed VITAGEL products and the CELLPAKER plasma collection system to us and we assumed manufacturing responsibility for these products. In the second half of 2006, we obtained pre-market approval (“PMA”) from the FDA to sell VITAGEL manufactured at our Malvern, Pennsylvania facility (the “VITAGEL PMA”) and started to market and sell VITAGEL manufactured by us. In January 2007, we obtained approval from the FDA for a PMA supplement which enables us to market and sell CELLPAKER manufactured at our subcontractor’s facility. In accordance with its terms, the distribution
agreement terminated in the first quarter of 2007 upon completion of the sale of all VITAGEL and CELLPAKER inventory products that we purchased from Angiotech in the third quarter of 2005. Until December 29, 2006, we paid royalties on sales of the VITAGEL and CELLPAKER inventory that we purchased from Angiotech in the third quarter of 2005 in accordance with the terms of the distribution agreement.
On December 29, 2006, pursuant to a royalty sale agreement with Angiotech, we purchased the profit-sharing royalty rights for VITAGEL and CELLPAKER products under the license agreement for $9,000,000 in cash. We recorded non-cash amortization expense related to this license right intangible of $850,352 in each of 2007 and 2008, and anticipate that we will record an annual non-cash amortization expense of at least $850,352 in each year thereafter through July 31, 2017. Concurrently with this purchase, we amended and restated our license agreement with Angiotech to eliminate our obligations to meet minimum sales requirements, extend the term of the license from December 31, 2014 through July 31, 2017, and eliminate certain termination rights in favor of Angiotech. Under the amended and restated license agreement, we have exclusive rights to manufacture, market and sell VITAGEL products throughout the world for orthopedic indications, and non-exclusive rights to manufacture, market, and sell CELLPAKER products throughout the world for all indications. Under the amended and restated license agreement, Angiotech has an option for co-exclusive rights outside the orthopedic field which, if exercised, would permit Angiotech to manufacture, market and sell an Angiotech-branded VITAGEL product throughout the world. Until Angiotech elects to exercise its option for co-exclusive rights, we have exclusive rights to manufacture, market and sell VITAGEL outside of the orthopedic field throughout the world. If Angiotech elects to exercise its option, we would then have co-exclusive rights to manufacture, market, and sell VITAGEL outside of the orthopedic field throughout the world. Prior to the amendment and restatement of the license agreement on December 29, 2006, we were required to make royalty payments thereunder based on a share of all revenue we received from net sales of VITAGEL and CELLPAKER products that we manufactured.
VITASURE Distribution Agreement
In April 2008, we obtained from Medafor, Inc. certain non-exclusive rights to distribute VITASURE Absorbable Hemostat pursuant to a distribution agreement. Our territory under the agreement currently consists of the United States, Australia, Belgium, Germany, Ireland, South Africa, Spain and the United Kingdom. We satisfied our minimum purchase obligation under the agreement for 2008 by purchasing $1,000,000 of VITASURE in the third quarter of 2008. We have no outstanding minimum purchase or sale requirements under the agreement, other than the obligation to purchase and pay for at least $1,000,000 of product from Medafor in the third quarter of 2009. The initial term of the agreement is scheduled to expire in December 2013 and we have the right to renew the agreement for an additional three year period if we meet certain purchase obligations during the fifth year of the agreement.
SIGNIFICANT CONTRACTUAL OBLIGATIONS
See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operation,” of this report for a discussion of significant contractual arrangements relating to (i) our leases, (ii) our joint product development and commercialization arrangement with Kensey, (iii) our senior secured note facility with LB I Group Inc., (iv) our contractual obligation to purchase minimum VITASURE product inventory in 2009, (v) expansion of manufacturing capacity and other facility renovations, and (vi) product development milestone and related payments.
OUR RESEARCH & DEVELOPMENT
We employ the disciplines of composites engineering, polymer science, biologics processing, solution chemistry and nanoparticulate ceramic glass science to create our orthobiologics and biosurgery materials technology platforms. We then utilize technologies developed, co-developed or licensed by us to commercialize orthobiologic and biosurgery products for orthopedic and surgical applications. Patents have been issued and
additional patent applications have been filed to protect our key developments. See “Patents and Proprietary Intellectual Property” below for additional information. We incurred approximately $6,711,000, $6,435,000, and $8,472,000 in research and development expenses in 2008, 2007 and 2006, respectively.
PATENTS AND PROPRIETARY INTELLECTUAL PROPERTY
Our strategy is to seek protection for our product technologies and manufacturing methods through the use of U.S. and non-U.S. patents. We have filed or intend to file applications as appropriate for patents covering our technologies, products and processes. As of February 20, 2009, certain of the products that we have developed or market are covered by one or more of our 20 issued U.S. patents, 19 pending U.S. patent applications and numerous counterparts of certain of these patents and pending patent applications outside the U.S., including Canada, Europe, Mexico and Japan. Our issued patents are set to expire between 2015 and 2025. The key patents covering the VITAGEL product that we market are set to expire in 2017, and the patent covering VITASURE is set to expire in 2019.
MANUFACTURING AND PRODUCT SUPPLY
The manufacture of our products is subject to regulation and periodic inspection by various regulatory bodies for compliance with current FDA Quality System Regulations, EU Medical Devices Directive, International Organization for Standardization (“ISO”) 9000 Series standards, ISO 13485/European Norm (“EN”) 13485 and equivalent requirements.
In-House Manufacturing. Our 24,800-square foot VITOSS, VITAGEL and CORTOSS manufacturing facilities that produce our commercial products are leased through July 2017 and are certified as meeting the requirements of ISO 9000: 2000 and EN 13485 for the period July 1, 2006 through July 1, 2009, and we expect to receive renewal of this certification by the second quarter of 2009 for an additional three-year period. These facilities are subject to inspection by the FDA for compliance with FDA device manufacture requirements. We believe our existing manufacturing facilities have the capacity to meet our commercial needs through at least 2012, assuming that, with respect to VITAGEL only, we obtain the requisite regulatory approval for our VITAGEL collagen processing facility as described in the following paragraph in the second half of 2010. In 2008, we completed renovations at our leased space to expand our capacity to manufacture VITAGEL and received approval from the FDA in January 2009 for this expanded portion of our VITAGEL manufacturing facility. We are also in the process of further expanding our VITAGEL manufacturing capacity and expect to submit a PMA supplement for this additional production line in the second quarter of 2009.
In the first quarter of 2008, we commenced renovating another leased space to establish a 10,700-square foot facility to process collagen used as a raw material in the manufacture of VITAGEL. This facility is leased through 2017. We expect to complete these renovations and submit a PMA supplement with the FDA for this facility in the third quarter of 2009. We believe that we have sufficient inventory of processed collagen acquired from a third party to meet our commercial needs for VITAGEL into the second half of 2010 (see-Raw Materials Supply below). We plan to fully transition the processing of collagen for VITAGEL in-house by early 2010. However, we cannot market commercial VITAGEL product containing collagen processed at our processing facility until the requisite PMA supplement for this facility has been approved by the FDA (see “GOVERNMENT REGULATION” below), which we do not expect will occur prior to 2010. As part of the establishment of our collagen processing facility, we acquired collagen production equipment and a non-exclusive, perpetual, royalty-free, irrevocable license to certain collagen production process technology and know-how from Allergan in September 2008. The license rights are limited to certain uses, including those related to the processing and production of collagen for surgical hemostats such as VITAGEL.
In 2008, we completed renovations at our leased space to expand our capacity to manufacture ALIQUOT, IMBIBE and CELLPAKER. We plan to submit an application to the FDA in the third quarter of 2009 for the manufacture of CELLPAKER at this renovated facility. We are not required to obtain regulatory approval to manufacture ALIQUOT and IMBIBE at this facility.
Third Party Manufacturers. We are manufacturing CELLPAKER, IMBIBE and ALIQUOT through outside third-party contract manufacturers. Our VITOSS is converted to VITOSS FOAM and VITOSS Bioactive FOAM by Kensey, our development partner under a long-term supply agreement. We purchase VITASURE from Medafor, which uses third-party manufacturers to make this product. Our and Medafor’s third-party manufacturers are regulated by government agencies and are required to be ISO 9001/EN 13485 certified or otherwise meet our quality system requirements (See “GOVERNMENT REGULATION” below).
Raw Materials Supply. Our ability to manufacture our products is dependent on a limited number of specialty suppliers of certain raw materials.
A key raw material for manufacturing VITAGEL is processed collagen that is derived from bovine hides. In September 2008, we acquired a strategic amount of processed collagen raw material from Allergan for use in the manufacture of VITAGEL after Allergan informed us of its intention to close its collagen processing plant and terminate a collagen supply agreement with us. We believe the strategic collagen reserve acquired from Allergan in 2008 will be sufficient to meet our commercial needs for VITAGEL into the second half of 2010. While we believe that bovine hides are available from various sources, the type of collagen necessary for VITAGEL in processed form is difficult to obtain. For this reason, we are establishing a facility to process collagen for VITAGEL, and expect to commence our in-house processing of collagen for VITAGEL by the third quarter of 2009. However, we must receive the requisite regulatory approvals for a collagen processing facility before we may sell VITAGEL containing collagen processed at a new facility. We do not expect to receive any such approval prior to 2010. We are also in the process of negotiating agreements for the supply of bovine hides.
We have various supply agreements with third parties for raw materials used in products we manufacture, and we have a supply agreement with Kensey for bovine collagen used in our VITOSS FOAM and VITOSS Bioactive FOAM product lines. However, we do not have supply agreements for all raw materials. The failure of any supplier to continue to provide us with materials at a price or quality acceptable to us, or at all, or our inability to find an alternative supplier with acceptable prices and quality, would have a material adverse effect on our ability to manufacture our products.
SALES AND MARKETING
We have a U.S. field sales network of direct sales representatives and independent non-stocking distributors who market VITOSS, VITAGEL, CELLPAKER, IMBIBE and VITASURE products. We continually seek to strengthen our field sales network through the addition of direct sales representatives in those U.S. sales territories where either we do not have independent distributor coverage or the territories are underserved. Outside the U.S., we primarily utilize a network of independent stocking distributors to market VITOSS, CORTOSS, ALIQUOT, VITAGEL, CELLPAKER and VITASURE products.
COMPETITION
Extensive research efforts and rapid technological change characterize the market for products in the orthopedic, orthobiologics and biosurgery markets. We face intense competition from medical device and biomedical technology companies. Our products could be rendered noncompetitive or obsolete by competitors’ technological advances. We may be unable to respond to technological advances through the development and introduction of new products. Moreover, many of our existing and potential competitors have substantially greater financial, marketing, sales, distribution, manufacturing and technological resources than us. These competitors may also be in the process of seeking FDA or other regulatory approvals, or patent protection, for new products. Our competitors could, therefore, commercialize new competing products in advance of our products. There can be no assurance that we will be able to compete successfully against current or future competitors or that competition will not have a material adverse effect on our business, financial condition and results of operations.
We believe VITOSS faces competition from numerous synthetic products, bone morphogenic proteins (BMPs), stem cell-based products and cadaver-based products, such as demineralized bone matrix (DBM) products, currently on the market that may be used for the same indications as our products as well as other products and technologies that may enter the market in the future. In 2004, lumbar total disc replacement (TDR) devices were introduced in the spinal market as a treatment alternative for degenerative disc disease designed to preserve the motion of the vertebrae of the spine. However, we believe that several factors may mitigate against the broad use of lumbar TDR devices, including the need for surgeon training, the high level of surgeon technical skills required, surgeon concern regarding the challenges of TDR revision surgery should that become necessary due to loosening or subsidence of the device over time, and procedure reimbursement. In 2007, cervical TDR devices were introduced in the spine market. As they may require a lower level of surgical technical skill than lumbar TDR devices, cervical TDR devices could become more widely adopted than lumbar TDR devices. TDR devices, particularly cervical TDR devices, could negatively impact the spinal fusion market which could in turn adversely impact the use of VITOSS in spine grafting procedures. It is too early to estimate the rate at which the market will ultimately adopt this or comparable technology as a treatment alternative or its resulting impact on our products.
VITAGEL is approved by the FDA as a surgical hemostat where bleeding may be a significant complication for many routine surgeries. As such, VITAGEL can be marketed broadly to general surgeons and is applicable in the spine, hip and knee replacement surgery markets. VITAGEL faces competition from several more established surgical hemostat products marketed by other companies with substantially greater resources than us. However, we believe VITAGEL offers unique advantages in comparison to these other products in terms of VITAGEL’s quick and easy preparation for use, as well as its use of the patient’s autologous plasma instead of pooled donated human plasma as is the case with the leading products in the market. In 2008, recombinant human thrombin was approved for sale in the U.S. We believe that recombinant human thrombin will be positioned as an improvement to bovine-derived thrombin, a raw material in our VITAGEL product, which could adversely affect our sales of VITAGEL. It is too early to estimate the effect of this new technology on our VITAGEL product. If management believes this effect to be material and adverse to our VITAGEL sales, it will consider alternative formulations of VITAGEL and the regulatory approvals that may be required for any such alternative formulations.
VITASURE competes with several thrombin products and surgical hemostats on the basis of its safety profile and pricing.
CORTOSS is under clinical development in the U.S. for use in the vertebral augmentation of VCFs and has received CE Certification for use in vertebral augmentation of VCFs and in screw augmentation. If CORTOSS is cleared by the FDA for use in vertebral augmentation of VCFs, it will face competition from the several PMMA bone cement products that have been 510(k) cleared by the FDA since 2004 for this indication. Outside the U.S., CORTOSS is facing competition from several other PMMA bone cement products that have received CE Certification since 2004 for this indication. We do not know of any products that have received FDA approval or a CE Certification for use in screw augmentation or for which such approval is being sought.
GOVERNMENT REGULATION
In order to market our products, we must apply for, be granted and maintain all necessary regulatory approvals, clearances and certifications. In addition, we must comply with all regulatory requirements in each applicable jurisdiction. We have received 510(k) regulatory clearance in the U.S. from the FDA in December 2000, and CE Certification in the EU from our Notified Body in July 2000 for VITOSS. We also received regulatory approval to sell VITOSS in Australia and Canada in March 2001 and June 2004, respectively. The CE Certification permits us to sell our approved products in all of the countries of the EU as well as in other countries, such as Switzerland and Turkey that have mutual recognition agreements with the EU or have adopted the EU’s regulatory standards. We received 510(k) regulatory clearance for VITOSS Canisters and VITOSS FOAM in November and December 2003, respectively, in the U.S. from the FDA. We received 510(k) regulatory clearance for VITOSS Bioactive FOAM and VITOSS Bioactive FOAM in September 2007 and September 2008,
respectively. In September 2001 and June 2005, we received 510(k) regulatory clearance in the U.S. from the FDA to market our IMBIBE product for use as a bone marrow aspiration syringe and needle, respectively. In July 2007, we received CE Certification for VITAGEL and CELLPAKER, which products are covered by PMA approvals from the FDA obtained by our licensor of such products. VITASURE is covered by a PMA and CE Certification obtained by the entity that granted us distribution rights for the product.
CORTOSS
We received CE Certification for CORTOSS in October 2001 in the EU and regulatory approval in March 2001 in Australia, which enables us to sell CORTOSS in these territories for use in securing the fixation of bone screws in patients with weak bone caused by osteoporosis. In addition, during January 2003 our CE Certification was extended to enable us to market CORTOSS in the EU for vertebral augmentation of VCFs, including compression fractures of the spine caused by osteoporosis and invasive tumors. During the second quarter of 2002, we received CE Certification from our Notified Body for ALIQUOT, which facilitates delivery of CORTOSS.
We have completed two FDA-approved IDE pilot clinical studies in the U.S. for the use of CORTOSS in vertebral augmentation of VCFs using the vertebroplasty and kyphoplasty surgical techniques, respectively. Both surgical techniques involve the injection of a self-setting material into the vertebral body to provide internal fixation of the VCF. Upon FDA review of the vertebroplasty pilot clinical data, we received approval from the FDA to begin patient enrollment in a prospective, randomized controlled pivotal phase of that clinical study. The study design was subsequently amended and approved by the FDA in August 2004 to allow the comparison of CORTOSS to a treatment arm using PMMA bone cement instead of a non-treatment arm consisting of conservative care and pain management. In February 2007, we completed enrollment of the pivotal CORTOSS study, which was conducted under an FDA Investigational Device Exemption (IDE). A total of 256 patients were enrolled in the pivotal study with a randomization of approximately 2:1 (162 patients treated using CORTOSS and 94 patients treated using a PMMA bone cement) at 22 sites. Patients were followed at predetermined intervals and annually until February 2009, the 24-month post-procedure period for the last-enrolled patient. In January 2008, we submitted to the FDA a 510(k) application for the use of CORTOSS in vertebral augmentation; this application remains pending after supplemental supportive materials were filed during 2008. Submission of additional information, including completed 24-month results of the pivotal IDE study, is anticipated in April 2009. FDA clearance of CORTOSS would permit Orthovita to market and sell the material in the United States.
The following discussion summarizes the regulatory requirements applicable to our products.
United States
The medical devices that we manufacture and market, or intend to market, are subject to extensive regulation by the FDA. Pursuant to the Federal Food, Drug and Cosmetic Act (“FFD&C Act”) and the regulations promulgated thereunder, the FDA regulates the clinical testing, manufacture, labeling, distribution and promotion of medical devices. Noncompliance with applicable requirements can result in, among other things, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, failure of the government to grant premarket clearance or premarket approval for devices, withdrawal of marketing approvals/clearances and criminal prosecution.
In the U.S., medical devices are classified into one of three classes (Class I, II or III) on the basis of the controls deemed necessary by the FDA to reasonably assure their safety and effectiveness. Under FDA regulations, Class I devices, the least regulated category, are subject to general controls and Class II devices are subject to general and special controls. Generally, Class III devices are those that must receive premarket approval by the FDA to ensure their safety and effectiveness.
Before we can introduce a new device into the market, we must generally obtain market clearance through a 510(k) notification or premarket approval through a premarket approval (“PMA”) application. A 510(k)
clearance will be granted if the submitted information establishes that the proposed device is “substantially equivalent” to a legally marketed Class I or II medical device, or to a Class III medical device for which the FDA has not required a PMA. The FDA may determine that a proposed device is not substantially equivalent to a legally marketed device or that additional information or data are needed before a substantial equivalence determination can be made. A request for additional data may require that clinical studies be performed to establish the device’s “substantial equivalence.”
Commercial distribution of a device for which a 510(k) notification is required can begin only after the FDA issues a letter finding the device to be “substantially equivalent” to a predicate device. Pursuant to the FFD&C Act, the FDA must make a determination with respect to a 510(k) submission within 90 days of its receipt. The FDA may, and often does, extend this time frame by requesting additional data or information.
A “not substantially equivalent” determination, or a request for additional information, could delay or prevent the market introduction of new products for which we file such notifications. For any of our products that are cleared through the 510(k) process, modifications or enhancements that could significantly affect the safety or efficacy of the device or that constitute a major change to the intended use of the device will require new 510(k) submissions. The FDA has implemented a policy under which certain device modifications may be submitted as a “Special 510(k),” which will require only a 30-day review. Special 510(k)s are limited to those device modifications that do not affect the intended use or alter the fundamental scientific technology of the device and for which substantial equivalence can be demonstrated through design controls.
We must file a PMA if our proposed device is not substantially equivalent to a legally marketed Class I or Class II device, or if it is a Class III pre-amendment device (on the market since prior to May 28, 1976) for which FDA has called for PMAs. A PMA must be supported by valid scientific evidence that typically includes extensive data, including pre-clinical and clinical trial data, to demonstrate the safety and effectiveness of the device, as well as extensive manufacturing information.
FDA review of a PMA generally takes one to two years from the date the PMA is accepted for filing, but may take significantly longer. The review time is often significantly extended should the FDA ask for more information or clarification of information already provided in the submission.
During the PMA review period, an advisory committee, typically a panel of clinicians, will likely be convened to review and evaluate the application and provide recommendations to the FDA as to whether the device should be approved. The FDA is not bound by the recommendations of the advisory panel. Toward the end of the PMA review process, the FDA generally will conduct an inspection of the manufacturer’s facilities to ensure that they are in compliance with Quality System Regulation (“QSR”) requirements.
If the FDA’s evaluations of both the PMA and the manufacturing facilities are favorable, the FDA will either issue an approval letter or an “approvable letter,” which usually contains a number of conditions that must be met in order to secure final approval of the PMA. When, and if, those conditions have been fulfilled to the satisfaction of the FDA, the agency will issue an approval letter, authorizing commercial marketing of the device for certain indications. If the FDA’s evaluation of the PMA or manufacturing facilities is not favorable, the FDA will deny approval of the PMA or issue a “not approvable letter.” The FDA may also determine that additional clinical trials are necessary, in which case PMA approval may be delayed up to several years while we conduct additional clinical trials and submit an amendment to the PMA. The PMA process can be expensive, uncertain and lengthy, and a number of devices for which other companies have sought FDA approval have never been approved for marketing.
Modifications to a device that is the subject of an approved PMA (including modifications to its labeling, raw material components or manufacturing process) may require approval by the FDA in the form of a PMA supplement or new PMA. Supplements to a PMA often require the submission of the same type of information required for an initial PMA, except that the supplement is generally limited to that information needed to support the proposed change from the product covered by the original PMA.
If clinical trials of a device are required in connection with either a 510(k) notification or a PMA and the device presents a “significant risk,” we will be required to file an IDE application prior to commencing clinical trials. The IDE application must be supported by data, typically including the results of animal and laboratory testing. If the IDE application is reviewed and approved by the FDA and one or more appropriate Institutional Review Boards (“IRBs”), clinical trials may begin at a specific number of investigational sites with a specific number of patients, as approved by the FDA. If the device presents a “non-significant risk” to the patient, we may begin the clinical trials after obtaining approval for the study by one or more appropriate IRBs. For “significant risk” devices, we must submit an IDE supplement to the FDA and receive approval from the FDA before we, or our investigator, may make a change to the investigational plan that may affect its scientific soundness or the rights, safety or welfare of human subjects. IRB approval may be required for changes in the investigational plan for both non-significant risk and significant risk devices.
Any products manufactured or distributed by us pursuant to FDA clearances or approvals are subject to extensive regulation by the FDA, including reporting and record keeping requirements. Device manufacturers are required to register their establishments and list their devices with the FDA and certain state agencies, and are subject to periodic inspections by the FDA and certain state agencies. The FFD&C Act requires devices to be manufactured in accordance with QSR requirements that impose certain procedural and documentation requirements upon us with respect to manufacturing and quality assurance activities. Medical devices are also subject to post-market reporting requirements for deaths or serious injuries when the device may have caused or contributed to the death or serious injury, and for certain device malfunctions that would be likely to cause or contribute to a death or serious injury if the malfunction were to recur. If safety or efficacy problems occur after the product reaches the market, the FDA may impose severe limitations on the use of any approved or cleared product.
Our labeling and promotion activities are subject to scrutiny by the FDA and, in certain instances, by the Federal Trade Commission. The FDA actively enforces regulations prohibiting marketing of products for unapproved or uncleared uses. We, as well as our products, are also subject to a variety of state laws and regulations in those states or localities where our products are or will be marketed. Any applicable state or local regulations may hinder our ability to market our products in those states or localities. We are also subject to numerous federal, state and local laws relating to such matters as safe working conditions, manufacturing practices, environmental protection, fire hazard control and disposal of hazardous or potentially hazardous substances. There can be no assurance that we will not be required to incur significant costs to comply with such laws and regulations now or in the future or that such laws or regulations will not have a material adverse effect upon our ability to do business. Noncompliance with applicable requirements can result in, among other things, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, failure of the government to grant the pre-market clearance or premarket approval for devices, withdrawal of marketing approvals, clearances and criminal prosecution.
Europe
In order to sell our products within the EU, we are required to achieve compliance with the requirements of the MDD and affix a CE Mark on our products to attest such compliance. To achieve this, our products must meet the “essential requirements” defined under the MDD relating to safety and performance and we must successfully undergo a verification of our regulatory compliance (“conformity assessment”) by an independent Notified Body. We have selected KEMA as our “Notified Body.” The nature of the conformity assessment will depend on the regulatory class of our products. Under European law, our products, other than IMBIBE and ALIQUOT (which are Class I-sterile and Class II-A, respectively), are likely to be in Class III. In the case of Class III products, we must (as a result of the regulatory structure which we have elected to follow) establish and maintain a complete quality system for design and manufacture as described in Annex II of the MDD and demonstrated by compliance with EN 13485:2003. We are certified as meeting the requirements of ISO 9001: 2000 and EN 13485 for the period July 1, 2006 through July 1, 2009 and expect to receive renewal of this certification by the second quarter of 2009 for an additional three-year period. Our Notified Body has audited our
quality system and determined that it meets the requirements of the MDD. In addition, the Notified Body must certify the specific design of each device in Class III, IIa and IIb. As part of the design certification process, the Notified Body must also verify that the products comply with the essential requirements of the MDD. In order to comply with these requirements, we must, among other things, complete a risk analysis and may be required to present clinical data. The clinical data presented by us must provide evidence that the products meet the performance specifications claimed by us, provide sufficient evidence of adequate assessment of unwanted side effects and demonstrate that the benefits to the patient outweigh the risks associated with the device. We are subject to continued surveillance by the Notified Body and are required to report any serious adverse incidents to the appropriate authorities of the European Union member states. The certification of the Notified Body is valid for a maximum of five years but may be extended by application for additional five year periods. We also are required to comply with additional national requirements that are outside of the scope of the MDD. There can be no assurance that we will not be required to incur significant costs to comply with such laws and regulations now or in the future or that such laws or regulations will not have a material adverse effect upon our ability to do business.
THIRD-PARTY REIMBURSEMENT
Successful sales of our products in the U.S. and other markets will depend on the availability of adequate coverage and reimbursement from third-party payers relative to our products. In the U.S., health care providers, such as hospitals and physicians that purchase or utilize our products for treatment of their patients, generally rely on independent third-party payers, such as private insurance companies or HMOs, and governmental payers, such as Medicare and Medicaid, to reimburse all or part of the costs and fees associated with the provision of items and services using our products. Physicians, hospitals, and other health care providers may not purchase our products if they do not receive satisfactory reimbursement from these payers for the cost of procedures using our products.
Each payer has its own process and standards for determining whether it will cover and reimburse a procedure or particular product. Private payers often rely on the lead of the governmental payers in rendering coverage and reimbursement determinations. Therefore, achieving favorable Medicare coverage and reimbursement is usually a significant gating issue for successful introduction of a new product. Medicare is a federally funded program managed by the Centers for Medicare and Medicaid Services, through local fiscal intermediaries and carriers, that administer coverage and reimbursement for certain health care items and services furnished to the elderly and disabled. Medicaid is an insurance program for the poor that is both federally and state funded and managed by each state. The federal government sets general guidelines for Medicaid and each state creates specific regulations that govern their individual program.
Medicare provides, among other things, health care benefits that cover, within prescribed limits, the major costs of most medically necessary care for such individuals, subject to certain deductibles and co-payments. The Medicare program has established, and continues to establish, standards and guidelines for the coverage and reimbursement of certain procedures, equipment, supplies and other items and services. Generally, in order to be covered and reimbursed by Medicare, a health care item or service furnished to a Medicare beneficiary must be reasonable and necessary for the diagnosis or treatment of an illness or injury or to improve the functioning of a malformed body part.
The methodology for determining (1) the coverage status of our products; and (2) the amount of Medicare reimbursement for our products, varies based upon, among other factors, the setting in which a Medicare beneficiary received health care items and services. Acute care hospitals are generally reimbursed by Medicare for inpatient operating costs based upon prospectively determined rates. Under the Prospective Payment System (“PPS”), acute care hospitals receive a predetermined payment rate based upon the Diagnosis-Related Group, or DRG, into which each Medicare beneficiary stay is assigned, regardless of the actual cost of the services provided. Certain additional or “outlier” payments may be made to a hospital for cases involving unusually high costs. Accordingly, acute care hospitals generally do not receive direct Medicare reimbursement under PPS for
the distinct costs incurred in purchasing our products. Rather, reimbursement for these costs is deemed to be included within the DRG-based payments made to hospitals for the services furnished to Medicare-eligible inpatients in which our products are utilized. Because PPS payments are based on predetermined rates and may be less than a hospital’s actual costs in furnishing care, acute care hospitals have incentives to lower their inpatient operating costs by utilizing equipment, devices and supplies, including those sold by us, that will reduce the length of inpatient stays, decrease labor or otherwise lower their costs. Our product revenue could be affected negatively if acute care hospitals discontinue product use due to insufficient reimbursement, or if other treatment options are perceived to be more cost-effective. Medicare also reimburses most outpatient services based on a prospective or predetermined payment basis, subject to certain exceptions and limitations. Similarly, some states reimburse certain health care providers for inpatient services under their Medicaid programs by using prospective rates for diagnosis-related groups of illnesses. Therefore, health care providers may refuse to use our products if coverage or reimbursement is inadequate. Also, any changes in federal legislation, regulations and policy affecting Medicare coverage and reimbursement relative to our products could have a material effect on our results of operations.
Inadequate coverage or reimbursement by private insurance companies and government programs could significantly reduce usage of our products. In addition, an increasing emphasis on managed care in the U.S. has placed, and we believe will continue to place, greater pressure on medical device pricing. Such pressures could have a material adverse effect on our ability to sell our products profitably. Failure by hospitals and other users of our products to obtain favorable coverage or reimbursement from third-party payers or changes in governmental and private third-party payers’ policies toward coverage or reimbursement for procedures employing our products could reduce demand for our products.
The European Union has not established a uniform process to govern the pricing and reimbursement of medical devices. Consequently, the individual EU member states operate various combinations of centrally financed health care systems and private health insurance systems. The relative importance of government and private systems varies from country to country. The choice of devices is subject to constraints imposed by the availability of funds within the purchasing institution and by hospital and authority priorities and procedures. Medical devices are most commonly sold to hospitals or health care facilities at a price set by negotiation between the buyer and the seller. A contract to purchase products may result from an individual initiative or as a result of a competitive bidding process. In either case, the purchaser pays the supplier, and payment terms vary widely throughout the EU. Failure to obtain favorable negotiated prices with hospitals or health care facilities could adversely affect sales of our products.
HEALTH CARE FRAUD AND ABUSE LAWS
We are subject to various federal and state laws pertaining to health care fraud and abuse, including anti-kickback laws and false claims laws. Similar regulations have been adopted by EU member states. Violations of these laws are punishable by criminal, civil and/or administrative sanctions, including, in some instances, fines, imprisonment, and exclusion from participation in federal, state and national health care programs, including Medicare, Medicaid and veterans’ health programs. Because of the far-reaching nature of these laws, there can be no assurance that the occurrence of one or more violations of these laws would not result in a material adverse effect on our business, financial condition and results of operations.
Anti-Kickback Laws. Our operations are subject to federal and state anti-kickback laws. The federal anti-kickback law prohibits entities such as us from knowingly and willfully offering, paying, soliciting or receiving any form of remuneration (including any kickback, bribe or rebate) in return for the referral of items or services for which payment may be made under a federal health care program, or in return for the recommendation, arrangement, purchase, lease or order of items or services for which payment may be made under a federal health care program. The definition of remuneration has been broadly interpreted to include anything of value, including for example gifts, discounts, the furnishing of supplies or equipment, payments of cash and waivers of payments. Several courts have interpreted the statute’s intent requirement to mean that if any one purpose of an
arrangement involving remuneration is to induce referrals or otherwise generate business involving goods or services reimbursed in whole or in part under federal healthcare programs, the statute has been violated. Violation of the federal anti-kickback law is a felony, punishable by criminal fines and imprisonment for up to five years or both. In addition, the Department of Health and Human Services may impose civil penalties and exclude violators from participation in federal health care programs such as Medicare and Medicaid Exclusion of a manufacturer would preclude any federal healthcare program from paying for its products. In addition, enforcement officials have argued (and some courts have agreed) that kickback arrangements can provide the basis for an action under the Federal False Claims Act, which is discussed below.
Government officials have focused recent enforcement efforts on, among other things, the sales and marketing activities of healthcare companies, and recently have brought cases against individuals or entities with personnel who allegedly offered unlawful inducements to potential or existing customers in an attempt to procure their business. Settlements of these cases by healthcare companies have involved significant fines and/or penalties and in some instances criminal pleas.
Many states have adopted similar prohibitions against payments intended to induce referrals of products or services paid by Medicaid or other third party payors.
False Claims. The federal False Claims Act imposes civil and criminal liability on individuals or entities who submit (or cause the submission of) false or fraudulent claims for payment to the government. Violations of the federal False Claims Act may result in penalties equal to three times the damages which the government sustained, an assessment of between $5,500 and $11,000 per claim, civil monetary penalties and exclusion from participation in the Medicare and Medicaid programs.
The federal False Claims Act also allows a private individual to bring a qui tam suit on behalf of the government against an individual or entity for violations of the False Claims Act. In a qui tam suit, the private plaintiff is responsible for initiating a lawsuit that may eventually lead to the government recovering money of which it was defrauded. After the private plaintiff has initiated the lawsuit, the government must decide whether to intervene in the lawsuit and become the primary litigant. In the event the government declines to join the lawsuit, the private plaintiff may choose to pursue the case alone, in which case the private plaintiff’s counsel will have primary control over the case (although the government must be kept apprised of the progress of the lawsuit). In return for bringing the suit on the government’s behalf, the statute provides that the private plaintiff is entitled to receive up to 30% of the recovered amount from the litigation proceeds if the litigation is successful plus reasonable expenses and attorneys fees. Recently, the number of qui tam suits brought against entities in the health care industry has increased dramatically. In addition, a number of states have enacted laws modeled after the False Claims Act that allow those states to recover money which was fraudulently obtained from the state.
Other Fraud and Abuse Laws. The Health Insurance Portability and Accountability Act of 1996 created, in part, two new federal crimes: Health Care Fraud and False Statements Relating to Health Care Matters. The Health Care Fraud statute prohibits the knowing and willful execution of a scheme or artifice to defraud any health care benefit program. A violation of the statute is a felony and may result in fines and/or imprisonment. The False Statements statute prohibits knowingly and willfully falsifying, concealing or covering up a material fact by any trick, scheme or device or making any materially false, fictitious or fraudulent statement in connection with the delivery of or payment for health care benefits, items or services. A violation of this statute is a felony and may result in fines and/or imprisonment.
The countries of the EU have individual and varying legislative provisions governing health care fraud and abuse, including provisions governing inducement to purchase. Violation of these provisions can lead to action both against the provider of the device and against the health care provider.
PRODUCT LIABILITY AND INSURANCE
We manufacture medical devices used on patients in surgery, and we may be subject to product liability lawsuits. We have experienced two product liability claims to date, which we have successfully resolved. There can be no assurance that other product liability claims will not be asserted against us in the future. Under certain of our agreements with our independent distributors and hospital customers, we provide indemnification from product liability claims. Any product liability claim brought against us, with or without merit, could result in the increase of our product liability insurance rates or the inability to secure coverage in the future. In addition, we would have to pay any amount awarded by a court in excess of policy limits. We maintain product liability insurance in the annual aggregate amount of up to $10,000,000, although our insurance policies have various exclusions. Thus, we may be subject to a product liability claim for which we have no insurance coverage, in which case we may have to pay the entire amount of any award.
EMPLOYEES
As of December 31, 2008, we had 234 full-time employees, with 119 employees at our Malvern, Pennsylvania headquarters, 104 employees in other parts of the U.S. and 11 employees in Europe. We consider our relations with our employees to be good.
ITEM 1A.
ITEM 1A. RISK FACTORS
We have organized the risk factors set forth below that may affect us or our securities into the following four categories: (i) risks related to our business and industry; (ii) risks related to our financial results and financing; (iii) risks related to our intellectual property and litigation; and (iv) risks related to investing in our stock and equity markets.
RISKS RELATED TO OUR BUSINESS AND INDUSTRY
If our current products are not commercially successful, or if we do not increase our product portfolio and successfully commercialize new products, our operating results will be impaired and our viability will be jeopardized.
We are highly dependent on successfully selling our products that have received regulatory approval or clearance. To date, VITOSS, VITAGEL, VITASURE, CELLPAKER and IMBIBE are approved or cleared for specified uses in the United States. VITOSS, CORTOSS, ALIQUOT, VITAGEL, CELLPAKER and VITASURE are cleared or approved for specified uses in the European Union and countries adhering to the regulatory standards of the European Union. VITOSS, CORTOSS and ALIQUOT are also cleared for specified uses in Australia. Revenues generated from sales of our approved or cleared products in their approved territories have not been and in the future may not be sufficient to fund operations. There is no assurance that we can increase our product portfolio or that any additional products will be commercially successful and generate revenues sufficient to enable us to fund operations. In particular, if our CORTOSS product is not cleared for marketing in the United States or does not become commercially successful, our long-term viability may be jeopardized. While our 510(k) application for the use of CORTOSS in vertebral augmentation is currently pending with the FDA, we cannot guarantee if or when we will receive FDA clearance of CORTOSS. FDA clearance of CORTOSS would permit us to market and sell the material in the United States.
Certain factors that may also limit our ability to increase sales include:
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the ability of our direct sales representatives to develop and retain a customer base and compete effectively with larger sales forces offering more extensive product portfolios;
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our dependence in certain geographical areas on the efforts of independent agents and distributors over which we have limited control to promote the use of our products;
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the introduction of new products based upon competing technologies into the market by competing orthopedic, biomedical and other companies;
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our dependence on the continued publication of independent pre-clinical and clinical data to support the use of our products;
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our need to educate and train a sufficient number of surgeons to create demand for our products; and
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the need for payors to authorize insurance reimbursement for procedures using our products.
Market acceptance of our products will largely depend on our ability to demonstrate their relative safety, efficacy, cost-effectiveness and ease of use. Surgeons will not use our products unless they determine, based on experience, clinical data and recommendations from prominent surgeons and mentors that our products are safe and effective. Our products are based on newer technologies and compete with more established treatments currently accepted as the standards of care. The attributes of some of our products may require some changes in surgical techniques that have become standard within the medical community, and there may be resistance to change. Therefore, for these products, we must be able to convince surgeons who currently favor existing techniques to switch to new procedures that would use our products. Many surgeons will not purchase our products until there is sufficient, long-term clinical evidence to convince them to alter their existing treatment methods. In addition, surgeons may be slow to change their medical treatment practices because of perceived liability risks arising from the use of new products and the uncertainty of third party reimbursement for our products. Any failure to gain market acceptance of our products could result in lower sales and our inability to become profitable.
The data from our pivotal CORTOSS trial may not be sufficient or sufficiently supportive, which may delay or preclude FDA clearance for commercial distribution of this product in the United States.
After receiving approval from the FDA in 2003 to conduct a pivotal trial for the use of our CORTOSS material in vertebral augmentation, we completed the trial in 2009 and have a 510(k) application for the use of CORTOSS in vertebral augmentation pending before the FDA. In response to comments that we received in 2008 from the FDA on this application, we plan to submit additional data and a clinical report to the FDA in April 2009 with all 24-month follow-up patient data from the pivotal trial. Any clearance of CORTOSS by the FDA may be delayed or precluded due to insufficient or insufficiently supportive data from our pivotal trial and submission package for the CORTOSS application. In addition, the completion of our pivotal trial and submission package for CORTOSS may be delayed or terminated for other various reasons, including, but not limited to:
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patients in the trial experience an unacceptable rate or severity of adverse side effects;
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any failure by third party clinical investigators to perform our pivotal trial in accordance with the clinical trial protocol, Good Clinical Practice and regulatory requirements, or other third party organizations do not perform data collection and analysis in a timely or accurate manner;
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inspections of our clinical trial sites by the FDA or Institutional Review Boards, or IRBs, find regulatory violations that require us to undertake corrective action or prohibit us from using some or all of the data in support of our FDA submission;
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FDA may require an advisory panel to review the submission;
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changes in laws, governmental regulations, administrative actions, or the general regulatory climate affecting either all medical devices or those designed for the spine industry, force us to modify the conduct of our trial or otherwise create unexpected burdens; or
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the FDA requests additional pre-clinical data in 2009 in support of our application.
If one or more of the foregoing events occur, it may delay or prevent us from obtaining clearance of the CORTOSS product in the United States.
If we are unable to operate an effective sales and distribution network, our ability to generate sales and become profitable will be impaired.
We have assembled a field sales network of direct sales representatives and independent non-stocking distributors in the U.S. to market VITOSS, VITAGEL, CELLPAKER, VITASURE and IMBIBE. Outside of the U.S., we utilize a network of independent stocking distributors to market VITOSS, CORTOSS, ALIQUOT, VITAGEL, CELLPAKER and VITASURE. We are dependent upon our direct sales representatives and distributors for the sale of our products. Any failure to maintain and effectively manage our distribution network will impair our ability to generate additional sales and become profitable.
In an effort to further grow our sales, we continue to build our sales management team and add direct sales representatives to our organization for certain open or underserved territories in the U.S. We also added four direct sales representatives in the United Kingdom in the fourth quarter of 2008. The addition of direct sales representatives will increase our operating expenses. Furthermore, there is no assurance that adding direct sales representatives will improve sales or that our direct sales representatives will be successful in generating sufficient sales to cover the cost of supporting their sales activities. There is no assurance that we will be able to attract and retain qualified personnel to market or sell our products or that we will successfully manage this type of sales and distribution method.
There can be no assurance that our distributors will perform effectively their obligations in their respective territories as expected, or that we will continue to derive any revenue from these arrangements. We cannot assure that our interests will continue to coincide with those of our distributors. In addition, we cannot assure that our distributors will not develop independently, or with other companies, competitive products.
The independent U.S. distributors selling VITOSS generally sell products for other orthopedic companies. A single distributor may sell VITOSS, as well as hardware manufactured by other orthopedic companies consisting of metal plates, screws and titanium spinal cages, to end user hospitals. Our sales could be adversely affected if, for any reason, one or more of our successful distributors lost their hardware product line provided by other orthopedic companies since VITOSS is typically sold with such hardware products. Additionally, our independent distributors may be unwilling to carry or unable to effectively sell VITOSS as a result of the introduction of new products based upon other technologies that could compete with VITOSS. Our sales could be adversely affected if one or more of our successful distributors eliminated VITOSS from its product line for any other reason or terminated its arrangement with us. Our sales could also be adversely affected if our independent distributors become concerned that their arrangements with us could be eliminated as a result of another company’s offer or threat to acquire us. The complete product line represented by the distributors, including our products, is an important factor in the distributors’ ability to penetrate the markets for our products. Accordingly, our ability to penetrate the markets that we serve or intend to serve is highly dependent upon the quality and breadth of the other product lines carried by our distribution network, the components of which may change from time to time, and over which we have little or no control.
If we do not manage commercial scale manufacturing capability and capacity for our products in compliance with regulatory requirements and in a cost-effective manner, our product sales and operating results may suffer.
The manufacture of our products is subject to regulation and periodic inspection by various regulatory bodies for compliance with the FDA Quality System Regulation (the “QSR”), and EU Medical Device Directives requirements, ISO 9000 Series standards, ISO/European Norm (“EN”) 13485 and equivalent requirements.
We manufacture our commercial VITOSS, VITAGEL and CORTOSS products at our 24,800-square foot FDA-registered manufacturing facilities located in Malvern, Pennsylvania. These facilities are leased through July 2017 and are certified as meeting the requirements of ISO 9000: 2000 and EN 13485 through July 1, 2009, and we expect to renew this certification by the second quarter of 2009 for an additional three-year period. We
are currently required to demonstrate and maintain compliance with the QSR, which is 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. The FDA enforces the QSR through periodic unannounced inspections. We have been, and anticipate in the future being, subject to such inspections. We assumed full responsibility for manufacturing VITAGEL in 2006 and CELLPAKER in 2007 after receiving the requisite approvals from the FDA. There can be no assurance that we will be able to comply with FDA requirements to continue to manufacture VITOSS, VITAGEL, CORTOSS or CELLPAKER, which could result in delay or inability to manufacture and sell the products. We believe our existing manufacturing facilities have the capacity to meet our commercial needs through at least 2012 and plan to transition processing of collagen for VITAGEL in-house after completion of renovations and obtaining regulatory approval for such processing facility, which we do not expect to occur before 2010. If we do not receive regulatory approval for our collagen processing facility in 2010 or earlier, we may not be able to manufacture VITAGEL to adequately meet commercial demand, if at all.
Our third-party manufacturers are also regulated by governmental agencies and are required to be ISO 9001/EN 13485-certified or otherwise meet our quality system requirements. We manufacture CELLPAKER, IMBIBE and ALIQUOT through outside third-party contract manufacturers. Our VITOSS is converted to VITOSS FOAM and VITOSS Bioactive FOAM by Kensey, and we purchase VITASURE finished product from Medafor, which uses third party manufacturers to make the product.
Our product sales depend upon, among other things, our ability to manufacture our products in commercial quantities, in compliance with regulatory requirements and in a cost-effective manner. There can be no assurance that regulatory authorities will not, during the course of an inspection of existing or new facilities, identify what they consider to be deficiencies in meeting the applicable quality standards and request or seek remedial action.
Failure to comply with such regulations or a delay in attaining compliance may result in:
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warning letters;
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injunctions suspending the manufacture of products;
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civil and criminal penalties;
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refusal to grant premarket approvals or clearances, CE Certifications, CE Certification renewals, or clearances to products that are subject to future or pending submissions;
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product recalls or seizures of products;
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total or partial suspensions of production; and
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refusal to permit the import or export of our products.
The imposition of any of these sanctions could cause our business and operating results to suffer. Furthermore, if we or any of our third party manufacturers cannot produce our products, our product sales would suffer.
We are dependent on a limited number of specialty suppliers of certain raw materials, and our business and financial results could be harmed if a specialty supplier no longer provides materials to us.
Our ability to manufacture VITOSS, VITAGEL and CORTOSS and to have VITOSS FOAM and VITOSS Bioactive FOAM manufactured by and for us is dependent on a limited number of specialty suppliers of certain raw materials. We have several single-source suppliers for raw materials used in our products. The failure of a supplier to continue to provide us with these materials at a price or quality acceptable to us, or at all, would have a material adverse effect on our ability to manufacture these products. Although we believe that we maintain good relationships with our suppliers, we cannot assure that such supplies and services will continue to be available with respect to our current and future commercialized products.
Allergan, our former supplier of processed collagen for VITAGEL, notified us in 2007 of its intention to shut down its collagen-processing facility and cease supplying us with this collagen raw material under our then-existing supply agreement. In November 2007, we entered into a new supply and license agreement under which Allergan agreed to sell us additional lots of processed collagen in 2008 before its facility closed. We received this strategic collagen reserve supply in September 2008 and we believe it will be sufficient to meet our needs for VITAGEL into the second half of 2010. Our acquisition of the strategic collagen reserve and plan to manufacture additional VITAGEL inventory reserve from this collagen may result in excess inventory. If we cannot successfully sell the VITAGEL inventory, we may be required to write off any expired inventory that remains unsold. Conversely, if our collagen inventory is insufficient or inadequate to support demand for VITAGEL, our sales could be adversely affected.
In addition, we are renovating sites we currently lease to establish a facility to process collagen raw materials that we plan to obtain after exhausting the strategic processed collagen reserve acquired from Allergan. We are in the process of negotiating supply agreements for collagen raw materials for VITAGEL. The occurrence of any of the following could have a material adverse effect on our ability to manufacture and sell VITAGEL and CELLPAKER, which is approved for use only in conjunction with VITAGEL:
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our inability to establish our collagen processing facility in a timely manner before our strategic reserve is exhausted, if at all;
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delays caused by the need to secure regulatory approval of the collagen raw material processing facility currently under construction; or
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our inability to secure an adequate supply of collagen raw materials meeting our pricing, quality and regulatory requirements.
If we are unable to sell VITAGEL and CELLPAKER for a period of time, our customers may seek alternative products and we may lose market share for VITAGEL and CELLPAKER. Further, there is no assurance that we will regain any VITAGEL and CELLPAKER market share that may be lost.
We also cannot assure that supply or manufacturing capability will be sufficient to meet our own needs and Angiotech’s needs if Angiotech elects to be supplied by us under our license agreement with them. Under our license agreement with Angiotech, in the future we may be obligated, under certain circumstances, to provide CoStasis (an Angiotech-branded VITAGEL product) and certain CoStasis materials to Angiotech. Our collagen supply or manufacturing capabilities may be inadequate, and we may need to seek additional suppliers for CoStasis materials.
We are dependent on a limited number of specialized manufacturing suppliers for certain products, and our business and financial results could be harmed if a third party manufacturer fails to supply us with these products.
We are dependent upon Kensey and other third party manufacturers for the supply of certain products. Approximately 63% of our product sales during 2008 were from products based upon our VITOSS FOAM platform co-developed with Kensey, including VITOSS Bioactive FOAM. Our VITOSS is converted to VITOSS FOAM and VITOSS Bioactive FOAM by Kensey, our development partner. We also manufacture certain delivery accessory products through third party specialty suppliers. There is no assurance that these manufacturers will continue to supply our requirements. If they fail to do so, we cannot guarantee that we will be able to engage another supplier for these products on a timely basis and on acceptable terms. A delay in our ability to obtain adequate supplies of these products may negatively impact our product sales.
If we fail to obtain and maintain the regulatory approvals or clearances necessary to make or sell our products, sales could be delayed or never realized.
The jurisdictions in which we seek to market our products will regulate these products as medical devices. In most circumstances, we and our distributors and agents must obtain regulatory clearances, approvals and
certifications and otherwise comply with extensive regulations regarding safety, quality and efficacy standards. These regulations vary from country to country, and the regulatory review can be lengthy, expensive and uncertain. We may not obtain or maintain the regulatory clearances, approvals and certifications necessary to make or market our products in our targeted markets. Moreover, regulatory clearances, approvals and certifications that are obtained may involve significant restrictions on the anatomic sites and types of procedures for which our products can be used. In addition, we may be required to incur significant costs in obtaining or maintaining our regulatory clearances, approvals and certifications. If we do not obtain or maintain regulatory clearances, approvals and certifications to enable us to make or market our products in the U.S. or elsewhere, or if the clearances, approvals and certifications are subject to significant restrictions, we may never generate significant revenues. The regulatory requirements in some of the jurisdictions where we currently market or intend to market our products are summarized below.
United States
Regulation by FDA. The FDA regulates the clinical testing, manufacturing, labeling, distribution and promotion of medical devices. To date, we have received 510(k) clearance from the FDA to market our VITOSS, VITOSS FOAM, VITOSS Bioactive FOAM and IMBIBE labels. We have a 510(k) application for the use of CORTOSS in vertebral augmentation pending before the FDA. We cannot guarantee if or when we will obtain FDA clearance to market CORTOSS for the designated use.
We market VITOSS, VITAGEL, CELLPAKER, IMBIBE and VITASURE in the U.S., and we market VITOSS, CORTOSS, ALIQUOT, VITAGEL, CELLPAKER and VITASURE outside the U.S. We manufacture VITOSS, VITAGEL, CELLPAKER and CORTOSS in the U.S, and we manufacture IMBIBE and ALIQUOT in the U.S. through outside third-party contract manufacturers. In addition, under our agreement with Kensey, Kensey has the exclusive right to manufacture any approved or cleared jointly developed products under the agreement. This right extends until February 2014 for the VITOSS FOAM product platform and at least until 2024 for the VITOSS Bioactive FOAM product platform. We purchase VITASURE from Medafor, which utilizes third-party manufacturers to produce this product. Under our distribution agreement with Medafor, Medafor is responsible for maintaining regulatory approval and ensuring compliance with manufacturing requirements for VITASURE.
VITOSS, VITAGEL and VITASURE, as well as any other products that we manufacture or distribute following their approval or clearance by the FDA, will be subject to extensive regulation by the FDA. If safety or efficacy problems occur after the product reaches the market, the FDA may impose severe limitations on the use of the product. Moreover, modifications to the approved or cleared product may require the submission of a new 510(k) notification or premarket approval application or premarket application supplement. We or our partners may not be successful in obtaining approval to market the modified product in a timely manner, if at all. Noncompliance with applicable requirements can result in, among other things, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, failure of the government to grant premarket clearance or premarket approval for devices, withdrawal of marketing approvals and criminal prosecution.
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.
European Union and Other International Markets
General. International sales of medical devices are subject to the regulatory requirements of each country in which the products are sold. Accordingly, the introduction of our products in markets outside the United States will be subject to regulatory approvals or clearances in those jurisdictions. The regulatory review process varies
from country to country. Many countries also impose product standards, packaging, labeling and language requirements and import restrictions on medical devices. In addition, the EU and each country outside of the EU has its own tariff regulations, duties and tax requirements. The approval or clearance by foreign government authorities is uncertain and can be expensive. Our ability to market our products could be substantially limited due to delays in receipt of, or failure to receive, the necessary approvals or clearances.
Requirement of CE Certification in the European Union. To market a product in the European Union, we must be entitled to affix a CE mark, an international symbol of adherence to quality assurance standards and compliance with applicable European medical device directives. A CE mark, preceded by the relevant certification process, enables us to market a product in all of the countries of the European Union, as well as in other countries, such as Switzerland and Turkey, that have mutual recognition agreements with the EU or have adopted the European Union’s regulatory standards. To date, we have received CE Mark approval for the use of VITOSS as a bone void filler, for the use of CORTOSS in screw augmentation and vertebral augmentation procedures, for VITAGEL as a surgical hemostat and for certain delivery accessories for VITOSS, CORTOSS and VITAGEL. There can be no assurance that we will receive CE Mark approval for CORTOSS for any other indications for use or that we will receive CE Mark approval for other products. VITASURE has CE Mark approval for use as a surgical hemostat.
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.
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.
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 until such clearance is obtained.
Any modification to an FDA-cleared device 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; any change that affects the
safety or effectiveness of a PMA approved device requires a premarket approval supplement. We have made modifications to some of our products in the past, and may make additional modifications in the future that we believe, based upon FDA’s regulations and guidance, do not or will not require additional clearances or approvals. If the FDA disagrees, we could be required to obtain new clearances or approvals for the modifications. We also may be required to recall and to stop marketing modified products until such clearance or approval is obtained, which could harm our operating results. We may be required to submit extensive pre-clinical and clinical data to support these supplementary submissions, 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 operating results.
If we cannot keep up with technological changes and marketing initiatives of competitors, sales of our products may be harmed.
Extensive research efforts and rapid technological change characterize the market for products in the orthopedic and biomaterials markets. We anticipate that we will face intense competition from medical device, medical products and pharmaceutical companies. There are many products that are competitive to our VITOSS platform products. For instance, the use of bone morphogenic proteins, or BMPs, in orthopedic surgery has increased significantly in the past five years and competitive stem cell products have recently entered the market, a trend we expect to continue. The spinal bone grafting market also saw the introduction of lumbar total disk replacement (TDR) devices in 2004 and cervical TDR devices in 2007 as treatment alternatives for degenerative disc disease designed to preserve the motion of the vertebrae of the spine. With respect to CORTOSS, several PMMA bone cements have received 510(k) clearance since 2004 for vertebral augmentation of VCFs. Further, recombinant human thrombin was approved by the FDA in 2008 and may be positioned as a better alternative to bovine-derived collagen, a raw material in our VITAGEL product. Our products could be rendered uncompetitive or obsolete by these and other competitors’ new technologies. We may be unable to respond to technological advances by others through the development and introduction of new products or the modification of existing products. Moreover, many of our existing and potential competitors have substantially greater financial, marketing, sales, distribution, manufacturing and technological resources than us. These competitors may be in the process of seeking FDA or other regulatory approvals or clearances, or patent protection, for competitive products. Our competitors could, therefore, commercialize competing products in advance of our products. They may also enjoy substantial advantages over us in terms of:
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research and development expertise;
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experience in conducting clinical trials;
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experience in regulatory matters;
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manufacturing efficiency;
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name recognition;
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sales and marketing expertise;
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established distribution channels; and
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established relationships with health care providers and payors.
These advantages may adversely affect our plans for market acceptance of our products.
If health care providers cannot obtain third-party reimbursement for procedures using our products, or if such reimbursement is inadequate, we may never become profitable.
Successful sales of our products in the United States and other markets will depend on the availability of adequate reimbursement from third-party payors. Healthcare providers, such as hospitals and surgery centers that
purchase medical devices for treatment of their patients, generally rely on third-party payors to reimburse all or part of the costs and fees associated with the procedures performed with these devices. Both public and private insurance reimbursement plans are central to product acceptance and use as healthcare providers may refuse to use our products if reimbursement is inadequate. Inadequate reimbursement by private insurance companies and government programs could significantly reduce usage of our products.
In addition, an increasing emphasis on managed care in the United States has placed, and we believe will continue to place, greater pressure on medical device pricing. Such pressures could have a material adverse effect on our ability to sell our products or to operate profitably.
If we do not successfully train a sufficient number of surgeons, demand for our products could be adversely affected.
It is critical to the commercial success of our products that our independent distributors and direct sales representatives succeed in training a sufficient number of surgeons and in providing them adequate instruction in the use of our products. This training requires a commitment of time and money by surgeons that they may be unwilling to give. Even if surgeons are willing, if they are not properly trained, they may misuse or ineffectively use our products. This may result in unsatisfactory patient outcomes, patient injury, negative publicity or lawsuits against us, any of which could damage our business and reduce product sales.
We may incur significant liability if it is determined that we are promoting the “off-label” use of our medical devices. The unapproved or “off-label” use of our products could also adversely affect the reputation of our products.
Under the Federal Food, Drug, and Cosmetic Act and other laws, we are prohibited from labeling, training, or promoting our products for off-label uses. This prohibition means that we cannot proactively discuss or provide information or training on the use of our products outside of their cleared or approved uses, except in certain limited scientific and other settings. In the practice of medicine, physicians may use devices for off-label uses. Because the interpretation of these requirements is subjective, the FDA could deem some of our activities as promotional even when we believe in good faith that such activities were not promotional. A company that is found to have improperly promoted off-label uses may be subject to significant liability, including civil and administrative remedies as well as criminal sanctions. Enforcement measures taken against us could harm our business.
The medical devices that we manufacture and market, or intend to market, are subject to extensive regulation by the FDA, the European Union Medical Device Directive and other worldwide regulatory agencies. In order to market our products, we must apply for, receive and maintain all necessary regulatory approvals or clearances in each applicable jurisdiction for specified uses of the products. Under FDA regulations and laws of other countries, we are only permitted to commercially distribute our products for approved indication(s) or use(s); failure to comply with these regulations may subject us to FDA and other enforcement action.
CORTOSS received CE Certification, an international symbol of adherence to quality assurance standards and compliance with applicable European medical device directives, in January 2003 for use in repairing vertebral compression fractures and in October 2001 for use in screw augmentation procedures. However, surgeons may have attempted to use CORTOSS “off-label” in procedures to repair vertebral compression fractures performed prior to the European Union’s approval of CORTOSS for this type of procedure. Furthermore, not all surgeons have been trained in the proper use of CORTOSS to repair vertebral compression fractures. A surgeon who has not been properly trained to use CORTOSS in a procedure to repair vertebral compression fractures could pose a risk to the reputation of our CORTOSS product. In addition, the occurrence of an adverse event while using our product “off-label” in procedures other than the repair of vertebral compression fractures or screw augmentation could adversely affect the reputation of CORTOSS or any of our other products as well as us and could subject us to liability.
We could be negatively impacted by future interpretation or implementation of federal and state fraud and abuse laws, including anti-kickback laws and false claims laws.
We are subject to various federal and state laws pertaining to health care fraud and abuse, including anti-kickback laws and false claims laws. Violations of these laws are punishable by criminal, civil, and/or administrative sanctions, including, in some instances, imprisonment and exclusion from participation in federal and state health care programs, including Medicare, Medicaid, and veterans’ health programs. Although we seek to structure our business practices to be in compliance with applicable requirements, these laws are broadly written and broadly interpreted, and it is often difficult to determine precisely how these laws will be applied in specific circumstances.
Health care fraud and abuse regulations are complex, and even minor, inadvertent irregularities can potentially give rise to claims that the law has been violated. Any violations of these laws could result in a material adverse effect on our business, financial condition and results of operations. If there is a change in law, regulation or administrative or judicial interpretations, we may have to change our business practices or our existing business practices could be challenged as unlawful, which could have a material adverse effect on our business, financial condition and results of operations. Any state or federal review of us, regardless of the outcome, could be costly and time consuming.
We could become subject to false claims litigation under federal or state statutes, which can lead to civil money penalties, criminal fines and imprisonment, and/or exclusion from participation in federal health care programs. These false claims statutes include the federal False Claims Act, which allows any person to bring suit alleging the false or fraudulent submission of claims for payment under federal programs or other violations of the statute and to share in any amounts paid by the entity to the government in fines or settlement. Such suits, known as qui tam actions, have increased significantly in recent years and have increased the risk that companies like us may have to defend a false claim action. We could also become subject to similar false claims litigation under state statutes. If we are unsuccessful in defending any such action, such action may have a material adverse effect on our business, financial condition and results of operations.
The difficulties of operating in international markets may harm sales of our products.
The international nature of our business subjects us and our representatives, agents and distributors to the laws and regulations of the jurisdictions in which they operate, and in which our products are sold and used. The types of risks that we face in international operations include:
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the imposition of governmental controls;
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logistical difficulties in managing international operations; and
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fluctuations in foreign currency exchange rates.
Our international sales and operations may be limited or disrupted if we cannot successfully meet the challenges of operating internationally.
We may acquire technologies, products or businesses in the future, and these acquisitions could result in disruption of our business, increased costs and dilution to our shareholders.
An acquisition of assets, products or another business entails risks, uncertainties and potential disruptions to our business, and could divert management attention. We also could fail to assimilate the acquired business or company, which could lead to higher operating expenses. In addition, certain acquired technology could require significant additional development work and efforts to obtain regulatory clearance or approval, which could cause us to incur significant expense or to expend significant amounts of cash. Further, any acquired product may not provide the intended complementary fit with our existing product portfolio. Our shareholders could also be diluted if we issue shares of our stock to acquire another company, business or technology.
Our business could suffer if we cannot attract and retain the services of key employees.
We depend substantially upon the continued service and performance of our existing executive officers. We rely on key personnel in formulating and implementing our product research, development and commercialization strategies. Our success will depend in large part on our ability to attract and retain highly skilled employees. We compete for such personnel with other companies, academic institutions, government entities and other organizations. We may not be successful in hiring or retaining qualified personnel. If one or more of our key employees resigns, the loss of that employee could harm our business. If we lose any key personnel, we may not be able to prevent the unauthorized disclosure or use of our technical knowledge or other trade secrets by those former employees, or successfully prevent them from competing against us despite our use of confidentiality and non-compete agreements.
Negative changes in economic conditions may adversely affect our sales, business or the profitability of our products.
The current economic conditions and recent financial crisis affecting the banking system and financial markets have resulted in a tightening in the credit markets, a low level of liquidity in many financial markets, and extreme volatility in fixed income, credit and equity markets. The impact of these conditions could result in a number of follow-on adverse effects on our business, liquidity and results of operations, including but not limited to:
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the inability of one or more of our key suppliers to obtain credit to finance their operations or the insolvency of one or more of our key suppliers, which could adversely affect our product supply and reduce our sales;
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the inability of customers to obtain credit to finance purchases of our products and/or customer insolvencies, which could reduce our sales, profitability and collectability of our receivables;
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an unwillingness or inability of our current or potential business partners to continue existing collaborations or enter into transactions with us;
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a negative impact our current investment portfolio; and
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our inability to raise funds through equity or debt financings, including through additional borrowings under our current debt facility with LB I Group, that may be necessary in the future for various purposes, including acquisitions of products, technologies or other companies.
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In addition, U.S. unemployment levels have been increasing. If patients become unemployed and lose health insurance previously obtained through their employers’ plans, we could see a decrease in elective surgeries that use our products, which would adversely affect our sales and could result in excess inventory.
RISKS RELATED TO OUR FINANCIAL RESULTS AND FINANCING
If our losses continue in the long term, they could limit our growth in the orthopedic industry and jeopardize our viability.
We have experienced negative operating cash flows since our inception and have funded our operations primarily from proceeds received from sales of our securities. In November and December 2006, we raised approximately $26,600,000 in net proceeds from the sale of 8,819,128 shares of our common stock to institutional investors. In July 2007, we sold 12,317,066 shares of our common stock for net proceeds of approximately $32,200,000. In addition, in July 2007, we entered into a senior secured note purchase facility with LB I Group Inc., an affiliate of Lehman Brothers Inc., under which we have issued $35,000,000 of our 10% senior secured notes due July 30, 2012. We believe our existing cash, cash equivalents, and short-term investments of $32,290,503 as of December 31, 2008 will be sufficient to meet our currently estimated operating
and investing requirements for the foreseeable future. To date, we have not been profitable. We have incurred substantial operating losses since our inception and at December 31, 2008, had an accumulated deficit of $176,672,323. These losses have resulted principally from:
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the development and patenting of our technologies;
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pre-clinical and clinical studies;
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preparation of submissions to the FDA and foreign regulatory bodies;
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the development of manufacturing, sales and marketing capabilities; and
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the repurchase of a revenue interest from Royalty Securitization Trust I in July 2007.
We expect to continue to incur significant operating losses in the future as we continue our product development efforts, expand our marketing and sales activities and further develop our manufacturing capabilities. We may not ever successfully commercialize our products in development. We may never be able to achieve or maintain profitability in the future and our products may never be commercially accepted or generate sufficient product sales to fund operations.
If we default under our senior secured note purchase facility, we may be required to repay amounts due under the facility, and we may incur additional interest and prepayment penalties. If we are unable to repay amounts due under the note facility, the note holders could foreclose on certain assets that are essential to our operations.
On July 30, 2007, we entered into a $45,000,000 senior secured note purchase facility with LB I Group Inc., an affiliate of Lehman Brothers Inc. Notes issued under the facility are due July 30, 2012. We initially issued $25,000,000 principal amount of our 10% senior secured notes under the facility and used most of the proceeds to repurchase a revenue interest obligation. On July 31, 2008 we issued an additional $10,000,000 principal amount of notes under the facility primarily to fund our acquisition of the collagen raw material, equipment and technology license from Allergan. Under our senior secured note purchase facility, we currently have the option through January 30, 2010 to issue up to an additional $10,000,000 aggregate principal amount of 10% senior secured notes due July 30, 2012 to fund working capital and other general business purposes, including product acquisitions, sales force expansion and product development, if certain conditions are met. In connection with entering into the facility, we issued to the note purchaser five-year warrants to purchase 1,466,276 shares of our common stock at an exercise price of $3.41 per share, of which warrants to purchase 1,099,707 shares are currently exercisable. The unexercisable warrants become exercisable ratably upon future issuances of the 10% senior secured notes under the facility. If we borrow additional funds under our senior secured note purchase facility, our debt service obligation would increase and some or all of the currently unexercisable warrants would vest. As of December 31, 2008, we had $10,000,000 available for additional borrowing under the facility. However, in September 2008, Lehman Brothers Holding Inc., an affiliate of LB I Group, filed for bankruptcy relief under Chapter 11 of Title 11 in the U.S. Bankruptcy Court. Accordingly, as an affiliate of Lehman Brothers Holding Inc., LB I Group may not be able to advance any additional funds under the debt facility.
Borrowings under the facility are guaranteed by us and one of our wholly-owned subsidiaries. The facility is secured by a first priority lien on substantially all of our assets (including intellectual property) other than those exclusively related to CORTOSS and ALIQUOT. We are required to make quarterly interest only payments to the note holder. Outstanding principal amounts under the notes bear annual interest at 10%, provided that interest would accrue at 12% per year during the continuance of any event of default and would be payable on demand. Based on the amount outstanding under the facility as of December 31, 2008, we will incur quarterly interest expense of $875,000 during 2009. The unpaid principal amount under the notes and accrued interest and all other obligations would become due and payable immediately if we are insolvent, are in bankruptcy proceedings or have a custodian or receiver appointed for any substantial part of our property. If an event of default not described in the preceding sentence occurs and is continuing (including a change of control of the Company),
then the holders of at least two-thirds in principal amount of notes then outstanding may declare the unpaid principal amount of the notes, accrued interest and all other obligations due and payable immediately. In addition, if the notes become due and payable, whether automatically or by declaration, by reason of any of the following events of default, then we must pay a prepayment premium of up to 16% of the outstanding principal balance of the notes then outstanding, depending on the timing of the prepayment:
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We fail to pay any principal on any note or prepayment premiums, if any, when due and payable;
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We fail to pay any interest on any note or other amount (other than principal or prepayment premiums) for more than three business days after becoming due and payable;
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We are insolvent, in bankruptcy proceedings or have a custodian or receiver appointed for any substantial part of our property; or
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A change of control of our company occurs.
Under the facility, we must comply with various financial and non-financial covenants. For example, we are required to maintain a minimum cash balance equal to at least 25% of the then outstanding principal amount under the notes in a separate account that is pledged as collateral for the loan. As of December 31, 2008, we must maintain a minimum cash balance of $8,750,000. The primary non-financial covenants limit our ability to incur indebtedness or liens, sell assets, conduct mergers or acquisitions, make investments and pay dividends.
As of December 31, 2008, we had $35,000,000 outstanding under the facility, had accrued approximately $875,000 in interest thereon, and were in compliance with all covenants under the facility. Based on our current operating plans, we expect to be in compliance with the covenants under the facility within the next twelve months from the date of filing of this report. However, if we default under the facility and cannot repay amounts then due, the note holders could foreclose on the pledged assets, we could be forced into bankruptcy and we could be otherwise harmed.
We may seek to obtain additional funds through additional borrowings, other debt financings, or strategic alliances with third parties either alone or in combination with equity or debt financing investments, which could adversely affect our financial condition and cause dilution to our existing shareholders.
There are factors that may cause our future capital requirements to be greater than anticipated or could accelerate our need for funds including, without limitation:
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delays in the timing of receipt of required regulatory approvals or clearances to make or sell products;
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unforeseen difficulties in operating an effective direct sales and distribution network;
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unanticipated expenditures in research and product development or manufacturing activities;
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delayed, insufficient or lack of market acceptance of our products;
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unforeseen developments during our pre-clinical and clinical trials;
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unanticipated expenditures in the acquisition, enforcement and defense of intellectual property rights;
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unforeseen changes in healthcare reimbursement for procedures using our products;
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inability to increase sales of our approved or cleared products;
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inability to train a sufficient number of surgeons to create demand for our products;
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lack of financial resources to adequately support our operations;
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difficulties in maintaining commercial scale manufacturing capacity and capability;
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unforeseen problems with our third-party manufacturers and service providers or with our specialty suppliers of certain raw materials;
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unanticipated difficulties in operating in international markets;
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the need to respond to technological changes and increased competition;
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unforeseen problems in attracting and retaining qualified personnel to market our products;
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enactment of new legislation or administrative regulation or changes in the regulatory climate affecting our products or the markets in which we compete;
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the application to our business of new court decisions and regulatory interpretations;
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claims that might be brought in excess of our insurance coverage;
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any imposition of penalties for failure to comply with regulatory guidelines; or
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management’s perception that uncertainties relating to these factors may be increasing.
In addition, we may seek to expand our operations and product line through acquisitions or joint ventures. Any such acquisitions or joint ventures may increase our capital requirements.
We cannot be certain that funding will be available on terms acceptable to us, if at all, particularly in light of current economic conditions. Any public or private financings may involve issuances of debt or common stock or other classes of our equity, which could further dilute existing shareholders’ percentage ownership. If we are unable to obtain funding to support operations, we may be forced to curtail our operations or be unable to develop products.
We are required annually, or on an interim basis as needed, to review the carrying value of our intangible assets for impairment. If sales of our VITAGEL product decline because of, for example, competition or an inability to manufacture sufficient supply of product, the intangible asset value of any declining product could become impaired.
As of December 31, 2008, we had approximately $12,354,000 of license and technology intangible assets, net of accumulated amortization, consisting of (i) $7,299,000 for our prepayment in December 2006 of the profit-sharing license royalties on VITAGEL and CELLPAKER and (ii) $5,055,000 recorded for the value of the collagen-processing technology license acquired from Allergan in the third quarter of 2008. If a change in circumstances causes us to lower our future sales forecast for VITAGEL, we may be required to write off a portion or all of the net book value of the intangible assets associated with that product. Intangibles subject to amortization 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 comparing the carrying amount of the asset against the estimated undiscounted future cash flows expected to be generated by this asset. If the sum of the expected future net cash flows are less than the carrying value of the asset being evaluated, an impairment loss would be recognized. The impairment loss would be calculated as the amount by which the carrying value of the asset exceeds its fair value. An impairment charge to our net intangible assets, depending on the size, could result in a material adverse effect on our business, financial condition and results of operations.
RISKS RELATED TO OUR INTELLECTUAL PROPERTY AND LITIGATION
Our business will be damaged if we are unable to protect our proprietary rights to our products, and we may be subject to intellectual property infringement claims by others.
We rely on patent protection, as well as a combination of copyright, trade secret and trademark laws, nondisclosure and confidentiality agreements and other contractual restrictions to protect our proprietary technology. However, these measures afford only limited protection and may not adequately protect our rights. For example, our patents may be challenged, invalidated or circumvented by third parties. As of February 20, 2009, we own or control 20 issued U.S. patents and 19 pending patent applications in the U.S., and counterparts
of certain of these patents and pending patent applications worldwide, including Canada, Europe, Mexico and Japan. There can be no assurance that patents will issue from any of the pending patent applications. Moreover, we cannot be certain that we were the first creator of inventions covered by pending patent applications or we were the first to file patent applications for the relevant inventions for the following reasons:
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patent applications filed prior to December 2000 in the U.S. are maintained in secrecy until issued;
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patent applications filed after November 2000 in the U.S. are maintained in secrecy until eighteen months from the date of filing; and
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the publication of discoveries in the scientific or patent literature tends to lag behind actual discoveries.
If we do receive a patent, it may not be broad enough to protect our proprietary position in the technology or to be commercially useful to us. In addition, if we lose certain key personnel, we may not be able to prevent the unauthorized disclosure or use of our technical knowledge or other trade secrets by those former employees. Furthermore, the laws of foreign countries may not protect our intellectual property rights to the same extent as the laws of the United States. Even if our intellectual property rights are adequately protected, litigation or other proceedings may be necessary to enforce our intellectual property rights, which could result in substantial costs to us and divert management attention. If our intellectual property is not adequately protected, our competitors could use the intellectual property that we have developed to enhance their products and compete more directly with us, which could damage our business.
In addition to the risk of failing to adequately protect our proprietary rights, there is a risk that we may become subject to a claim that we infringe upon the proprietary rights of others. Although we do not believe that we are infringing the rights of others, third parties may claim that we are doing so. There is a substantial amount of litigation over patent and other intellectual property rights in the medical device industry generally, and in the spinal market segments particularly. If the holder of a proprietary right brought an infringement action against us, the cost of litigating the claim could be substantial and divert management attention. In addition, if a court determined that one of our products infringed a proprietary right, we could be prevented from selling that product unless we could obtain a license from the owner of the right. A license may not be available on terms acceptable to us, if at all. Modification of our products or development of new products to avoid infringement may require us to conduct additional clinical trials for these modified or new products and to revise our filings with the FDA, which is time consuming and expensive. If we are not successful in obtaining a license or redesigning our product, our business could suffer.
We have obtained certain of our intellectual property rights and our rights to develop and commercialize certain products, and made certain commitments regarding our intellectual property and these rights, through license and development agreements with third parties. These agreements generally may be terminated by our counterparty if we materially breach any of our obligations under the agreement. We may disagree with these third parties as to our and their obligations under the agreements or the interpretation of provisions in the agreements. Any such disagreements could cause these third parties to seek to terminate our rights under the particular agreement. If any of our agreements were terminated, we could lose the rights to the product, product candidate or intellectual property covered by the agreement, reducing our revenue, potential revenues and significantly harming our business. Whether or not such a termination were proper, if a dispute arises under any of our agreements, the need to resolve the dispute could consume significant resources and divert management’s time and attention.
We distribute VITASURE, which we purchase from Medafor and is manufactured by third parties on behalf of Medafor. Medafor and these third parties have patents, licenses, and proprietary technologies related to VITASURE. We cannot be certain that no one will challenge the validity or enforceability of any patent that they own. We cannot be certain that if anyone does make such a challenge, that these third parties will be able to successfully defend that challenge, with or without our assistance. In addition, others may infringe these third parties’ patents or use their proprietary rights inappropriately. If others infringe patents owned or licensed by
these third parties and related to VITASURE, we may choose to assist in bringing an infringement action and may incur substantial costs in any efforts to uphold the validity and prevent infringement of a patent or to protect proprietary technologies and methods. Furthermore, we cannot be certain that competitors will not independently develop similar technologies, duplicate technologies, design around the patented aspects of such technologies, or attempt to duplicate their proprietary technologies that have no patent protection. In addition, we cannot be sure that these third parties’ technologies will not infringe patents or other rights owned by others.
If we are sued in a product liability action, we could be forced to incur substantial defense costs, pay substantial damages and the attention of our management team may be diverted from operating our business.
We manufacture medical devices that are used on patients in surgery, and we may be subject to product liability lawsuits. In particular, the market for spine products has a history of product liability litigation. Under certain of our agreements with our distributors and hospital customers, we indemnify the distributor or hospital from product liability claims. Any product liability claim brought against us, with or without merit, could result in the increase of our product liability insurance rates or the inability to secure coverage in the future. In addition, we could incur substantial costs to defend these claims and would have to pay any amount awarded by a court in excess of policy limits. We maintain product liability insurance in the annual aggregate amount of up to $10,000,000, although our insurance policies have various exclusions. Thus, we may be subject to a product liability claim for which we have no insurance coverage, in which case we may have to pay the entire amount of any defense costs or award. Even in the absence of a claim, our insurance rates may rise in the future to a point where we may decide not to carry this insurance. A meritless or unsuccessful product liability claim would be time-consuming and expensive to defend and could divert management’s attention from our core business. A successful product liability claim or series of claims brought against us in excess of our coverage could have a material adverse effect on our business, financial condition and results of operations.
RISKS RELATED TO INVESTING IN OUR STOCK AND EQUITY MARKETS
Our stock price may be volatile for many reasons, including fluctuations in our results of operations due to factors out of our control.
The market price of our common stock may fluctuate substantially, which could adversely affect the value of an investment in our common stock or shareholders’ ability to sell our shares. Our stock price may fluctuate due to fluctuations in our results of operations or for other reasons. Future levels of our product sales and the timing of regulatory clearances and product introductions are difficult to predict, and product sales to date may not be indicative of future sales levels. We currently sell VITAGEL and CELLPAKER under a license agreement, the termination of which would have a material adverse effect on our sales revenues. Our results of operations may fluctuate significantly in the future as a result of a number of additional factors, many of which are outside of our control. These factors include, but are not limited to:
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the timing of governmental approvals or clearances for our products and our competitors’ products;
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the timing of product introductions by us or our competitors;
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unanticipated events associated with clinical and pre-clinical trials of our products;
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the medical community’s acceptance of our products;
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issues in establishing adequate commercial-scale manufacturing capabilities;
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disruptions with the manufacturing of our products, including with respect to our third-party manufacturers and suppliers of raw materials;
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difficulties in establishing and expanding our sales and distribution channels;
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the mix of our products as profit margins differ between our products;
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product recalls;
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the timing in obtaining adequate third-party reimbursement of our products;
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the success of competitive products;
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our ability to enter into strategic alliances with other companies;
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expenses associated with development and protection of intellectual property matters;
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events affecting logistics and elective surgery trends;
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the timing of expenses related to commercialization of new products;
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competitive disruptions to our sales and distribution channels;
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fluctuations in sales levels, which may be caused by seasonality of elective surgeries, the timing of orders from hospitals or distributor stocking orders, and other factors;
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news concerning economic or market conditions in the general economy or within our industry, or the movement of capital into or out of our industry;
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changes in U.S. or foreign government regulations impacting our industry;
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the adequate training of a sufficient number of surgeons in the use of our products; and
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the timing of governmental approvals or clearances for us to manufacture the products we sell.
The results of our operations may fluctuate significantly from quarter to quarter and may not meet expectations of securities analysts and investors. This may also cause our stock price to be volatile.
In general, equity markets, including NASDAQ, have from time to time experienced significant price and volume fluctuations that are unrelated to the operating performance of particular companies. These broad market fluctuations, including the following factors, may adversely affect the market price of our common stock:
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changes in the financial guidance we provide to the investment community;
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changes in stock market analyst recommendations regarding our stock;
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sales by existing holders of significant numbers of shares of our stock into the market, including sales by the three institutional investors that, as of December 31, 2008, held approximately one-quarter of our outstanding shares;
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FDA and international regulatory actions regarding us or our competitors;
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determinations by governments and insurance companies regarding reimbursement for medical procedures using our or our competitors’ products;
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product sales growth rates;
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developments with respect to patents or proprietary rights;
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public concern as to the safety of products developed by us or by others;
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changes in health care policy in the United States and internationally;
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acquisitions or strategic alliances by us or our competitors;
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business conditions affecting other medical device companies or the medical device industry generally;
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general market conditions, particularly for companies with small market capitalizations; and
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pending or threatened offers to acquire us.
Provisions of Pennsylvania law or our Articles of Incorporation may deter a third party from seeking to obtain control of us or may affect your rights as a shareholder.
Certain provisions of Pennsylvania law could make it more difficult for a third party to acquire us, or could discourage a third party from attempting to acquire us. These provisions could limit the price that certain investors might be willing to pay in the future for shares of our common stock. In addition, our Articles of Incorporation enable our board of directors to issue up to 19,998,100 shares of preferred stock having rights, privileges and preferences as are determined by the board of directors. Accordingly, our board is empowered, without shareholder approval, to issue preferred stock with dividend, liquidation, conversion, voting or other rights superior to those of holders of our common stock. For example, an issuance of preferred stock could:
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adversely affect the voting power of the common shareholders;
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make it more difficult for a third party to gain control of us;
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discourage bids for our common stock at a premium; or
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otherwise adversely affect the market price of our common stock.
Future sales of our common stock in the public market could adversely affect our stock price.
We cannot predict the effect, if any, that future sales of our common stock or the availability for future sales of shares of our common stock or securities convertible into or exercisable for our common stock will have on the market price of our common stock prevailing from time to time. We have an effective registration statement on Form S-3 which allows us to sell up to approximately $67.5 million of securities in one or more public offerings. The registration statement provides us with the flexibility to determine the type of security we choose to sell, including common stock, preferred stock, warrants with debt securities, as well as the ability to time such sales when market conditions are favorable.
As of December 31, 2008, we had outstanding options to purchase 6,675,326 shares of our common stock at a weighted average exercise price of $3.55 per share and 341,114 shares underlying restricted share and restricted stock unit grants issued to employees, directors and consultants pursuant to our 2007 Omnibus Equity Compensation Plan, 421,200 performance-based equity awards, and outstanding warrants to purchase 1,466,276 shares of our common stock at an exercise price of $3.41 per share. In order to attract and retain key personnel, we may issue additional securities, including stock options, restricted stock grants and shares of common stock, in connection with our equity compensation plan. The sale, or the availability for sale, of substantial amounts of common stock by our existing shareholders pursuant to an effective registration statement or under Rule 144, through the exercise of registration rights or the issuance of shares of common stock upon the exercise of stock options or warrants, or the perception that such sales or issuances could occur, could adversely affect the prevailing market prices for our common stock.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not applicable.
ITEM 2.
ITEM 2. PROPERTIES
Our headquarters are located at the Great Valley Corporate Center in Malvern, Pennsylvania, which is a suburb of Philadelphia. We lease several buildings within the Great Valley Corporate Center as follows:
(*) Currently under renovation
We believe our existing manufacturing facilities have the capacity to meet our commercial needs through at least 2012. We are also expanding our manufacturing capability for VITAGEL at sites we currently lease (see-MANUFACTURING AND PRODUCT SUPPLY-Raw Materials Supply under Item 1. BUSINESS, above). Based on our current commercial needs and estimated requirements for the possible U.S. launch of CORTOSS, we do not anticipate the need in the foreseeable future for additional capacity for CORTOSS.
We conduct our international sales and marketing activities through administrative office space in Leuven, Belgium, which we have leased through May 2009.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Settlement of Lawsuit: As previously reported in our Annual Report on Form 10-K for the year ended December 31, 2007, Mo-Sci Corporation (“Mo-Sci”) filed a complaint against us on March 4, 2008 in the United States District Court for the Eastern District of Pennsylvania (the “Court”). As previously reported in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2008, we asserted counterclaims and third-party claims against Mo-Sci and Dr. Erik Erbe, an individual we believe had served as a consultant to Mo-Sci and who is our former employee. On October 28, 2008, Mo-Sci entered into a settlement agreement with us. Pursuant to the agreement, (i) Mo-Sci has dismissed with prejudice its claims against us, and we have dismissed with prejudice our counterclaims against Mo-Sci, that were filed in the lawsuit; (ii) Mo-Sci reimbursed us for part of the legal fees that we incurred defending the litigation; and (iii) Mo-Sci entered into a supply agreement with us under which it agreed to supply us with certain glass components for our products. We did not make any payment to Mo-Sci to settle the litigation. Our third party claims against Dr. Erbe have not been dismissed.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is quoted on the NASDAQ Global Market (“NASDAQ”) under the symbol “VITA.” The following table reflects the ranges of high and low sale prices for our common stock as reported on NASDAQ for the stated periods.
As of March 6, 2009 there were 220 holders of record for shares of our common stock. Since a portion of our common stock is held in “street” or nominee name, we are unable to determine the exact number of beneficial holders. On March 6, 2009, the last sale price of our common stock as reported by NASDAQ was $2.88 per share. We have never declared or paid cash dividends on shares of our common stock and do not intend to pay any cash dividends in the foreseeable future on shares of our common stock.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table presents selected historical consolidated financial data derived from the consolidated financial statements of Orthovita, Inc. and subsidiaries as of and for each of the five years in the period ended December 31, 2008. This data should be read in conjunction with our consolidated financial statements, including notes thereto, and “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION,” included in this report.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
FORWARD-LOOKING STATEMENTS
Forward-looking statements give our current expectations, forecasts of future events or goals. You can identify these statements by the fact that they do not relate strictly to historical or current facts. These statements may include words such as “may,” “will,” “anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,” “believe,” “seek” and other words and terms of similar meaning in connection with any discussion of future operating or financial performance. Any or all of our forward-looking statements in this Form 10-K may turn out to be incorrect. They can be affected by inaccurate assumptions we might make, or by known or unknown risks and uncertainties. Consequently, no forward-looking statement can be guaranteed. Actual future results may vary materially. There are important factors that could cause actual events or results to differ materially from those expressed or implied by forward-looking statements including, without limitation, the development, regulatory approval, demand and market acceptance of our products; the amount of data that the FDA will require for our CORTOSS® 510(k) application and whether any data will be sufficient to support approval; the cost to expand our manufacturing and operating facilities; the development of our sales network; capital expenditures; future liquidity; uses of cash; the achievement of product development goals and the amount and timing of related milestone and other payments; sales product mix and related margins; our ability to manage our manufacturing facilities and requirements; cost and availability of raw materials; inventory levels; development costs for existing and new products; equity compensation expense; changes in market interest and foreign currency exchange rates; fluctuations in our stock price; and the other risk factors addressed in ITEM 1A. “RISK FACTORS” in this report.
We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our filings with the U.S. Securities and Exchange Commission (the “SEC”). This discussion is provided as permitted by the Private Securities Litigation Reform Act of 1995.
OVERVIEW
Product sales for 2008 increased 33% to $76,914,983 from $58,045,676 in 2007. Increased product sales principally reflect increased sales of our VITOSS® FOAM (including sales of VITOSS Bioactive FOAM products introduced in 2008) and VITAGEL® products in the United States. Nevertheless, we anticipate our product sales will remain insufficient to support our present operations at expected spending levels. We expect to continue to incur operating losses for the foreseeable future as we plan to continue to expand our sales and marketing activities, pursue research and product development efforts, further develop our manufacturing capabilities and attempt to increase manufacturing efficiencies.
The following discussion summarizes our principal cash commitments at December 31, 2008 and, as of the date of this report, our principal anticipated expenditures: For additional information on commitments and expenditures, see Note 15 to our consolidated financial statements included in this report.
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Operations. We expect to use cash, cash equivalents and short-term investments to fund our operations until we generate sufficient cash to support our operations. We have contractual commitments to pay approximately $800,000 in rent during 2009 under leases. In addition, we expect to hire additional direct sales representatives to support not only the growth of our existing products, but to plan ahead for the possible clearance and commercial launch of CORTOSS in the United States. While we believe that our investment in our sales force may also support opportunities we may pursue to in-license or distribute additional products, we expect to continue spending for research and development for new products. We also expect to build inventory in 2009 to plan for the possible clearance and launch of CORTOSS in the U.S. and to establish a strategic inventory reserve for VITAGEL.
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Agreement with Kensey. Approximately 63% of our product sales during 2008 were from products based upon our VITOSS FOAM platform co-developed with Kensey. As of December 31, 2008, we
owed Kensey $3,154,552 for manufactured product inventory and royalties, which amount is included in accounts payable and other accrued expenses on our consolidated balance sheet as of December 31, 2008 included in this report.
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Research and development. We expect to incur between approximately $3,000,000 and $4,000,000 in external costs during 2009 for research and development activities. Of this amount, we expect to incur approximately $700,000 in external costs for the CORTOSS 510(k) application that is currently under review by the FDA. The remainder relates to certain payment obligations based on the achievement of certain product development and other milestones in 2009 and beyond. See “CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS-Research and development” below for more information.
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Debt service obligation. We expect to pay approximately $875,000 in quarterly interest payments during each quarter of 2009 under the $35,000,000 aggregate principal amount of notes issued under our debt facility with LB I Group Inc. See Note 9 to our consolidated financial statements included in this report for additional information.
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Expansion of manufacturing capacity and other facility renovations. We expect to spend approximately $4,000,000 for plant renovations and equipment during 2009, primarily to further expand our capacity to manufacture VITAGEL. We plan to finance the renovations and equipment through cash on hand.
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Medafor Agreement. We are required to spend $1,000,000 in the third quarter of 2009 to purchase additional VITASURE product inventory under our distribution agreement with Medafor.
We believe our existing cash, cash equivalents, and short-term investments of $32,290,503 as of December 31, 2008 will be sufficient to meet our currently estimated operating and investing requirements for the foreseeable future.
CRITICAL ACCOUNTING POLICIES
The preparation of our consolidated financial statements requires us to make assumptions, estimates and judgments which affect the reported amounts of assets and liabilities, the disclosures of contingent assets and liabilities as of the date of our consolidated financial statements, and the reported amounts of revenues and expenses during the reporting periods. By their nature, these assumptions, estimates and judgments are subject to an inherent degree of uncertainty. We use authoritative pronouncements, historical experience and other assumptions as the basis for making estimates. Actual results will differ from those estimates. The critical accounting policies addressed below have been reviewed with the Audit Committee of our Board of Directors and reflect our most significant judgments and estimates used in the preparation of our consolidated financial statements.
Revenue Recognition
Revenue is not recognized until persuasive evidence of an arrangement exists, performance or delivery has occurred, the sales price is fixed or determinable and collection is probable. In the U.S., product sales revenue is recognized upon either shipment of purchased product to the customer, or receipt of documentation from the customer indicating its consumption of product from consigned inventory. In 2008, for transactions outside the U.S., we modified our shipping terms from FOB destination to FOB shipping point. Accordingly, outside the U.S., 2008 revenue from product sales was primarily recognized upon shipment of our product to our independent stocking distributors. Prior to 2008, we primarily recognized product sales outside the U.S. upon receipt of our product by our independent stocking distributors. We do not allow product returns or exchanges. We have no obligations to our customers once title has been transferred. Both our U.S. customers and our independent stocking distributor customers outside of the U.S. are generally required to pay on a net 30-day basis and payment discounts are not offered.
Allowance for Doubtful Accounts
We maintain an accounts receivable allowance for an estimated amount of losses that may result from a customer’s failure to pay for product purchased. The allowance for doubtful accounts is reviewed quarterly and is
estimated based on historical bad debts, customer concentrations, known trends with current customers, and changes in customer payment patterns. If the financial condition of our customers or the overall condition of the healthcare industry were to deteriorate and result in an impairment of our customers’ ability to make payments, additional allowances may be required.
Inventories
Inventories are stated at the lower of cost or market value using the first-in first-out basis, or FIFO. A provision is recorded to reduce the cost of inventories to the estimated net realizable values, if required. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 2, “Accounting for Research and Development Costs,” the costs of producing inventory in the reporting periods prior to the receipt of regulatory approval or clearance are recorded as research and development expense.
Income Taxes
We account for income taxes in accordance with an asset and liability approach requiring the recognition of deferred tax assets and liabilities for the expected tax consequences of events that have been recognized in the financial statements or tax returns. Deferred tax assets and liabilities are recorded without consideration as to their ability to be realized. The deferred tax asset includes net operating loss and credit carry forwards, and the cumulative temporary differences related to certain research and patent costs, which have been charged to expense in our consolidated statements of operations but have been recorded as assets for tax return purposes. The portion of any deferred tax asset, for which it is more likely than not that a tax benefit will not be realized, must then be offset by recording a valuation allowance against the asset.
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. With the exception of the Texas margin tax credit as described below, management believes it is more likely than not that we will not realize the deferred tax assets in excess of deferred tax liabilities. A valuation allowance is maintained against the net deferred tax assets in excess of the Texas margin tax credit.
In October 2008, the United States Congress enacted the Housing Assistance Act of 2008 (Public Law 100-289), which enabled us to make federal tax election to claim accelerated research tax credits in lieu of bonus depreciation. As a result of Public Law 110-289, we recognized a current income tax benefit of $54,856 in the fourth quarter of 2008.
In 2006, Texas enacted a margin tax which restructured the state business tax by replacing the taxable capital components of the current franchise tax with a new “taxable margin” component. The Texas margin tax was effective for taxable years ended on or after January 1, 2007. As a result of the Texas margin tax, during 2008 and 2007, we recognized current state income tax expense of $45,216 and $35,000, respectively and a deferred state income tax benefit of $296,006 and $302,980, respectively, for the Texas temporary credit on taxable margin. Under the Texas margin tax, we have the right to claim a temporary credit against our Texas margin tax liability over a 20 year period. As a result, we have recorded a deferred tax asset of $296,006 as of December 31, 2008, which is included in Other Assets on our consolidated balance sheet. We have recognized a deferred tax asset related to the Texas tax credit as we believe it will more likely than not to be realized based on projections of future Texas margin tax liabilities. See Note 14 to our consolidated financial statements included in this report for additional information.
Accounting for Stock Options Issued to Employees
We apply SFAS No. 123R, “Share-Based Payment” which requires companies to expense the value of employee stock options and similar awards in our consolidated statements of operations. Compensation expense
for awards granted prior to 2006 is being amortized based upon a graded vesting schedule in accordance with FASB Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.” Stock-based compensation expense for all stock-based compensation awards granted to employees on and after January 1, 2006 is amortized on a straight-line basis over the requisite service period of the award.
Impairment of Long-Lived Assets
SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets”, (“SFAS No. 144”), addresses the accounting of and reporting for the impairment of long-lived assets and for long-lived assets to be disposed of such as property, equipment, and intangibles. In accordance with SFAS No. 144, we evaluate the recoverability of long-lived assets whenever events or changes in circumstances indicate that an asset’s carrying amount may not be recoverable. Such circumstances could include, but are not limited to (1) a significant decrease in the market value of an asset, (2) a significant adverse change in the extent or manner in which an asset is used, or (3) an accumulation of costs significantly in excess of the amount originally expected for the acquisition of an asset. We measure the carrying amount of the asset against the estimated undiscounted future cash flows associated with it. Should the sum of the expected future net cash flows be less than the carrying value of the asset being evaluated, an impairment loss would be recognized. The impairment loss would be calculated as the amount by which the carrying value of the asset exceeds its fair value. The fair value is measured based on quoted market prices, if available. If quoted market prices are not available, the estimate of fair value is based on various valuation techniques, including the discounted value of estimated future cash flows.
We did not recognize any impairment charges related to property and equipment or intangible assets subject to amortization during 2008, 2007 or 2006 as their carrying amounts were not impaired.
Research & Development Costs
In accordance with SFAS No. 2 “Accounting for Research and Development Costs”, we expense all research and development expenses as incurred.
Fair Value Measurements
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 clarifies the definition of fair value, establishes a framework for measuring fair value and expands disclosures on fair value measurements. In February 2008, the FASB issued two final staff positions (“FSP”) amending SFAS No. 157. FSP SFAS 157-1 amends SFAS No. 157 to exclude SFAS No. 13, “Accounting for Leases” and its related interpretive accounting pronouncements that address leasing transactions. FSP SFAS 157-2 delays the effective date of SFAS No. 157 until fiscal years beginning after November 15, 2008 for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis. We adopted SFAS No. 157 on January 1, 2008, except for the items covered by FSP SFAS 157-2.
SFAS No. 157 establishes a three-tier fair value hierarchy, which prioritize the inputs used in measuring fair value as follows:
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Level 1: Observable inputs such as quoted prices in active markets;
•
Level 2: Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and
•
Level 3: Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.
Our short-term investments are reported at fair value on our consolidated balance sheet based on quoted prices in active markets for identical or comparable assets (Level 1).
Recent Accounting Pronouncements
In December 2007, the FASB issued SFAS No. 141R, “Business Combinations” (“SFAS No. 141R”) and SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements-an amendment to ARB No. 51” (“SFAS No. 160”), SFAS Nos. 141R and 160 require most identifiable assets, liabilities, noncontrolling interests, and goodwill acquired in a business combination to be recorded at “full fair value” and require noncontrolling interests (previously referred to as minority interests) to be reported as a component of equity, which changes the accounting for transactions with noncontrolling interest holders. Both statements are effective for periods beginning on or after December 15, 2008, and early adoption is prohibited. Accordingly, SFAS No. 141R will be applied to business combinations occurring on or after January 1, 2009. SFAS No. 160 will be applied prospectively to all noncontrolling interests, including any that arose before the effective date. The adoption of SFAS No. 160 is not expected to have any impact on our consolidated financial position and results of operations.
LIQUIDITY AND CAPITAL RESOURCES
We have experienced negative operating cash flows since our inception, and we have funded our operations primarily from the proceeds we received from sales of our common stock and other debt and equity securities. At December 31, 2008, we had cash, cash equivalents and short-term investments of $32,290,503.
Discussion of Cash Flows
Cash Flows Used in Operating Activities
Net cash used in operating activities in 2008 was $14,210,656, compared to $14,173,620 used in operating activities in 2007. Our operating cash outflows for 2008 primarily were used to fund our operations and include $3,186,797 to fund increases in inventories, as well as funding our growing product sales. In addition, increases in accounts receivable of $2,577,916 and decreases in accounts payable and other accrued expenses of $1,829,826 were a use of operating cash flows in 2008.
We expect to continue to focus our efforts on sales growth under our VITOSS, VITAGEL, and VITASURE product platforms in 2009. We launched Bioactive VITOSS FOAM and VITASURE in 2008. We may continue to add direct sales representatives to our organization for those territories in the U.S. where either we do not currently have independent distributor coverage or the territory is underserved in an effort to increase sales of our VITOSS and VITAGEL product lines and to plan ahead for the possible clearance of CORTOSS in the United States. Also, we intend to fund studies to collect and publish post-clinical data relating to the performance of VITOSS to support our marketing and sales efforts.
We expect to continue to use cash, cash equivalents and short-term investment proceeds to fund our operations until we are profitable. We anticipate that our product sales for the foreseeable future will remain insufficient to support our present operations at expected spending levels. As a result, we expect to continue to incur operating losses for the foreseeable future as we continue to expand our sales and marketing activities, pursue product development efforts and further develop our manufacturing capabilities.
We expect to use between approximately $3,000,000 and $4,000,000 of cash in 2009 for external research and development activities. Of this amount, we expect to incur approximately $700,000 in external costs for the CORTOSS 510(k) application that is currently under review by the FDA. The remainder represents certain payment obligations based on the achievement of specified product development and other milestones in 2009 and beyond. See “CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS-Research and development” below for more information. The overall level of our research and development expense in future periods will depend upon the development status and cost of products currently in our pipeline and any new products that we may determine to pursue in the future. We also expect to incur additional expenses to support the U.S. launch of CORTOSS if it receives FDA clearance.
Our operating cash requirements are dependent heavily upon: (i) the timing of receipt of regulatory clearance for new products, (ii) the rates at which we add new direct sales representatives and our field sales network generates sales, (iii) our product sales mix as relative increases in sales of our lower margin products result in lower gross profit, which tends to increase our cash needs, (iv) the amount of inventory, including raw materials and work-in-process, that we maintain to support product sales, anticipated product sales and anticipated product launches, and (v) the timing of subsequent product launches and market acceptance of our new products. Accordingly, for the foreseeable future, our operating cash requirements will continue to be subject to quarterly volatility.
We are required to use cash, cash equivalents and short-term investments to purchase and pay for $1,000,000 of VITASURE product in the third quarter of 2009 in accordance with our distribution agreement with Medafor. We launched VITASURE in 2008.
Cash Flows Provided by (Used In) Investing Activities
Net cash provided by investing activities was $2,720,246 for 2008 compared to net cash used in investing activities of $27,557,306 for 2007. The increase in cash provided by investing activities in 2008 primarily reflects the proceeds from the sale and maturity of investments of $55,674,156, partially offset by the purchases of new investments of $40,749,867. In addition, we spent $5,852,043 in 2008 to purchase equipment and leasehold improvements to support further expansion of our product development and manufacturing capabilities for VITAGEL and VITOSS, as compared to $2,605,825 spent in 2007 for equipment and leasehold improvements. Additionally, we spent $6,552,000 in 2008 for the acquisition of collagen raw materials, equipment, and technology from Allergan for the manufacture of VITAGEL. The cash used in investing activities in 2007 primarily reflects the proceeds from the sale and maturity of investments of $35,640,156, offset by the purchase of new investments of $61,050,117. In addition, we spent $2,605,825 in 2007 to purchase equipment and leasehold improvements to support further expansion of our product development and manufacturing capabilities for VITAGEL and VITOSS.
We invest our excess cash in highly liquid investment-grade marketable securities, including corporate debt securities and government-sponsored enterprise debt securities. Marketable securities having maturities greater than three months and less than one year are classified as short-term investments.
Cash, cash equivalents and investments consisted of the following:
We expect to spend approximately $4,000,000 in 2009 primarily to expand our manufacturing facility for VITAGEL, as well as for leasehold improvements and capital equipment. We plan to finance the expansion, renovations and equipment through cash on hand.
Cash Flows Provided by Financing Activities
Net cash provided by financing activities for 2008 was $10,196,900 compared to $35,454,219 for 2007. The decrease of $25,257,319 for 2008 reflects primarily our 2007 issuance and sale of an aggregate of 12,317,066 shares of our common stock at $2.64 per share to raise aggregate net proceeds of $32,153,762, partially offset by cash provided by financing activities in 2008 primarily from the $10,000,000 in proceeds from additional amounts borrowed under our debt facility with LB I Group (see Note 9 to our consolidated financial statements included in this report). In addition, in 2007 we issued notes and warrants under our debt facility with LB I Group for proceeds of $25,000,000 and used the majority of these proceeds to pay Royalty Trust the $20,000,000 cash portion of the revenue interest obligation repurchase price (see Note 8 to our consolidated financial statements included in this report). We have used, and intend to continue using, the net proceeds from our note issuance in 2008 to expand our manufacturing capabilities.
We do not expect sales to generate cash flows in excess of operating expenses for the foreseeable future. Until we achieve sales levels to enable us to fund operating expenses, we expect to continue to use cash, cash equivalents and short-term investment proceeds to fund operating and investing activities. As of December 31, 2008, we had cash, cash equivalents and short-term investments of $32,290,503, and we had $10,000,000 available for additional borrowing under our debt facility with LB I Group Inc. However, in September 2008, Lehman Brothers Holding Inc., an affiliate of LB I Group, filed for bankruptcy relief under Chapter 11 of
Title 11 in the U.S. Bankruptcy Code. Accordingly, as an affiliate of Lehman Brothers Holding Inc., LB I Group may not be able, or may be unwilling, to advance any additional funds under the debt facility. We believe our existing cash, cash equivalents and investments will be sufficient to meet our currently estimated operating and investing requirements for the foreseeable future. The extent and timing of proceeds from future stock option and warrant exercises, if any, are primarily dependent upon future trading prices for our common stock and the expiration dates of these instruments.
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
Notes Payable. On July 30, 2007, we entered into a $45,000,000 senior secured note purchase facility, to which we refer as our “debt facility” or “facility” with LB I Group Inc., an affiliate of Lehman Brothers Inc. Notes issued under the facility are due July 30, 2012. We issued a $25,000,000 principal amount of notes under the facility on July 30, 2007 and used most of the proceeds to repurchase a revenue interest obligation. On July 31, 2008, we issued an additional $10,000,000 principal amount of notes under the facility. We applied the proceeds of this note toward payment of (i) the $6,552,000 purchase price for the collagen raw material, equipment and technology license acquired under our supply and license agreement with Allergan during the third quarter of 2008; and (ii) costs to expand our manufacturing capacity for VITAGEL and ancillary products such as ALIQUOT, IMBIBE and CELLPAKER.
Borrowings under the facility are guaranteed by us and one of our wholly-owned subsidiaries. The facility is secured by a first priority lien on substantially all of our assets (including intellectual property) other than those exclusively related to CORTOSS and ALIQUOT. We are required to make quarterly interest only payments to the note holder. Outstanding principal amounts under the notes bear annual interest at 10%, except that during the continuance of any event of defaults, interest would accrue at the rate of 12% per year and the notes be payable on demand. As of December 31, 2008, we expect to incur quarterly interest expense of $875,000 under our debt facility during 2009.
Leases. We lease facilities under non-cancelable operating leases. During 2008, we extended the termination date of all of our facility leases to July 31, 2017.
Expansion of manufacturing capacity and other facility renovations. As of December 31, 2008, we have approximately $1,400,000 in commitments outstanding for plant expansion and equipment to increase our capacity at sites we currently lease to manufacture VITAGEL.
Our contractual obligations under our notes and leases, as well as our commitments for manufacturing expansion, are set forth in the table below:
In addition to the contractual obligations and commitments set forth above, we have the following contractual obligations:
Research and development. In connection with the development of new products with business partners, we may contractually agree to make milestone payments upon achievement of specified developmental goals. The
timing and actual amount of these payments can be difficult to determine as they depend upon satisfactory achievement of product development and other milestones, which will be determined based on events that may occur in the future. As of the date of the filing of this report, we have paid approximately $1,200,000 in 2009 for non-recurring license fees and product development milestones pursuant to contractual obligations that we incurred in 2009. Additional milestone payments may become due as early as 2009 if certain other milestones are met during the year. We expect to incur between $1,000,000 and $2,000,000 for milestone payments during 2009 in addition to those already paid for research and development activities. In addition, if products under development are brought to market, we may be obligated to make certain launch-related milestone payments of up to $1,000,000, as well as additional payments which may be made depending upon the potential achievement of sales milestones in future periods.
Agreement with Medafor. In April 2008, we obtained certain non-exclusive rights in the United States and in certain limited territories outside of the United States to distribute VITASURE pursuant to an agreement with Medafor. Under the agreement, if certain conditions are met, we are required to purchase and pay for at least $1,000,000 of additional VITASURE product from Medafor in the third quarter of 2009.
Agreement with Kensey Nash Corporation. See above discussion under “OVERVIEW,” above.
RESULTS OF OPERATION
This section should be read in conjunction with the detailed discussion under “Liquidity and Capital Resources.” As noted above, we expect to continue to incur operating losses in the future as we continue our product development efforts.
Comparison of the Year Ended December 31, 2008 to the Year Ended December 31, 2007
Product Sales. Product sales for 2008 increased 33% to $76,914,983 as compared to $58,045,676 for 2007. Sales growth in 2008 was primarily attributable to increased sales of VITOSS FOAM and VITAGEL product portfolios in the United States. Approximately 63% and 60% of our product sales during 2008 and 2007, respectively, were from products based upon our VITOSS FOAM platform co-developed with Kensey (see Note 15 to our consolidated financial statements included in this report for additional information). VITAGEL contributed approximately 24% of our product sales during 2008, as compared to approximately 21% of our product sales during 2007.
For 2008 and 2007, 94% and 93% of product sales, respectively, were in the U.S., primarily from sales of VITOSS, VITAGEL and IMBIBE. The remaining sales during 2008 and 2007 were a result of VITOSS, CORTOSS and ALIQUOT sales outside the U.S., primarily in Europe.
Gross Profit. Gross profit for 2008 and 2007 was $50,986,345 and $37,502,313, respectively. As a percentage of sales, gross profit was 66% for 2008, as compared to 65% for 2007. The increase in the gross margin for 2008, as compared to 2007, primarily reflects more favorable product mix and lower VITAGEL royalty expense as a percentage of product sales. Our gross margins may fluctuate from quarter to quarter based on the mix of products sold from period to period.
Operating Expenses. Operating expenses for 2008 and 2007 were $60,169,878 and $51,080,283, respectively, which represents an 18% increase from 2007 to 2008 as compared to a 33% increase in product sales and a 36% increase in gross profit from 2007 to 2008. Operating expenses for 2008 and 2007 included non-cash compensation expense of $1,271,514 and $1,220,217, respectively, related to stock options, restricted stock grants and restricted stock units awarded to employees and non-employee directors. Operating expenses were 78% and 88% of product sales for 2008 and 2007, respectively.
General and administrative expenses for 2008 remained relatively constant at $10,753,166, as compared to $10,700,612 for 2007. General and administrative expenses for 2008 included non-cash employee compensation
expense of $583,492, as compared to $832,118 for the year 2007, relating to stock options, restricted stock grants and restricted stock units awarded to employees and non-employee directors. General and administrative expenses were 14% and 18% of product sales for 2008 and 2007, respectively.
Selling and marketing expenses were $42,705,540 in 2008, a 26% increase from $33,944,777 in 2007. Selling and marketing expenses increased in 2008 primarily due to higher expenses incurred in order to support the growth, and anticipated growth of U.S product sales, and higher commissions paid in the U.S. as a result of increased product sales in 2008. Our field sales team increased from 98 employees at December 31, 2007, of which 83 were direct sales representatives, to 103 employees at December 31, 2008, of which 87 were direct sales representatives. Selling and marketing expenses for 2008 include non-cash employee compensation expense of $463,398 relating to stock options and restricted stock units awarded to employees. Selling and marketing expenses for 2007 included non-cash employee compensation expense of $306,959 and a non-cash adjustment of $355,343 relating to the change in fair value for our fully-vested non-employee consultant stock options then outstanding. Selling and marketing expenses were 56% and 58% of product sales for 2008 and 2007, respectively.
Research and development expenses increased 4% to $6,711,172 in 2008 from $6,434,894 for 2007. The increase for 2008 was primarily due to higher costs associated with our CORTOSS product development and U.S. clinical trials. Research and development expenses for 2008 included non-cash employee compensation expense of $183,041, as compared to $29,021 for 2007, relating to stock options and restricted stock units awarded to employees. Research and development expenses were 9% and 11% of product sales for 2008 and 2007, respectively.
Net other expense. Net other expense included interest income, interest expense, gain or loss on asset disposals, a one-time charge for the revenue interest obligation repurchase, revenue interest expense and an income tax benefit. We recorded $1,568,853 and $16,304,193 of net other expense for 2008 and 2007, respectively. The decrease in net other expense is primarily a result of the one-time charge of $16,605,029 for the revenue interest obligation repurchase in 2007, partially offset by increased interest expense incurred under our debt facility (see Note 8 to our consolidated financial statements included in this report) in 2008. On July 30, 2007, we repurchased the revenue interest obligation from Royalty Trust. As a result, since that date we have not been obligated to pay royalties on our products that had been subject to the revenue interest obligation, including VITOSS and CORTOSS.
Comparison of the Year Ended December 31, 2007 to the Year Ended December 31, 2006
Product Sales. Product sales for 2007 increased 24% to $58,045,676 as compared to $46,828,047 for the same period in 2006. Sales growth in 2007 was primarily attributable to increased sales of VITOSS FOAM and VITAGEL product portfolios in the U.S. as we further develop our U.S. field sales network. Approximately 61% and 60% of our product sales during 2007 and 2006, respectively, were from products based upon our VITOSS FOAM platform co-developed with Kensey Nash Corporation (see Note 13 to our consolidated financial statements included in this report for additional information). VITAGEL, which was launched at the start of 2005, contributed approximately 21% of our product sales during 2007, as compared to approximately 17% of our product sales during 2006.
For 2007 and 2006, 93% of product sales were in the U.S., primarily from sales of VITOSS, VITAGEL and IMBIBE. The remaining sales, during 2007 and 2006, were a result of VITOSS, CORTOSS and ALIQUOT sales outside the U.S., primarily in Europe.
Gross Profit. Gross profit for 2007 and 2006 was $37,502,313 and $29,045,472, respectively. As a percentage of sales, gross profit was 65% for 2007, as compared to 62% for 2006. The increase in the gross margin for 2007 as compared to 2006 primarily reflects improved manufacturing efficiencies and lower VITAGEL royalty expense. Accordingly, our gross margins may fluctuate from quarter to quarter based on the mix of products sold from period to period.
Operating Expenses. Operating expenses for 2007 and 2006 were $51,080,283 and $46,005,939, respectively, which represents an 11% increase from 2006 to 2007 as compared to a 24% increase in product sales and a 29% increase in gross profit during the same period. Operating expenses for 2007 and 2006 include executive severance of $662,000 and $0, respectively, and non-cash compensation expense of $1,220,217 and $1,562,825, respectively, related to stock options, restricted stock grants and restricted stock units. In addition, operating expenses for 2007 include a net non-cash charge of $475,770 for non-employee consultant stock options, while 2006 expenses were reduced by a non-cash fair value adjustment of $535,469 for our fully-vested non-employee consultant stock options then outstanding. Operating expenses were 88% and 98% of product sales for 2007 and 2006, respectively.
General and administrative expenses for 2007 increased 20% to $10,700,612 from $8,939,005 for 2006, primarily due to executive severance, legal costs, and charges associated with stock options and restricted stock issued to current and former Board members. General and administrative expenses for 2007 included non-cash employee compensation expense of $839,969, as compared to $631,827 for the year 2006, relating to stock options and restricted stock units awarded to employees. General and administrative expenses were 18% and 19% of product sales for 2007 and 2006, respectively.
Selling and marketing expenses were $33,944,777 for 2007, a 19% increase from $28,595,431 for 2006. Selling and marketing expenses increased for 2007 primarily due to higher salary and benefit costs incurred by expanding our field sales team in order to support the growth of U.S product sales, as well as higher commissions paid in the U.S. as a result of increased product sales in 2007. Our field sales team increased from 92 employees at December 31, 2006, of which 76 were direct sales representatives, to 98 employees at December 31, 2007, of which 83 were direct sales representatives. Selling and marketing expenses for 2007 include non-cash employee compensation expense of $306,959 relating to stock options and restricted stock units awarded to employees and a non-cash adjustment of $355,343 for our fully-vested non-employee consultant stock options outstanding. Selling and marketing expenses for 2006 included non-cash employee compensation expense of $535,646 relating to stock options and restricted stock units awarded to employees, while expenses were reduced by non-cash fair value adjustments of $499,455 for our fully-vested non-employee consultant stock options outstanding. Selling & marketing expenses were 58% and 61% of product sales for 2007 and 2006, respectively.
Research & development expenses decreased 24% in 2007 to $6,434,894 from $8,471,503 for 2006. The decrease for 2007 was primarily due to lower costs associated with our CORTOSS product development and U.S. clinical trials. Research & development expenses for 2007 included non-cash employee compensation expense of $73,289, as compared to $395,352 for the year 2006, relating to stock options and restricted stock units awarded to employees. Research & development expenses were 11% and 18% of product sales for 2007 and 2006, respectively.
Net other expense. Net other expense included a charge for the revenue interest obligation repurchase, a gain on an asset sale, interest income, interest expense, revenue interest expense and an income tax benefit. We recorded $16,304,193 and $503,172 of net other expense for 2007 and 2006, respectively. The increase in net other expense is primarily a result of the charge for the revenue interest obligation repurchase.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Currency Risk
The functional currency for our European branch operation is the Euro. The functional currency for our UK subsidiary operation is the British pound sterling. Accordingly, in accordance with SFAS No. 52, “Foreign Currency Translation,” all assets and liabilities related to this operation are translated at the current exchange rates at the end of each period. Revenues and expenses are translated at average exchange rates in effect during the period. The resulting translation adjustments are accumulated in a separate component of shareholders’ equity (accumulated other comprehensive income). Foreign currency transaction gains and losses, if any, are included in results of operations.
As of December 31, 2008, our total exposure to foreign currency risk in U.S. dollar terms was approximately $2,525,000, or 3%, of our total assets. The potential impact of a hypothetical 10% decline in the Euro foreign exchange rate would result in a total decline in the fair value of our assets of approximately $253,000 at December 31, 2008.
Market Risk
We may be exposed to market risk through changes in market interest rates that could affect the value of our short-term investments; however, we do not believe the fair value of our investment portfolio or related income would be significantly affected by changes in interest rates due mainly to the relatively short-term nature of the majority of our investment portfolio.
As of December 31, 2008 and 2007, our short-term investments consisted of highly liquid investment-grade marketable securities including corporate debt securities and government sponsored enterprise debt. The impact on our future interest income and future changes in investment yields will depend on the gross amount of our investments and various external economic factors.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements of the Company and its subsidiaries and supplementary data required by this item are attached to this annual report on Form 10-K beginning on 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, 2008. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2008 our disclosure controls and procedures are functioning effectively to provide reasonable assurance that the information required to be disclosed by us in reports filed under the Securities Exchange Act of 1934 is (i) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding disclosure.
MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of Orthovita, Inc. (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) of the Securities Exchange Act of 1934. The 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. The Company’s internal control over financial reporting includes those policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, provide reasonable assurance that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and 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.
Management evaluated the Company’s internal control over financial reporting as of December 31, 2008. In making this assessment, management used the framework established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Management’s assessment included an evaluation of the design of our internal control over financial reporting and testing of the operational effectiveness of our internal control over financial reporting. Management reviewed the results of its assessment with the Audit Committee of the Company’s Board of Directors. Based on that assessment and based on the criteria in the COSO framework, management has concluded that, as of December 31, 2008, the Company’s internal control over financial reporting was effective.
The Company’s independent registered public accounting firm, KPMG LLP, has audited the effectiveness of our internal control over financial reporting as of December 31, 2008. KPMG LLP’s report on the effectiveness of the Company’s internal control over financial reporting appears below.
Antony Koblish
Albert J. Pavucek, Jr.
Chief Executive Officer
Chief Financial Officer
March 16, 2009
Changes in Internal Control Over Financial Reporting
There have been no changes in our internal control over financial reporting during the quarter ended December 31, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
Orthovita, Inc.:
We have audited Orthovita, Inc. and subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Orthovita, Inc. and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Orthovita, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Orthovita, Inc. and subsidiaries as of December 31, 2008 and 2007, and the related consolidated statements of operations, shareholders’ equity and comprehensive loss, and cash flows for each of the years in the three-year period ended December 31, 2008, and our report dated March 16, 2009 expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
Philadelphia, Pennsylvania
March 16, 2009
ITEM 9B.
ITEM 9B. OTHER INFORMATION
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
(a) Identification of Directors
Information with respect to the members of the Board of Directors of the Company is set forth under the caption “Election of Directors” in the Company’s definitive proxy statement, to be filed within 120 days after the end of the year covered by this annual report on Form 10-K, which information is incorporated herein by reference.
(b) Identification of Executive Officers
Information with respect to the executive officers of the Company is set forth under the caption “Executive Officers of Orthovita” in the Company’s definitive proxy statement, to be filed within 120 days after the end of the year covered by this annual report on Form 10-K, which information is incorporated herein by reference.
(c) Section 16(a) Beneficial Ownership Reporting Compliance
Information with respect to the Section 16(a) compliance of the directors and executive officers of the Company is set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s definitive proxy statement, to be filed within 120 days after the end of the year covered by this annual report on Form 10-K, which information is incorporated herein by reference.
(d) Code of Conduct and Ethics
Information with respect to the Company’s Code of Conduct is set forth under the caption “Governance of the Company-Code of Conduct” in the Company’s definitive proxy statement, to be filed within 120 days after the end of the year covered by this annual report on Form 10-K, which information is incorporated herein by reference.
(e) Audit Committee Financial Expert
Information with respect to the Company’s Audit Committee Financial Expert is set forth under the caption “Governance of the Company-Audit Committee” in the Company’s definitive proxy statement, to be filed within 120 days after the end of the year covered by this annual report on Form 10-K, which information is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information required by this item is set forth under the caption “Compensation of Executive Officers and Directors” in the Company’s definitive proxy statement, to be filed within 120 days after the end of the year covered by this annual report on Form 10-K, which information is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Equity Compensation Plan Information as of December 31, 2008
The information called for by this item not contained in this annual report on Form 10-K will be set forth under the captions “Stock Ownership-Securities Ownership of Certain Beneficial Owners and Management” in our definitive proxy statement, to be filed within 120 days after the end of the year covered by this annual report on Form 10-K, and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information called for by this item not contained in this annual report on Form 10-K will be set forth under the caption “Certain Relationships and Related Transactions” in our definitive proxy statement, to be filed within 120 days after the end of the year covered by this annual report on Form 10-K, and is incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information called for by this item not contained in this annual report on Form 10-K will be set forth under the caption “Ratification of Appointment of Independent Registered Public Accounting Firm” in our definitive proxy statement, to be filed within 120 days after the end of the year covered by this annual report on Form 10-K, and is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) Documents filed as part of this Report
1. Financial Statements. The following consolidated financial statements and notes thereto which are attached hereto beginning on page have been included by reference into Item 8 of this part of the annual report on Form 10-K:
2. Financial Statement Schedules. All schedules are omitted because they are inapplicable, or not required, or the information is shown in the Financial Statements or notes thereto.
3. Exhibits. The information required by this item is set forth in the Exhibit Index hereto which is incorporated herein 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.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
Orthovita, Inc.:
We have audited the accompanying consolidated balance sheets of Orthovita, Inc. and subsidiaries (the Company) as of December 31, 2008 and 2007, and the related consolidated statements of operations, shareholders’ equity and comprehensive loss, and cash flows for each of the years in the three-year period ended December 31, 2008. 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 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Orthovita, Inc. and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Orthovita, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 16, 2009 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
/s/ KPMG LLP
Philadelphia, Pennsylvania
March 16, 2009
ORTHOVITA, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these statements.
ORTHOVITA, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these statements.
ORTHOVITA, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND
COMPREHENSIVE LOSS
ORTHOVITA, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND
COMPREHENSIVE LOSS-(Continued)
The accompanying notes are an integral part of these statements.
ORTHOVITA, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these statements.
ORTHOVITA, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. The Company:
We are an orthobiologics and biosurgery company which develops and markets novel medical devices. The orthobiologics platform offers products for the fusion, regeneration, and fixation of human bone. The biosurgery platform offers products for controlling intra-operative bleeding, also known as hemostasis. Our current fusion and regeneration products are based on our proprietary VITOSS® Bone Graft Substitute technology and address the non-structural bone graft market with synthetic, bioactive alternatives to patient- and cadaver-derived bone tissue. Our proprietary CORTOSS® Bone Augmentation Material, an injectable, polymer composite which mimics the structural characteristics of human bone, provides the basis for our fixation portfolio. CORTOSS Bone Augmentation Material is approved for certain uses in certain countries outside the U.S. and is under review for regulatory clearance in the U.S. for vertebral augmentation. Our hemostasis portfolio includes VITAGEL® Surgical Hemostat, a proprietary, collagen-based matrix that controls bleeding and facilitates healing, and VITASURE™ Absorbable Hemostat, a plant-based product that can be deployed quickly throughout surgery. We also market accessories and delivery products which complement our orthobiologics and biosurgery platforms.
We seek to expand our product portfolio through internal product development efforts, co-development efforts with strategic partners and acquisition opportunities. We employ in-house research and development personnel in support of our technology platforms. We internally developed our VITOSS and CORTOSS materials and maintain an ongoing internal research and development program. In addition, we work jointly with Kensey Nash Corporation (“Kensey”) to develop and commercialize certain orthobiologics products and we have acquired rights from third parties to market VITAGEL and VITASURE. We continue to pursue in-licensing, co-development and other opportunities to acquire complementary products and technologies to broaden our product offerings and further leverage our sales force.
In the U.S., we have assembled a field sales network of direct sales representatives and independent non-stocking distributors in order to market VITOSS, VITAGEL, VITASURE, the IMBIBE® Bone Marrow Aspiration System and the CELLPAKER® Plasma Collection System. Outside of the U.S., we primarily utilize a network of independent stocking distributors to market VITOSS, CORTOSS, ALIQUOT® Delivery System, VITAGEL and CELLPAKER.
The current economic downturn, including disruptions in the capital and credit markets, may continue indefinitely and intensify, and could adversely affect our results of operations, cash flows and financial condition or those of our customers and suppliers. These circumstances could adversely affect our access to liquidity needed to conduct or expand our business or conduct acquisitions or make other discretionary investments. These circumstances may also adversely impact the capital needs of our customers and suppliers, which, in turn, could adversely affect their ability to purchase our products or supply us with necessary equipment, raw materials or components. This could adversely affect our results of operations, cash flows and financial condition. A weakening business climate could cause longer sales cycles and slower growth, and could expose us to increased business or credit risk in dealing with customers or suppliers adversely affected by economic conditions. Our ability to collect accounts receivable may be delayed or precluded if our customers are unable to pay their obligations.
2. Summary of Significant Accounting Policies:
Preparation of Financial Statements and Use of Estimates
The preparation of the consolidated financial statements requires us to make assumptions, estimates and judgments that affect the reported amounts of assets and liabilities, the disclosures of contingent assets and liabilities as of the date of the consolidated financial statements, and the reported amounts of revenues and
expenses during the reporting periods. On an ongoing basis, we evaluate our estimates, including, but not limited to, those related to accounts receivable, inventories and realizability of intangible assets. We use historical experience and other assumptions as the basis for making estimates. Illiquid credit markets, volatile equity, foreign currency, and energy markets, and declines in consumer spending have combined to increase the uncertainty inherent in such estimates and assumptions. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in those estimates resulting from continuing changes in the economic environment, will be reflected in the financial statements in those future periods.
Basis of Consolidation
The consolidated financial statements include the accounts of Orthovita, Inc. and our wholly owned subsidiaries. We have eliminated all intercompany balances in consolidation.
Net Loss Per Common Share
We have presented net loss per common share pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings per Share.” Basic net loss per share excludes securities exercisable for or convertible into shares of common stock, and is computed by dividing net loss applicable to common shareholders by the weighted average number of shares of common stock outstanding for the period. Diluted net loss per common share data is computed assuming the conversion or exercise of all dilutive securities such as common stock options and warrants.
Equity awards and warrants exercisable to purchase 8,903,916, 8,022,051 and 9,124,280 shares were excluded from our computation of diluted net loss per common share for 2008, 2007 and 2006, respectively, because the inclusion of the shares in the calculation would have been anti-dilutive due to our losses.
Revenue Recognition
Revenue is not recognized until persuasive evidence of an arrangement exists, performance or delivery has occurred, the sales price is fixed or determinable and collection is probable. In the U.S., product sales revenue is recognized upon either shipment of purchased product to the customer, or receipt of documentation from the customer indicating its consumption of product from consigned inventory. In 2008, for transactions outside the U.S., we modified our shipping terms from FOB destination to FOB shipping point. Accordingly, outside the U.S., 2008 revenue from product sales was primarily recognized upon shipment of our product to our independent stocking distributors. Prior to 2008, we primarily recognized product sales outside the U.S. upon receipt of our product by our independent stocking distributors. We do not allow product returns or exchanges. We have no obligations to our customers once title has been transferred. Both our U.S. customers and our independent stocking distributor customers outside of the U.S. are generally required to pay on a net 30-day basis and payment discounts are not offered.
Allowance for Doubtful Accounts
We maintain an accounts receivable allowance for an estimated amount of losses that may result from a customer’s failure to pay for product purchased. The allowance for doubtful accounts is reviewed quarterly and is estimated based on historical bad debts, customer concentrations, known trends with current customers, and changes in customer payment patterns. If the financial condition of our customers or the overall condition of the healthcare industry were to deteriorate and result in an impairment of our customers’ ability to make payments, additional allowances may be required.
Inventories
Inventories are stated at the lower of cost or market value using the first-in first-out basis, or FIFO. A provision is recorded to reduce the cost of inventories to the estimated net realizable values, if required. In accordance with SFAS No. 2, “Accounting for Research and Development Costs” the costs of producing inventory in the reporting periods prior to the receipt of regulatory approval or clearance are recorded as research and development expense.
Property and equipment
Property and equipment are recorded at cost. Depreciation is calculated on a straight-line basis over the estimated useful life of each asset, generally three to five years. The useful life for leasehold improvements is generally the remaining term of the facility lease. Expenditures for major renewals and improvements are capitalized, and expenditures for maintenance and repairs are charged to operations as incurred.
Income Taxes
We account for income taxes in accordance with an asset and liability approach requiring the recognition of deferred tax assets and liabilities for the expected tax consequences of events that have been recognized in the financial statements or tax returns. Deferred tax assets and liabilities are recorded without consideration as to their ability to be realized. The deferred tax asset includes net operating loss and credit carryforwards, and the cumulative temporary differences related to certain research and patent costs, which have been charged to expense in our consolidated statements of operations but have been recorded as assets for tax return purposes. These tax assets are amortized over periods generally ranging from 10 to 17 years for tax purposes. The portion of any deferred tax asset, for which it is more likely than not that a tax benefit will not be realized, must then be offset by recording a valuation allowance against the asset.
Accounting for Stock Options Issued to Employees
We apply SFAS No. 123R, “Share-Based Payment” which requires us to expense the fair value of employee stock options and similar awards in our consolidated statements of operations. Compensation expense for awards granted prior to 2006 are being amortized based upon a graded vesting schedule in accordance with FASB Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.” Compensation expense for all stock-based compensation awards granted to employees on and after January 1, 2006 is amortized on a straight-line basis over the requisite service period of the award.
The following table sets forth the total stock-based compensation expense resulting from SFAS No. 123R included in our consolidated statements of operations for the years ended December 31, 2008, 2007, and 2006.
The fair value of stock option grants was estimated using the Black-Scholes option pricing model with the following weighted average assumptions for 2008, 2007 and 2006.
The weighted average fair value of options granted in 2008, 2007 and 2006 was $1.70, $1.61 and $2.02, respectively.
For 2008, 2007 and 2006, we calculated expected volatility based upon the historical daily closing prices of our common stock as quoted on the NASDAQ Global Market (“NASDAQ”) or NASDAQ Europe (for closing prices prior to August 2, 2000, our date of listing on NASDAQ), over a prior period having a term equal to the expected life of the stock options.
Impairment of Long-Lived Assets
SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), addresses the accounting of and reporting for the impairment of long-lived assets and for long-lived assets to be disposed of such as property, equipment, and intangibles. In accordance with SFAS No. 144, we evaluate the recoverability of long-lived assets whenever events or changes in circumstances indicate that an asset’s carrying amount may not be recoverable. Such circumstances could include, but are not limited to (1) a significant decrease in the market value of an asset, (2) a significant adverse change in the extent or manner in which an asset is used, or (3) an accumulation of costs significantly in excess of the amount originally expected for the acquisition of an asset. We measure the carrying amount of the asset against the estimated undiscounted future cash flows associated with it. If the sum of the expected future net cash flows are less than the carrying value of the asset being evaluated, an impairment loss would be recognized. The impairment loss would be calculated as the amount by which the carrying value of the asset exceeds its fair value. The fair value is measured based on quoted market prices, if available. If quoted market prices are not available, the estimate of fair value is based on various valuation techniques, including the discounted value of estimated future cash flows.
We did not recognize any impairment charges related to property and equipment or intangible assets subject to amortization during 2008, 2007 and 2006 as their carrying amounts were not impaired.
Research & Development Costs
In accordance with SFAS No. 2 “Accounting for Research and Development Costs,” we expense all research and development expenses as incurred.
Supplemental Cash Flow Information
During 2008 and 2007, we recorded $285,508 and $1,206,460, respectively, to additional paid-in-capital for the fair value of exercisable warrants in connection with entering into a senior secured note purchase facility and issuing notes thereunder.
During 2006, we issued options and warrants for the purchase of 48,398 shares of common stock with various exercise prices to certain vendors in consideration for services valued at $125,359.
We recorded a non-cash adjustment in 2008, 2007 and 2006 for the change in fair market value of our fully-vested non-employee consultant stock options outstanding. During 2008 and 2007, we exchanged 131,250 and 614,063 non employee stock options for shares of our common stock. We recorded a non-cash charge of $170,082 and $1,160,724 for 2008 and 2007, respectively, as a result of these exchanges. See Note 4.
During 2008, 2007 and 2006, we granted restricted stock awards of 28,200, 36,204 and 24,192 shares to our non-employee directors in consideration of their services. During 2008, 2007 and 2006, we recorded compensation expense of $40,122, $141,395 and $26,756, respectively, related to these awards.
In 2007 and 2006, we incurred capital lease obligations of $12,610 and $322,469, respectively. We incurred no capital lease obligations in 2008.
In 2008, 2007 and 2006, cash paid for interest expense and revenue interest expense aggregated $2,324,568, $1,358,934 and $1,424,958, respectively.
In 2008, 2007 and 2006 cash paid for income taxes aggregated $81,694, $31,942 and $52,702, respectively.
Fair Value Measurements
In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 clarifies the definition of fair value, establishes a framework for measuring fair value and expands disclosures on fair value measurements. In February 2008, the FASB issued two final staff positions (“FSP”) amending SFAS No. 157. FSP SFAS 157-1 amends SFAS No. 157 to exclude SFAS No. 13, “Accounting for Leases” and its related interpretive accounting pronouncements that address leasing transactions. FSP SFAS 157-2 delays the effective date of SFAS No. 157 until fiscal years beginning after November 15, 2008 for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis. We adopted SFAS No. 157 on January 1, 2008, except for the items covered by FSP SFAS 157-2.
SFAS No. 157 establishes a three-tier fair value hierarchy, which prioritize the inputs used in measuring fair value as follows:
•
Level 1: Observable inputs such as quoted prices in active markets;
•
Level 2: Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and
•
Level 3: Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.
Our short-term investments are reported at fair value on our consolidated balance sheet based on quoted prices in active markets for identical or comparable assets (Level 1).
Effective January 1, 2008, we adopted SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115” (“SFAS No. 159”). Under SFAS No. 159, we may elect to report certain securities and certain other items at fair value on a contract-by-contract basis with changes in value reported in earnings. We have elected not to apply the fair value option to any of our current eligible financial assets and liabilities.
Recent Accounting Pronouncements
In December 2007, the FASB issued SFAS No. 141R, “Business Combinations” (“SFAS No. 141R”) and SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements-an amendment to ARB No. 51” (“SFAS No. 160”), SFAS Nos. 141R and 160 require most identifiable assets, liabilities, noncontrolling interests, and goodwill acquired in a business combination to be recorded at “full fair value” and require noncontrolling interests (previously referred to as minority interests) to be reported as a component of equity, which changes the accounting for transactions with noncontrolling interest holders. Both statements are effective for periods beginning on or after December 15, 2008, and early adoption is prohibited. Accordingly, SFAS No. 141R will be applied to business combinations occurring on or after January 1, 2009. SFAS No. 160 will be applied prospectively to all noncontrolling interests, including any that arose before the effective date. The adoption of SFAS No. 160 is not expected to have any impact on our consolidated financial position and results of operations.
Reclassifications
Certain amounts from prior years have been reclassified to conform to the 2008 presentation.
3. Business Acquisition:
In September 2008, we purchased collagen raw materials, equipment and a technology license from Allergan, Inc. and its affiliate Allergan Sales, LLC under a supply and license agreement dated November 2007 for an aggregate purchase price of $6,552,000 in cash, which was funded through our senior secured note
purchase facility (see Note 9). We accounted for the purchase under the guidance of SFAS No. 141, “Accounting for Business Combinations”, which requires us to record the acquisition at fair value allocated among the assets purchased. The raw materials, equipment and license acquired from Allergan relate primarily to the production of our VITAGEL Surgical Hemostat product. The purchase price of $6,552,000 was allocated to the fair value of the assets purchased as follows: $980,400 of raw material inventory, $372,617 of equipment, and $5,198,983 of acquired technology. The purchase price allocation was based upon a third party independent valuation. The acquired technology will be amortized over approximately nine years, which is the estimated remaining life of the relevant VITAGEL patent. There were no liabilities assumed in the transaction.
4. Accounting for Derivative Liability Associated With Non-Employee Stock Options:
During 2006, we granted to certain consultants (i) options for the purchase of an aggregate of 25,000 shares of common stock with various exercise prices in consideration for services related to sales and marketing, and (ii) options for the purchase of an aggregate of 15,000 shares of common stock with various exercise prices in consideration for research and development services. Accordingly, we recorded $80,403 in selling and marketing expenses and $44,954 in research and development expenses in our consolidated statements of operations for 2006 for the aggregate grant date fair value of these options. These stock options were for services rendered, were fully vested on the date of grant and were valued using the Black-Scholes model on the respective dates of their grant.
Historically, the common stock options we have granted to non-employee consultants as compensation for services rendered were fully vested on the date of the grant. Upon adoption of SFAS No. 123R, during the service and vesting period, these options are accounted for under SFAS No. 123R. However, once the service period terminates, these options are then accounted for in accordance with Emerging Issues Task Force (“EITF”) No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in a Company’s Own Stock”, from the date the service/vesting period terminates through the expiration of the option or until it is exercised, whichever is earlier. In certain circumstances, these awards may have to be settled in cash. Accordingly, effective January 1, 2006, we reclassified from equity to liabilities the aggregate fair value of our fully-vested non-employee consultant stock options that were outstanding as of January 1, 2006. In addition, we are required to record a fair value adjustment at the end of each quarter for the change in the fair value of our fully-vested non-employee consultant stock options outstanding.
The following table sets forth the change in fair value of our fully vested non-employee consultant stock options outstanding included in our consolidated statements of operations for the years ended December 31, 2008, 2007 and 2006. The decreases in fair value were recorded as a reduction in expenses for the years ended December 31, 2008, 2007 and 2006 as indicated below.
Our stock price may be volatile and may fluctuate. Since we cannot determine what our stock price will be at the end of future quarters, we cannot estimate the impact of EITF No. 00-19 on our consolidated balance sheet and consolidated statements of operations in the future. An increase to our stock price as of the last day of a given quarter, as compared to our stock price as of the last day of the prior quarter, may result in an increase to the liability recorded to our consolidated balance sheet and an increase to operating expenses recorded in our consolidated statements of operations. Conversely, a decrease to our stock price as of the last day of a given
quarter, as compared to our stock price as of the last day of the prior quarter, may have the opposite effect. Additionally, any subsequent changes to the assumptions used in the Black-Scholes model to estimate the fair value of these non-employee consultant options will impact the effect of EITF No. 00-19 on our consolidated balance sheet and consolidated results of operations.
On January 1, 2006, when EITF No. 00-19 became effective for fully vested non-employee awards, we recorded the fair value of our outstanding non-employee consultant stock options as a reduction to additional paid in capital and an increase to our derivative liability in the amount of $2,267,086. The table below summarizes the changes in our derivative liability associated with non-employee consultant stock options for the period from January 1, 2006 through December 31, 2008.
The fair value of our derivative liability associated with non-employee consultant stock options was estimated using the Black-Scholes option pricing model. The weighted average fair value per share of our non-employee consultant stock options outstanding was $1.43, $1.59 and $2.02, which was based on the closing price of our stock as quoted on NASDAQ on December 31, 2008, 2007 and 2006, which was $3.39, $3.49 and $3.63 per share, respectively, and the following weighted average assumptions as of December 31, 2008, 2007 and 2006:
During 2008 and 2007, we exchanged options to purchase 131,250 and 614,063 shares of our common stock, respectively, for 131,250 and 614,063 common shares with our non-employee consultants. In connection with these exchanges, we incurred a non-cash charge of $170,082 in 2008 and $1,160,724 in 2007. On the date of exchange, the fair value of the non-employee consultant stock options was $245,835 in 2008 and $782,060 in 2007, and the value of the common stock issued was $415,917 and $1,942,784 in 2008 and 2007, respectively.
As of December 31, 2008, our non-employee consultants held fully-vested stock options to purchase 66,323 shares of our common stock, at an average exercise price of $3.35 per share and an average remaining term of approximately four years. We have classified this liability as non-current (included in other long-term liabilities) as management does not believe that it will need to be satisfied using current assets within the next twelve months.
5. Cash, Cash Equivalents and Short-Term Investments:
We invest excess cash in highly liquid investment-grade marketable securities including corporate debt securities and government-sponsored enterprise debt securities. For financial reporting purposes, we consider all highly liquid investment instruments purchased with an original maturity of three months or less to be cash equivalents. Additionally, short-term investments are considered available-for-sale and, accordingly, unrealized gains and losses are included as a separate component of shareholders’ equity. As of December 31, 2008 and 2007, all short-term investments mature within one year of the balance sheet date.
Recent U.S. sub-prime mortgage defaults have had a significant impact across various sectors of the financial markets, causing global credit and liquidity issues. The short-term funding markets have experienced instability during 2007 and 2008, leading to liquidity disruption in asset-backed commercial paper and failed auctions of auction rate securities. Further deterioration of the global credit market could adversely impact certain financial institutions that may have invested in or offered such securities. To the extent that we hold corporate bonds issued by those financial institutions in our portfolio, we could be adversely impacted and we could determine that some of our investments are impaired, which could adversely impact our financial results. As of December 31, 2008, we had not been adversely affected by these credit and liquidity issues.
At December 31, 2008 cash, cash equivalents and short-term investments consisted of the following:
Amortization of discounts and premiums related to investments resulted in income of $388,753, $832,214 and $119,197 recorded for 2008, 2007 and 2006, respectively.
6. Inventories:
As of December 31, 2008 and 2007, inventories consisted of the following:
7. Property and Equipment:
As of December 31, 2008 and 2007, property and equipment consisted of the following:
As of December 31, 2008 and 2007, property and equipment included assets designated as construction in-progress and not placed in service. These assets begin depreciating when they are eventually placed into service.
We capitalized interest cost incurred on borrowed funds used to expand our manufacturing facilities. The capitalized interest is recorded as part of the asset to which it relates and is amortized over the asset’s estimated useful life. Interest cost capitalized was $342,099 for 2008. We did not capitalize interest for 2007.
None of our assets were under capital lease at December 31, 2008 and 2007. Depreciation expense for 2008, 2007 and 2006 was $1,712,700, $1,588,823 and $1,566,517, respectively.
8. Former Revenue Interest Obligation:
In 2001, we completed a $10,000,000 product development and equity financing with Paul Capital Royalty Acquisition Fund, L.P., which was subsequently assigned to Royalty Securitization Trust I (“Royalty Trust”), which provided for the payment of revenue interest to Royalty Trust. On July 30, 2007, we repurchased the revenue interest obligation from Royalty Trust. As a result, we are no longer obligated to pay royalties on our products that had been subject to the revenue interest obligation, including VITOSS and CORTOSS. The repurchase price for the revenue interest obligation consisted of a payment of $20,000,000 in cash and 1,136,364 shares of our common stock valued at $3.32 per share, which was the market price per share on the date of the transaction. As a result of the repurchase, we recorded a charge of $16,605,029 during 2007 to account for the difference between the repurchase price valued at $23,772,729 and the $7,167,700 carrying value of the revenue interest liability on our consolidated balance sheet as of the date of the transaction. In connection with the repurchase, Royalty Trust assigned to us all of its interest under the agreements relating to the revenue interest
obligation, effectively terminating the security interest in certain of our assets and the pledge of stock of our wholly-owned subsidiary that we had granted Royalty Trust to secure our obligations under the revenue interest agreement.
In 2006 and during the period from January 1, 2007 through July 30, 2007, we paid Royalty Trust 4.375% on the portion of our product sales that specifically related to VITOSS and CORTOSS.
Throughout the term of the Royalty Trust revenue interest agreement, we were required to make advance payments on the revenue interest obligation at the beginning of each year. In March 2007, the revenue interest agreement with Royalty Trust was amended by mutual agreement to reduce the advance payment for 2007 from $3,000,000 to $1,750,000. As a result, in March 2007, Royalty Trust returned to us $1,250,000 of the $3,000,000 advance payment for 2007 that we had previously paid Royalty Trust in January 2007. As a result of our repurchase of the revenue interest from Royalty Trust on July 30, 2007, Royalty Trust retained $756,703 of the 2007 advance payment for revenue interest owed to Royalty Trust as of the repurchase date, and returned the $993,297 balance to us.
The products that had been subject to the revenue interest agreement had been marketed for only several years or were still under development. For this reason, through July 30, 2007, we could not make a reasonable estimate of future revenues and payments that could become due to Royalty Trust under this financing. Accordingly, while the revenue interest was in effect, we did not amortize any portion of the liability attributable to the revenue interest obligation, and we charged revenue interest expense in accordance with EITF No. 88-18, “Sales of Future Revenues” (EITF No. 88-18) for the revenue interest due to Royalty Trust as revenues subject to the revenue interest obligation were recognized. Revenue interest expense of $756,703 and $1,179,466 was recorded for 2007 and 2006, respectively.
9. Notes Payable and Capital Lease Obligations:
On July 30, 2007, we entered into a $45,000,000 senior secured note purchase facility with LB I Group Inc., an affiliate of Lehman Brothers Inc. Notes issued under the facility are due July 30, 2012. We initially issued $25,000,000 of our 10% senior secured notes due July 30, 2012 under the facility. The majority of the proceeds from the initial $25,000,000 principal amount note issuance was used to (i) pay to Royalty Trust the $20,000,000 cash portion of the revenue interest obligation repurchase price (see Note 8); and (ii) pay off approximately $2,000,000 of outstanding indebtedness under capital lease obligations and notes payable.
On July 31, 2008, we issued an additional 10% senior secured note in the original principal amount of $10,000,000 under the facility. We applied the proceeds of this note toward payment of (i) the $6,552,000 purchase price for the collagen raw material, equipment and technology license acquired under our supply and license agreement with Allergan during the third quarter of 2008; and (ii) costs to expand our manufacturing capacity for VITAGEL and ancillary products such as ALIQUOT, IMBIBE and CELLPAKER. As a result of our issuance of the $10,000,000 note on July 31, 2008, previously issued warrants to purchase 366,569 shares of our common stock at an exercise price of $3.41 per share became exercisable. The fair value of the warrants that became exercisable as of July 31, 2008 was $285,508 and was determined using the Black-Scholes option-pricing model. This fair value has been recorded as a debt discount against the carrying value of the notes and is being amortized into interest expense over the remaining four-year term of the facility. These warrants were previously issued upon entering into the debt facility with LB I Group Inc. in July 2007.
As of December 31, 2008, we had the option through January 30, 2010 to issue, under the debt facility, up to an additional $10,000,000 aggregate principal amount of 10% senior secured notes due July 30, 2012 to fund working capital and other general business purposes, including product acquisitions, sales force expansion and product development, if certain conditions are met, including:
(1) our consolidated net revenues for the most recently ended four consecutive quarterly periods are at least $45,000,000; and
(2) we have not exercised our option to prepay any of the notes outstanding under the facility.
However, in September 2008, Lehman Brothers Holding Inc., an affiliate of LB I Group, filed for bankruptcy relief under Chapter 11 of Title 11 in the U.S. Bankruptcy Court. Accordingly, as an affiliate of Lehman Brothers Holding Inc., LB I Group may not be able to advance any additional funds under the debt facility.
Borrowings under the facility are guaranteed by us and one of our wholly-owned subsidiaries. The facility is secured by a first priority lien on substantially all of our assets (including intellectual property) other than those exclusively related to CORTOSS and ALIQUOT. We are required to make quarterly interest only payments to the note holder. Upon the occurrence of various events, including our receipt of (i) proceeds in excess of 5% of our total assets for certain asset dispositions; (ii) more than $1,000,000 in aggregate cash insurance proceeds for damaged or destroyed property that is not applied to the repair or replacement of the property within one year; or (iii) more than $7,500,000 in gross cash proceeds from judgment awards or settlements, the note holders are entitled to prepayment of the outstanding principal amount of the notes to the extent of the net cash proceeds that we receive. We may prepay at any time any part of the outstanding balance under the notes, in a minimum amount of $2,000,000 and in increments of at least $1,000,000 in excess of such minimum, together with interest accrued thereon. Both mandatory and optional prepayments are subject to a prepayment premium of up to 16% of the principal balance of the notes then outstanding, depending on the timing of the prepayment. The unpaid principal amount under the notes and accrued interest and all other obligations shall become due and payable immediately if we are insolvent, are in bankruptcy proceedings or have a custodian or receiver appointed for any substantial part of our property. If an event of default not described in the preceding sentence occurs and is continuing (including a change of control of the Company), then the holders of at least two-thirds in principal amount of notes then outstanding may declare the unpaid principal amount of the notes, accrued interest and all other obligations due and payable immediately. In addition, if the notes become due and payable, whether automatically or by declaration, by reason of any of the following events of default, then we must pay a prepayment premium of up to 16% of the principal balance of the notes then outstanding, depending on the timing of the prepayment:
•
We fail to pay any principal on any note or prepayment premiums, if any, when due and payable;
•
We fail to pay any interest on any note or other amount (other than principal or prepayment premiums) for more than three business days after becoming due and payable;
•
We are insolvent, in bankruptcy proceedings or have a custodian or receiver appointed for any substantial part of our property; or
•
A change of control of the Company occurs, which is defined as (i) any person becoming a beneficial owner, directly or indirectly, of Company securities representing more than 50% of the voting power of the then outstanding securities of the Company (excluding transactions in which the Company becomes a subsidiary of another corporation and in which the Company’s shareholders immediately prior to the transaction will beneficially own, immediately after the transaction, shares entitling the shareholders to more than 50% of all votes to which all shareholders of the parent corporation would be entitled in the election of directors); (ii) the consummation of a merger or consolidation of the Company with another corporation where the Company’s shareholders immediately prior to the transaction will not beneficially own, immediately after the transaction, shares entitling the shareholders to more than 50% of all votes to which all shareholders of the surviving corporation would be entitled in the election of directors; (iii) the consummation of a sale or other disposition of all or substantially all of the Company’s assets; (iv) a liquidation or dissolution of the Company; or (v) individuals who, as of July 30, 2007, constituted the Company’s board of directors (the “Incumbent Directors”) ceasing for any reason to constitute at least a majority of the board; provided that any person becoming a director subsequent to July 30, 2007 and whose election or nomination for election to the board was approved by a vote of at least a majority of the Incumbent Directors who are directors at the time of such vote shall be deemed an Incumbent Director.
Under the facility, we must comply with various financial and non-financial covenants. Under the financial covenant, we are required to maintain a minimum cash balance equal to at least 25% of the then outstanding
principal amount under the notes in a separate interest-bearing deposit or other similar demand investment account that is pledged as collateral for the loan. As of December 31, 2008, we must maintain a minimum cash, cash equivalents, and short-term investments of $8,750,000. If the balance in the separate account falls below an amount equal to 40% of the principal amount outstanding under the notes, we must obtain and maintain for the benefit of favor of the note holders a letter of credit in the amount of 25% of the principal amount outstanding under the notes. As of December 31, 2008, we must maintain a minimum balance of $14,000,000 in our cash, cash equivalents, and short-term investments in order to avoid obtaining a letter of credit, and currently we are not required to obtain a letter of credit. The primary non-financial covenants limit our ability to incur indebtedness or liens, sell assets, conduct mergers or acquisitions as defined in the facility terms, make investments and pay dividends.
Outstanding principal amounts under the notes bear annual interest at 10%, provided that interest shall accrue at the rate of 12% per year during the continuance of any event of default and shall be payable on demand.
In connection with entering into the facility, we issued to the note purchaser five-year warrants to purchase 1,466,276 shares of our common stock at an exercise price of $3.41 per share, of which warrants to purchase 1,099,707 shares are currently exercisable. The unexercisable warrants shall become exercisable ratably upon future issuances of the 10% senior secured notes under the facility. The fair value of the exercisable warrants of $1,491,968 was determined using the Black-Scholes option-pricing model. Of this amount, $1,206,460 for exercisable warrants to purchase 733,138 shares was recorded on our consolidated balance sheet at inception as a discount to the initial loan amount of $25,000,000 and is being amortized into interest expense over the five-year term of the facility. In addition, $285,508 for exercisable warrants to purchase 366,569 shares was recorded on our consolidated balance sheet on July 31, 2008 as a discount to the $10,000,000 borrowed on July 31, 2008 and is being amortized into interest expense over the remaining four year term of the facility. At December 31, 2008, the unamortized debt discount to the loan amount related to the warrants totaled $1,191,394. The carrying value of the note on our consolidated balance sheet was $33,808,606 and $23,895,376 as of December 31, 2008 and 2007, respectively.
As of December 31, 2008, we had $35,000,000 outstanding under the facility, and had accrued $875,000 in interest thereon.
Borrowing obligation maturities as of December 31, 2008 are as follows:
Interest expense on notes payable and capital lease obligations was $2,776,953, $1,342,173 and $245,492 for 2008, 2007 and 2006, respectively.
Capital Lease Obligations
We had no capital lease obligations outstanding as of December 31, 2008 and 2007. During 2007 and 2006, we entered into an aggregate of $12,610 and $322,469 of capital leases, respectively. The terms of these leases originally ranged from 42 months to 60 months with annual interest rates ranging from 7.37% to 13.39%. The leases were secured by the underlying equipment.
10. Other Accrued Expenses:
As of December 31, 2008 and 2007, other accrued expenses consisted of the following
11. Profit Sharing Plan:
We have a Section 401(k) plan for all qualified employees, as defined. Our contributions are discretionary and determined annually and were $667,409, $479,580, and $390,669 for 2008, 2007 and 2006, respectively.
12. Shareholders’ Equity:
Common Stock
During 2008, we issued 6,700 shares of common stock valued at $20,971 for consulting services rendered, pursuant to consultant services agreements.
In July 2007, we sold 12,317,066 shares of our common stock in a private placement transaction for net proceeds of $32,198,758. We also issued 1,136,364 shares of our common stock in July 2007 as partial consideration for the repurchase of our revenue interest obligation to Royalty Trust (See Note 8). We also incurred costs of $44,996 in 2007 associated with prior sales of our common stock.
During 2007, we issued 3,791 shares of common stock valued at $11,410, for consulting services rendered, pursuant to consultant services agreements.
During 2006, we sold 8,819,128 shares of our common stock in a registered underwritten offering for net proceeds of $26,573,492.
Equity Compensation Plan
We have an equity compensation plan (the “Plan”) that provide for incentive and nonqualified stock options, restricted stock awards, restricted stock units and other equity incentives to be granted to directors, employees, and consultants. The Plan has been approved by our shareholders.
As of December 31, 2008, there were 13,850,000 shares authorized for issuance under our Plan with 2,308,903 underlying shares available for grant and 7,442,640 of underlying shares currently outstanding.
Performance-based Equity Awards
In September 2008, we issued grants of performance-based equity awards under our Plan to certain executive officers under which up to an aggregate 421,200 shares of our common stock, valued at $2.68 per share, may be issued. The number of shares of common stock payable under each award is dependent upon our achievement of certain revenue amounts from U.S. sales of CORTOSS Bone Augmentation Material and related delivery systems during the twelve-month period commencing with the first calendar month immediately
following the date on which the U.S. Food and Drug Administration grants 510(k) clearance for the use of CORTOSS in vertebral augmentation. The performance-based equity awards were valued on the date of grant and will be recognized as compensation expense based on the most probable achievement of revenue amounts after we receive the above-mentioned 510(k) clearance. The performance-based equity awards will be null and void if the 510(k) clearance for COROTSS is not received on or before September 17, 2011. Because the performance-based equity awards also require ongoing future service, we will recognize compensation over a 3 year period subsequent to the 510(k) clearance date. These shares will vest 50% on the first anniversary date of 510(k) clearance and 50% on the second anniversary date, provided the recipient remains continuously employed with us through the vesting date. As of December 31, 2008, we had not achieved any of the performance conditions related to these awards and therefore did not recognize any expense in the year 2008.
Restricted Stock and Restricted Stock Units
We did not issue any restricted common stock units to our employees during 2008. During 2007, we issued an aggregate of 318,332 restricted common stock units valued at $1,040,946 to certain employees. These units vest 50% on each of the second and fourth anniversaries of the date of issuance. As of December 31, 2008, 269,666 restricted common stock units were outstanding.
During 2008, 2007 and 2006, we issued restricted common stock awards for an aggregate of 28,200, 36,204 and 24,192 shares, respectively, to our non-employee directors in consideration of their services. These shares were valued at $66,270, $104,992 and $89,994, respectively. With respect to the shares granted in 2008, the shares vest in equal one-third installments on each anniversary of the date of grant, or earlier upon either (i) a change of control of the Company, (ii) the recipient’s death or (iii) the recipient’s departure in good standing from our board of directors provided he or she served on the board for at least five years or the sum of his or her age and length of services is at least 65. The shares granted in 2007 and 2006 vest on the five year anniversary of the date of grant, or earlier upon a change of control of the Company or when the recipient no longer serves on our board of directors. As of December 31, 2008, 71,448 restricted common shares were outstanding.
We have $413,984 of unrecognized cost related to unvested restricted stock and restricted stock units as of December 31, 2008 which is expected to be recognized over a weighted average period of approximately 2.3 years. The compensation expense recorded for these awards during 2008, 2007 and 2006 was $368,203, $431,221 and $26,997, respectively.
Common Stock Options
Options are granted with exercise prices equal to or greater than the fair market value of the common stock on the date of grant. Generally, incentive stock options become exercisable in equal installments over a four-year period and nonqualified stock options to non-employee consultants are fully vested at the date of grant. The options generally remain exercisable for a maximum period of ten years.
In July 2006, we issued to our non-employee directors options to purchase 60,000 shares of our common stock in the aggregate. These options have an exercise price of $3.72 per share, vested as to 50% of the underlying shares on the date on grant and vest as to 25% of the underlying shares on each of the two successive anniversaries of the date of grant.
In March 2007, we issued options to purchase 25,000 shares of our common stock to a non-employee director in connection with his appointment to our board of directors. These options have an exercise price equal to $2.83 per share, were fully vested upon grant and expire 10 years after the date of grant.
In June 2007, we issued to our non-employee directors options to purchase 70,000 shares of our common stock in the aggregate. These options have an exercise price of $2.90 per share, vested as to 50% of the underlying shares on the date on grant and vest as to 25% of the underlying shares on each of the two successive anniversaries of the date of grant.
In July 2007, we issued options to purchase an aggregate 50,000 shares of common stock to two new non-employee directors appointed to our board of directors. These options have an exercise price equal to $3.32 per share, were fully vested upon grant and expire 10 years after the date of grant.
In July 2008, we issued to our non-employee directors options to purchase 84,000 shares of our common stock in the aggregate. These options have an exercise price of $2.35 per share and vest as to 25% of the underlying shares on each of the four successive anniversaries of the date of grant.
We had $3,005,342 of unrecognized compensation cost related to unvested stock options as of December 31, 2008 which is expected to be recognized over a weighted average period of approximately 2.9 years.
For all options outstanding as of December 31, 2008, the weighted average exercise price per share was $3.55 with a weighted average remaining contractual life of approximately 6.5 years and an aggregate intrinsic value of $1,428,431.
For all options exercisable as of December 31, 2008, the weighted average exercise price per share was $3.78 with a weighted average remaining contractual life of approximately 5 years and an aggregate intrinsic value of $632,722.
Summary stock option information is as follows:
Additional information regarding stock options as of December 31, 2008 is as follows:
During 2006 and 2005, we granted stock options to certain consultants in consideration for various services (see “Accounting for Derivative Liability Associated with Non-Employee Stock Options”, above in Note 4).
Employee Stock Purchase Plan
In 2008, we amended and restated our Employee Stock Purchase Plan (the “ESPP”) that was originally established in 1998 to provide eligible employees an opportunity to purchase our common stock. Under the terms of the ESPP, eligible employees may have up to 10% of eligible compensation deducted from their pay to purchase common stock. As part of the amendment and restatement of the ESPP in 2008, we authorized an additional 200,000 shares of our common stock for issuance under the ESPP, and extended the term of the ESPP to 2018. The per share purchase price under the ESPP is 95% of the closing price of our common stock as reported on NASDAQ on the last trading day of each calendar quarter. There were 75,361, 42,394, and 28,061 shares purchased under the ESPP during 2008, 2007 and 2006, respectively, for cash proceeds of $185,296, $125,055 and $102,253, respectively. As of December 31, 2008, there were 500,000 shares of our common stock authorized for issuance under the ESPP, of which 218,345 shares were available for purchase and issue.
Common Stock Purchase Warrants
On July 30, 2007, we issued five-year warrants to purchase 1,466,276 shares of our common stock at an exercise price of $3.41 per share in connection with entering into a senior secured note purchase facility (See Note 9). Of these, warrants to purchase 1,099,707 shares are currently exercisable. The unexercisable warrants shall become exercisable ratably upon future issuances of notes under the facility, if any. These warrants expire in July 2012.
During 2007, warrants to purchase 10,000 shares of common stock were exercised for gross proceeds of $17,500. During 2008, warrants to purchase 1,100,787 shares of common stock at an exercise price of $3.53 per share expired.
13. Product Sales:
For 2008, 2007 and 2006, product sales by geographic market were as follows:
Approximately 63%, 61%, and 60% of our product sales during 2008, 2007 and 2006, respectively, were from products based upon our VITOSS FOAM platform co-developed with Kensey (see Note 15). VITAGEL contributed approximately 24% of our product sales during 2008, as compared to approximately 21% and 17% of our product sales during 2007 and 2006, respectively.
14. Income Taxes:
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
The asset and liability method requires that deferred tax assets and liabilities be recorded without consideration as to their realizability. The portion of any deferred tax asset for which it is more likely than not that a tax benefit will not be realized must then be offset by recording a valuation allowance. A valuation allowance has been established against all of our deferred tax assets, with the exception of the Texas margin tax credit, as it is we have determined not more likely than not to be realized given our history of operating losses. The deferred tax asset primarily includes net operating loss and tax credit carryforwards, accrued expenses not currently deductible and the cumulative temporary differences related to certain research and patent costs, which have been charged to expense in the accompanying statements of operations but have been recorded as assets for income tax purposes.
The components of income taxes are as follows:
Reconciliation between the provision (benefit) for income taxes, computed by applying the statutory federal income tax rate of 34% to income before income taxes, and the actual provision (benefit) for income taxes follows:
Components of our deferred tax asset as of December 31, 2008 and 2007 were as follows:
In October 2008, the United States Congress enacted the Housing Assistance Act of 2008 (Public Law 100-289), which enabled us to make a federal tax election to claim accelerated research tax credits in lieu of bonus depreciation. As a result of Public Law 110-289, we recognized a current income tax benefit of $54,856 in the fourth quarter of 2008.
In 2006, Texas enacted a margin tax which restructured the state business tax by replacing the taxable capital components of the current franchise tax with a new “taxable margin” component. The Texas margin tax was effective for taxable years ended on or after January 1, 2007. As a result of the Texas margin tax during 2008 and 2007, we recognized current state income tax expense of $45,216 and $35,000, respectively, and a deferred state income tax benefit of $296,006 and $302,980, respectively, for the Texas temporary credit on taxable margin. Under the Texas margin tax, we have the right to claim a temporary credit against our Texas margin tax liability over a 20 year period. As a result, we have recorded a deferred tax asset of $296,006 as of December 31, 2008, which is included in Other Assets on our consolidated balance sheet. We have recognized a deferred tax asset related to the Texas tax credit as we believe it will more likely than not to be realized based on projections of future Texas margin tax liabilities.
As of December 31, 2008, we had approximately $119,280,000 of federal net operating loss carryforwards, $103,600,000 of state net operating loss carryforwards and $11,535,000 of foreign net operating loss carryforwards. Federal net operating loss carryforwards begin to expire in 2009 while the state net operating carryforwards have begun to expire. The foreign net losses have an unlimited carryforward period. The amount of U.S. federal net operating loss and credit carryforwards which can be utilized in any one period may be limited by federal and state income tax regulations, since a change in ownership as defined in Section 382 and 383 of the Internal Revenue Code may have occurred in prior years. The amount of net operating loss carryforwards which can be utilized in any one period on the Pennsylvania corporate income tax return is limited to the greater of $3,000,000, or 12.5%, of apportioned net taxable income beginning in 2007. Federal and Pennsylvania research and development tax credits of $1,531,000 and $253,000 begin to expire in 2010 and 2014, respectively. The Texas margin tax temporary credit of $296,006 has a carryforward period of 20 years.
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position reported or expected to be reported on a tax return. FIN 48 also provides guidance on the recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We adopted the provisions of FIN 48 on January 1, 2007. Upon adoption of FIN 48 and through December 31, 2008, we determined that we had no liability for uncertain income taxes as prescribed by FIN 48. Our policy is to recognize potential accrued interest and penalties related to the liability for uncertain tax benefits, if applicable, in income tax expense. The adoption of FIN 48 did not have an impact on the Company’s results of operations and financial position.
15. Commitments and Contingencies:
Operating Leases
We lease facilities under non-cancelable operating leases. During 2008 we extended our operating leases through July 2017 for space located in the Great Valley Corporate Center in Malvern, Pennsylvania. For 2008, 2007 and 2006, our lease expense was $783,238, $689,826 and $563,810, respectively. At December 31, 2008, future minimum rental payments under operating leases are as follows:
Agreement with Kensey Nash Corporation.
In March 2003, we entered into an agreement with Kensey to jointly develop and commercialize certain biomaterials-based products based upon our VITOSS platform. The new products to be developed under this agreement are based on our internally developed proprietary VITOSS bone void filler material in combination with proprietary resorbable Kensey biomaterials. Kensey has the exclusive right to manufacture any approved or cleared jointly developed product under the agreement, and we will market and sell the product worldwide. This right extends until February 2014 for the VITOSS FOAM product platform. Following the regulatory approval or clearance of each new product under the agreement, we have obligations to pay Kensey for manufacturing the product and make royalty payments to Kensey based on the net sales of such product. In December 2003, we received 510(k) clearance from the U.S. Food and Drug Administration (“FDA”) for the first jointly developed product platform, VITOSS FOAM, and we commenced sales on the first of several product configurations under the VITOSS FOAM product platform during February 2004.
During 2008, 2007 and 2006, we purchased $7,887,419, $8,194,360 and $3,624,662, respectively, of product inventory manufactured by Kensey on our behalf. As of December 31, 2008 and 2007, we owed Kensey $3,154,552 and $2,569,004, respectively, for manufactured product inventory and royalties, which are included in accounts payable and other accrued expenses on our consolidated balance sheets. All product royalty expense payable to Kensey is included in cost of sales on our consolidated statements of operations as we recognize product sales revenue from our customers.
In addition, we pay royalties to Kensey on our VITOSS Bone Graft Substitute product sales, based on a royalty arrangement that Kensey purchased from the product’s co-inventor effective April 2004, up to an aggregate payment of $5,000,000. From inception of the royalty arrangement through December 31, 2008, we have made aggregate royalty payments of $2,614,106.
Agreement with Medafor
In April 2008, we obtained certain non-exclusive rights in the United States and in certain limited territories outside of the United States to distribute VITASURE pursuant to an agreement with Medafor. We purchased $1,000,000 of VITASURE product inventory from Medafor and launched the VITASURE product during the third quarter of 2008. Under the agreement, if certain conditions are met, we are required to purchase and pay for $1,000,000 of additional VITASURE product from Medafor in the third quarter of 2009.
Product Development Milestones
In 2009, we contractually agreed to make milestone payments upon achievement of specified goals in connection with the development of new products with one or more business partners. The timing and actual amount of these payments can be difficult to determine as these payments depend upon satisfactory achievement of product development and other milestones, which will be determined based on events that may occur in the future. As of the date of the filing of this report, we have paid approximately $1,200,000 in 2009 for non-recurring license fees and product development milestones pursuant to contractual obligations that we incurred in 2009. Additional milestone payments may become due in 2009 if certain other milestones are met during the year. We expect to incur between $1,000,000 and $2,000,000 for milestone payments during 2009 in addition to those already paid for research and development activities. In addition, if products under development are brought to market, we may be obligated to make certain launch-related milestone payments of up to $1,000,000, as well as additional payments which may be made depending upon the potential achievements of sales milestones in the future.
16. Agreements with Angiotech Pharmaceuticals, Inc.
In June 2004, we entered into a distribution agreement with Angiotech to distribute to surgical customers throughout North America the CoStasis® composite liquid hemostat (which we re-branded as VITAGEL Surgical Hemostat) and the CELLPAKER® plasma collection system used in conjunction with VITAGEL. Under the distribution agreement, we purchased the products from Angiotech and paid royalties based on the net sales of such products. During the third quarter of 2005, the distribution agreement was amended to provide for the transition of product and accessory manufacturing responsibility from Angiotech to us, and we purchased all available existing VITAGEL and CELLPAKER products, accessories and work-in-process from Angiotech for $1,800,000. Effective January 1, 2006, we entered into a license agreement with Angiotech pursuant to which Angiotech licensed VITAGEL products and the CELLPAKER plasma collection system to us and we assumed manufacturing responsibility for these products. In the second half of 2006, we obtained pre-market approval (“PMA”) from the FDA to sell VITAGEL manufactured at our Malvern, Pennsylvania facility (the “VITAGEL PMA”) and started to market and sell VITAGEL manufactured by us. In January 2007, we obtained approval from the FDA for a PMA supplement which enables us to market and sell CELLPAKER manufactured at our subcontractor’s facility. In accordance with its terms, the distribution agreement terminated in the first quarter of 2007 upon completion of the sale of all VITAGEL and CELLPAKER inventory products that we purchased from Angiotech in the third quarter of 2005. Until December 29, 2006, we paid royalties on sales of the VITAGEL and CELLPAKER inventory that we purchased from Angiotech in the third quarter of 2005 in accordance with the terms of the distribution agreement.
On December 29, 2006, pursuant to a royalty sale agreement with Angiotech, we purchased the profit-sharing royalty rights for VITAGEL and CELLPAKER products under the license agreement for $9,000,000 in cash. Concurrently with this purchase, we amended and restated our license agreement with Angiotech to eliminate our obligations to meet minimum sales requirements, extend the term of the license from December 31, 2014 through July 31, 2017, and eliminate certain termination rights in favor of Angiotech. Under the amended and restated license agreement, we have exclusive rights to manufacture, market and sell VITAGEL products throughout the world for orthopedic indications, and non-exclusive rights to manufacture, market and sell CELLPAKER products throughout the world for all indications. Under the amended and restated license agreement, Angiotech has an option for co-exclusive rights outside the orthopedic field which, if exercised, would permit Angiotech to manufacture, market and sell an Angiotech-branded VITAGEL product throughout the world. Until Angiotech elects to exercise its option for co-exclusive rights, we have exclusive rights to manufacture, market and sell VITAGEL outside of the orthopedic field throughout the world. If Angiotech elects to exercise its options, we would then have co-exclusive rights to manufacture, market and sell VITAGEL outside of the orthopedic field throughout the world. Prior to the amendment and restatement of the license agreement on December 29, 2006, we were required to make royalty payments thereunder based on a share of all revenue we received from net sales of VITAGEL and CELLPAKER products that we manufactured. The $9,000,000 payment has been recorded as a License Right Intangible on the accompanying consolidated balance sheet. This amount is being amortized based upon the greater of (a) straight-line amortization through July 31, 2017, or (b) actual units sold in a given period in relation to the total estimated units to be sold over the expected life of the applicable patent, which is July 31, 2017.
During 2006, we purchased $64,944 of product inventory from Angiotech. We did not purchase any product inventory from Angiotech in 2008 or 2007. As of December 31, 2008, we did not owe Angiotech any amounts for manufactured product inventory or royalties. Amortization of $850,392 for the license right intangible was recorded during each of 2008 and 2007, and is included in cost of sales on the accompanying consolidated statements of operations.
17. Quarterly Financial Data (Unaudited):
18. Valuation and Qualifying Accounts:
(1) Represents write-offs of specific accounts receivable.
19. Gain on Sale of Assets
On February 15, 2007, we sold our assets associated with the Endoskeleton TA Vertebral Body Replacement structural device product line for $458,480, which was recorded as a gain of $372,375 on the sale of assets during 2007. As a result of the sale, we no longer manufacture or sell Endoskeleton products. We recorded revenue of $902,593 in 2006 for sales of Endoskeleton products. We did not record any revenue in 2008 or 2007 for sales of Endoskeleton products.
EXHIBIT INDEX
* Constitutes management contract or compensatory plan or arrangement required to be filed as an exhibit to this form.
(1) Filed herewith.
(2) Filed as an Exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 2000 and incorporated herein by reference.
(3) Filed as an Exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 2002 and incorporated herein by reference.
(4) Filed as an Exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 and incorporated herein by reference.
(5) Filed as an Exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 2007 and incorporated herein by reference.
(6) Filed as an Exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004 and incorporated herein by reference.
(7) Filed as an Exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2005 and incorporated herein by reference.
(8) Filed as an Exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2006 and incorporated herein by reference.
(9) Filed as an Exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2007 and incorporated herein by reference.
(10) Filed as an Exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2008 and incorporated herein by reference.
(11) Filed as an Exhibit to the Company’s Current Report on Form 8-K filed on June 30, 2004 and incorporated herein by reference.
(12) Filed as an Exhibit to the Company’s Current Report on Form 8-K filed on December 7, 2006 and incorporated herein by reference.
(13) Filed as an Exhibit to the Company’s Current Report on Form 8-K filed on March 12, 2007 and incorporated herein by reference.
(14) Filed as an Exhibit to the Company’s Current Report on Form 8-K filed on July 31, 2007 and incorporated herein by reference.
(15) Filed as an Exhibit to the Company’s Current Report on Form 8-K filed on December 27, 2007 and incorporated herein by reference.
(16) Filed as an Exhibit to the Company’s Current Report on Form 8-K filed on September 18, 2008 and incorporated herein by reference.